LONDON (Reuters) - British banks are facing big difficulties, as what amounts to a crash in both housing and commercial real estate threatens to devastate their loan portfolios.
The most probable outcome is a long strength-sapping credit crunch alongside repeated dividend cuts and capital raisings. At the least it will be a headache for policymakers and at worst will tax severely government budgets that are already stretched.
Commercial property developers and house buyers both drank deeply at the well when loans were being made freely in past years, using increasing amounts of leverage despite the fact that the income the asset could generate was often not enough to cover the payments.
Both markets have now come unstuck spectacularly.
British house prices are down about 11 percent from the peak and derivatives markets are pricing in another 20 percent fall from here.
It is if anything a bit worse for commercial property, where derivatives traders are pricing in a fall of about a third from the peak in June 2007 to the end of 2009, according to Morgan Stanley calculations.
While the borrowers will of course take the first hit, increasing numbers will default, forcing writedowns by banks.
“We have an ongoing process of writing down and raising fresh capital. That is going to be demanding for a very, very long time,” said Marc Ostwald, strategist at Monument Securities in London.
“The government are going to have to step into the breach. The consumers are borrowed to the hilt and the banking sector is no longer able to provide the consumer with credit. Unless they want to see a major collapse in the financial sector, the government will have to fund the difference and borrow a lot more.”
The banks too are flying into the storm with very little put aside as insurance. British residential property loans have done fantastically well during the past decade, arguably making lenders complacent.
Little wonder: only the most disorganised or unlucky borrowers will default on loans with 6 percent rates of interest when the asset is rising in value by 10 percent a year or more.
On a 2007 annual basis, HBOS HBOS.L and Bradford & Bingley BB.L are carrying reserves against losses on their mortgage books of just 14 basis points, or 0.14 percent. Barclays (BARC.L) is carrying reserves equal to 11 basis points, Royal Bank of Scotland (RBS.L) just 5 basis points and Lloyds TSB (LLOY.L) 4 basis points.
Taking a 25 percent fall in property values as a baseline and making assumptions based on their differing books of business, Merrill Lynch analyst Manus Costello calculates that these reserves will have to increase substantially. He estimates that HBOS, which has a fairly high percentage of specialist and buy-to-let loans and has grown its book recently, thus leaving it with higher loans to value, might have to raise its rate of loss provisioning to an annualized 63 basis points in order to rebuild reserves in two years.
Bradford & Bingley would need an annualized 122 basis point charge under the same scenario. Things are less severe for the large clearing banks, though their provisioning needs would rise in greater proportion if the fall in property prices was 30 or 35 percent, which is by no means out of the question.
B&B’s bankers were recently left holding over 70 percent of its 400 million pound rights issue to raise capital after many existing investors declined to increase their exposure to the lender.
Banks could be under similar pressure to classify commercial property loans as impaired in coming years, according to analysts at Morgan Stanley led by Martin Allen.
About 170 billion pounds of loans were made on UK commercial property during the boom between mid-2005 and mid-2007, according to data from De Montford University.
Morgan Stanley estimates that just under 100 billion pounds of that will by the end of 2009 be in negative equity, with the properties now worth about 13 billion less than the loans.
While there are plenty of investors out there who might like to snap up these properties at distressed prices, higher costs of financing and a more uncertain economic outlook mean they would require higher returns, implying lower prices and the scope for considerable losses by the banks.
It is not just capital values which are falling in commercial real estate. Britain’s economy and its once vibrant financial sector are being hit hard and many tenants may stop paying rent.
Morgan Stanley thinks that the five largest UK lenders could face 25 billion pounds of losses on commercial property loans if things get as bad as during the early 1990s downturn.
While we may not see another Northern Rock, the outlook is for further consolidation in banking and for borrowing costs to remain uncomfortably high.
James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.