Breaking the bonds

Two real estate financing units of German banks have been in the news recently, for the wrong reasons. Firstly, in December WestLB, which had been hoping to sell Westdeutsche ImmobilienBank (WestImmo), finally rejected a buy-out deal for its subsidiary from US-based private equity group Apollo Global Management rumoured to be worth in the region of EUR 400 mln - but rather less than the EUR 700 mln they had been hoping for. WestLB had originally been ordered to sell the unit by the end of 2011 by the European Commission in return for a EUR 5.4 bln bail-out in October 2008 following the collapse of Lehman Brothers. According to WestLB, it was disagreements over potential liabilities resulting from the sale, the low price and the market situation that had combined as factors precluding the sale. In a press statement, Dietrich Voigtländer, the chairman of WestLB's management board, said: "It was our declared aim to bring the sale negotiations to a conclusion, also with a view to preserving jobs. However, the further deterioration in the market environment and the economic valuation leave us no choice. The transaction and above all extended liability risks would be untenable for the bank and its owners." With Apollo being the last remaining bidder for WestImmo, it would appear that the only course open now for WestLB is to place the unit into a ?bad-bank' for liquidation.
The other German property financing unit hitting the recent headlines was Eurohypo, a subsidiary of Commerzbank, which according to media reports has given up on plans to sell it to the state or to a bad-bank. In November it was announced that Eurohypo would cease lending and re-focus on its portfolio in Germany and Poland, subject to a review. Commerzbank needs to raise EUR 5.3 bln in fresh equity as demanded by the European Banking Authority by June 30th, but is now apparently looking to achieve this by limiting real estate loans and by absorbing Eurohypo. The latter step would require EC permission, since Commerzbank has been ordered to offload the loss-making unit by 2014 under an EU-restructuring plan.

Moodier ratings
Another blow to the prospects for Commerzbank and Eurohypo came on January 20th, when Moody's downgraded both institutions: Commerzbank AG and Irish-registered Commerzbank Europe's ratings both fell from C- to D+ to reflect "the rising risk and earnings constraints stemming from Eurohypo's exposures and persistent loss generation", while Eurohypo's rating sank to E+ from D- due to the "fragility of its franchise", the risk of further losses due to Greek debt exposure, its reliance on Commerzbank for funding, and the prospect of regulatory changes adversely affecting its business model. At the end of last June Eurohypo was still burdened with EUR 60 bln in risk-weighted assets. The problem Commerzbank has with selling Eurohypo to the German government seems to have been that it would be regarded as state aid and another bail-out, thus further eroding confidence in the bank. The future looks bleak for both WestImmo and Eurohypo, who pre-credit crunch were both heavily involved in real estate financing in the CEE region. Both are funded to a significant extent by Pfandbriefe - covered bonds strictly regulated by the German state. Such bonds had come in for some criticism prior to the collapse of Lehman for the inflexibility of the rules governing them - as opposed to the less regulated, uncovered corporate bonds. Later, however, as the market for uncovered bonds dried up, Pfandbriefe were heralded as a much more secure form of bank funding.In the wake of Eurohypo and WestImmo's recent troubles, the question is: have Pfandbriefe failed to be the great hope for the German banking sector?

Rush for cover
As one of the directors of a German real estate lender explains: "Pfandbrief bonds are the main pillar of our funding, but we also rely on uncovered corporate bonds - and it is this part of our and the financial industry's funding that has shrunk considerably after the collapse of Lehman Brothers. Investors became extremely shy - their preception was that products were not priced appropriately and they could not assess the risks any more. As a result, corporate bonds have not been in demand for a very long time." As he explains, covered bonds are still in demand and continue to constitute a liquid investment. "Even when investors are nervous about governments and sovereign debt, most of the Pfandbriefe issues have still retained their triple-A rating. Now investors are asking very detailed questions and higher due diligence is required," he explains.
An expert on Pfandbriefe we spoke to agrees: "I don't think Pfandbriefe are part of the current problems with the German banking sector. In fact, they are part of the solution. Bank capital right now is very scarce and the future regulatory environment will make it more so. The equity market is quite down and banks find it hard to raise new capital given their medium and long term outlook. They have to become slimmer, de-leverage - and to do so they have to dispense with capital intensive units, such as those dedicated to real estate." The bank director adds to this that "at the moment the question is how to get the funding, and this is not so much in terms of Pfandbriefe but non-covered bonds. As a result, banks are going to have to significantly reduce their businesses, restricting development loans and generally winding down this side of their operations. The present need for such banks is to reduce their quantum of debt and reduce risks - and this will result in a reduced capability to extend existing loans." The restructuring of the sector is being forced by the European Banking Authority (EBA), which is currently translating into action the Basel III accord, which would impose a 3 pct leverage ratio putting a cap on the loans that individual banks can issue. Lower margin business, including real estate finance portfolios, is likely to be hit first by this measure, and so banks may decide that they have to sell their property financing units.

Euro woes
The eurozone crisis is another considerable setback for such banks. "If bonds are issued in euros," says the bank director, "then of course the market for them has been affected by the eurozone crisis. Non-European investors, for example, may not want exposure to the euro crisis, so it is an additional factor for Pfandbriefe, but not a problem inherent to them. The amount of liquidity has shrunk, the euro crisis is ongoing... so I have the feeling that the sector will have hiccups and problems for years to come." The German expert we spoke to agrees that this is not a problem with Pfandbriefe per se, but with bank funding through bonds in general. In fact, as he argues, since the beginning of the financial crisis many banks have been entering the covered bond market and countries that hitherto did not have such a legal framework have adopted one or are about to do so. For example, at the moment there is a lively debate about introducing a US Covered Bond Act, while a covered bond regime was introduced in Australia at the end of 2011. However, covered funding is not the new unsecured - especially when it comes to development loans. Eurohypo, for instance, only issued such loans in the past through non-Pfandbrief funding. According to our Pfandbrief expert: "Covered bonds cannot provide the solution to any funding shortfall on their own. We need a restart of the securitisation market and for spreads in the senior unsecured market to come back down to lower levels. The pressure is still on, given the debate about restructuring and given the EU no longer wants to keep bond-holders away from losses." Until such a recovery occurs, the lack of such ready bank finance looks set to continue to inhibit the activities of international real estate investors, and the CEE will not be isolated from this. As the bank director concludes: "The real estate market as a whole will be punished - but this will not be specifically limited to the CEE region. Bank finance will only be granted for core products where the risk is fully understood. Investors are now only happy to invest in real estate if they have confidence in the risks and returns, know the products and know the banks won't get over-stretched."