Banks with big exposure to Central European real estate are essentially insolvent, but this is masked because they have not revalued the underlying assets, industry sources say. However, with many loans issued in the boom years ahead of the crisis coming up for refinancing and a pullback in funding of regional subsidiaries, these banks could finally be forced to act.
While politicians across Central Europe talk up the stability of the banking sectors in their country, hoping to head off the risks to economic growth from lowered funding from the Western banks that dominate most markets, there's a potential time-bomb ticking away on the balance sheets of the local units - one that could total €1.5 trillion.
Much as anticipated, a distressed-asset feeding frenzy never materialised in the region's real estate sector during the first phase of the crisis, because the banks thought they could get through to the other side without having to take losses on the over-leveraged sector. Now it looks like that was merely a postponement.
One real estate industry player says that in contrast to the trend seen in 2008, some banks in the region are becoming very aggressive in instructing borrowers to sell projects to catch up with their commitments. With much of the five- to seven-year debt issued in the boom years about to come up for refinancing, "the next 12 to 18 months will be very interesting," he suggests. "It's difficult to say how it will pan out."
Rock and a hard place
The banks in the region are caught on the horns of a dilemma. The same loans that were quietly left to their own devices during the first phase of the crisis in 2008 are now coming up for refinancing, so continued inaction is not an option. Yet the banks will struggle to approve new loans for the region's beleaguered developers.
However, the option of enforcing their claims on the assets underlying non-performing loans (NPLs) could lead down a very rocky road. The banks' previous inaction meant they could simply keep the valuations of the assets unchanged. Enforcing the contracts would see those valuations plummet to current market rates. One Austrian banker who declined to be named suggested: "Every Austrian bank with significant exposure to CEE real estate is essentially insolvent - they just haven't reassessed the valuations on their balance sheets."
Claims the real estate industry player: "The banks are absolutely terrified of doing that exercise."
That's understandable if Deloitte is correct in its analysis. The consultant's Czech real estate practice estimates that the property sector in CEE faces a "huge refinance hurdle of €1.5 trillion," adding that the Austrian banks are set to cut their exposure. "[The] banks are in control of huge portfolios of 'underperforming' files," Deloitte's analysts say in a report.
The credit ratings agencies are also concerned. On December 1, Moody's Investors Service changed its outlook on the Czech banking system from stable to negative, suggesting "the banks' operating environment will weaken, amidst a broader EU economic slowdown... over the next 12-18 months." Moody's took similar action on Polish banks in mid-November.
Of particular worry in the Czech Republic, on top of rising levels NPLs, are "high levels of concentration in the loan books... including... continued asset concentrations in the corporate segment, especially in commercial real estate," Moody's says.
Figures from the Czech National Bank show that NPLs in the sector have steadily risen to 7.0% of total loans in the last six months. However, the share of commercial real estate loans in that total has risen dramatically. At 10.5% of NPLs, the sector's share hit double figures for the first time in the last decade in June 2010, a ratio which remained steady to May. However, in June they suddenly leapt to 12.4%, and have since climbed each month to leave them standing at 13.6% of total NPLs in October.
Petr Bittner of Czech bank Ceska Sporitelna insists that while he "wouldn't dispute the claim of the Austrian banker," the danger, to the Czech sector at least, is not imminent. While the exposure of the country's banks to commercial real estate did bump up slightly in the boom of 2006, it has remained close to the current 11.9% of total loans - equivalent to around CZK270bn (€11bn). Meanwhile, he says, keen oversight from the Czech National Bank (CNB) has helped the sector into a position of resilience, with a capital ratio of 15%. "I don't see any significant threats resulting from exposure of the Czech banking sector to commercial real estate," he says, adding that he doesn't "expect any significant growth of loan volumes to be rolled over.
Meanwhile, Bittner says Czech banks have, give or take, CZK180bn of "capital surplus", and can face losses up to this level without the necessity of having to raise capital.
However, the banks are hardly in the same sort of rude health in every country in the region. For instance, the effect of the regulatory issues in Hungary are well known, and Raiffeisen Bank International worries that "some of the buffers that have served the CEE economies (especially in Southeast Europe) to withstand the global crisis, have been depleted."
Running out of options
The preferred option of the local banks over the next year or two would clearly be to restructure or roll over the current debt and quietly wait it out once more, with the assets left on their balance sheets at what are now inflated valuations. Bittner says "even if the need for rollover does grow, Czech banks still have (and will have) the resources to do that. The threat of liquidity squeeze from parent banks is possible, but the regulatory rules of the CNB are quite strict, and it's not so easy to transfer liquidity surplus across the board."
However, the constraints on cross-border funding from Western European parent banks are well documented. During the 2008 crisis, the region's banks had their funding flows protected by parents by the Vienna initiative; in November this year, Austria's banking regulator launched what is effectively the "anti-Vienna initiative," which will force local units owned by Austrian banks to rely almost completely on their own funding to continue lending. For a regional banking sector that has one of "the highest dependency on cross-border banking and on Western European banks in particular," as analysts at Raiffeisen put it, this arrangement will likely complicate the situation.
Even Marek Belka, governor of the National Bank of Poland, who led the objections to Moody's change to its outlook on the country's banking sector, admitted that this presents the region's banks with a major question. "Half of short-term financing to Polish subsidiaries from European parents matures in 2012," he pointed out. "Will they want to finance their unit on the same terms?"
Rolling over loans to real estate borrowers in particular could prove even more difficult, says one analyst. "What if the local units are being told to cut their exposure to the sector in CEE, as is very likely?" he asks.
At the same time, Raiffeisen analysts worry that high and persistent NPLs could turn into a drag on economic growth. "If NPLs are continuously rolled over, capital is locked up in unprofitable activities," they note.
However, the second option - to pull the plug - looks even worse. In that case, seized assets would go to auction and the banks would receive cash sums that are a fraction of the valuations for the underlying assets on their balance sheets. Yet leave it too long, and they could be forced to accept far less still should borrowers go bankrupt.
This risk could see more lenders follow the example of Ireland's National Asset Management Agency (Nama), which was originally set up in 2009 to deal with the toxic assets of banks taken over by the state. In Central Europe, Nama - whose assets have already been written down - has become increasingly aggressive even on some of the better assets, claims the real estate source. "It seems to be coming to the crunch for the Irish developers in the region," he suggests. "Anglo-Irish has been looking at enforcement options since the spring. This is going to force the Irish developers in the region to the wall."
Perhaps the best option for all involved would be the arrival of opportunist buyers and lenders - assuming they will be prepared to offer prices that will keep the wheels turning. That remains "a key block" according to Deloitte, but the region's large private financial groups - PPF Group, J&T Group, Penta Investments, and the recently ravenous Czech Property Investments - are said to be on the prowl for acquisitions.
At the same time, distressed debt funds are sniffing around the region. One group recently advised local service providers that it is interested in "buying discounted senior debt," suggesting "some of the portfolios coming from the... Western European banks pulling out of CEE markets could be of interest."