Creating entities for distressed property loans is an effective way for banks to clean up their balance sheets But such “bad banks’ need freedom to structure deals and define their market role
There are good reasons to suppose that the current eurozone and UK financial crises are founded in the real estate industry. They are certainly the result of a badly fractured banking system; this fracture is in part caused by challenged and distressed real estate loan portfolios and equity positions – both intentionally and unintentionally obtained.
In response, a number of organisations have established, within a good bank, a “bad bank”. This split is straightforward and, on the face of it, sensible. In reality, it is fraught with difficulty. The senior management of the bank is faced with such dilemmas as:
• how should the bank’s capital be allocated between the two components of the business?
• which clients belong in which part of the bank?
• how can the necessary policy differences between the good and bad banks be reconciled?
• how do you deal with “bad assets” forcefully when you have continuing social and relationship banking responsibilities?
Perhaps the more fundamental point is that, in a highly challenging property market, the regulatory and capital frameworks in which banks are required to operate inhibit the use of innovative work-out structures. For example, history has shown that joint ventures with new sponsors are a very effective way for banks to deal with distressed assets – particularly in the case of operating real estate such as hotels and care homes. Such structures mean the lender can retain an important voice in how the asset is managed and, critically, share in any value recovery over time.
The benefits of freedom
Empirical observation suggests that people charged with working out or restructuring bad debt need freedom in a variety of guises. First, they need to be free to handle each case on its merits without regard to client relationships or the need to generate new business. Second, they need to be free of regulatory regimes that are not fit for the purpose of dealing with challenged assets. Third, they need the freedom that comes when the market is clear on your role: that is, to deal with legacy, full stop.
Finally, they need to be free of time constraints, since once a market knows a vendor is a forced seller, prices often drop.
We can learn from the clear segregation of challenged assets from the originating organisation and freedom from the then-current regulatory regime. Organisations such as the Resolution Trust Corporation, set up by the US government at the end of the 1980s to deal with the fallout from the savings and loan industry crisis, Nama and UK Asset Resolution have demonstrated that superior progress is made when vehicles have a clear mandate and relative freedom to structure transactions.
Though each of these organizations has been criticised, the fact is that they have all been able to demonstrate better progress than those organisations that seek to manage both the good and the bad together. In the UK there is an urgent need to deal with the challenged portfolios that are now not only preventing recovery but also are contributing to further drops in value.
It is an over-simplification to lay the dearth of transactions at the banks’ door, but it is the case that the difficulty the banks are having in reducing their bad loan books is forcing them to allocate more capital to the problem, so there is less bank debt available to fund new deals.
It seems to be a catch-22 situation at present: lenders are concerned that if they sell assets at distressed prices, then the value of their assets is impaired further; yet if they do not dispose of assets, they are not freeing up capital or real estate market exposure capacity and thus the debt drought will continue.
This sounds to me like another copper-bottomed argument for removing the legacy from within the good banks into a completely separate vehicle. It is only in this way that there can be any market stimulus. The simple answer to this is that if there is a wholesale transfer of portfolios at a low value, the market will “tank”. The contrarian view is that, if well executed – and there is much to learn from “bad bank” initiatives from Europe, Asia and the Americas – it can actually be the catalyst for renewed market growth.
An additional advantage
The establishment of more vehicles that are outside the banking sector would have the additional advantage of making a whole lot of bankers’ lives more useful. Though not currently a popular sentiment, it is one which needs to be embraced – for everyone’s benefit.
Robin Priest is a senior adviser at Alvarez & Marsal
