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Archive for the ‘Banks’ Category

Lehman Brothers

I‘m not going to write much about Lehman’s demise because there will be thousands of column inches out there (most ignoring the equally important news of the BoA purchase of Merrill Lynch and the problems at AIG). Lehman’s British companies have mostly been put into administration. All I want to note is that in a live interview with the Administrators (PwC) it was stated that some of the best assets left in the UK companies were real estate assets, held in special purpose companies and joint ventures. This shows that – despite the current hand wringing about property markets and reference to ‘toxic’ real estate involvements in the Media – owning real estate assets is safer than lending on them. This is a point I will return to in a future post.

HBOS

Amongst the carnage on the Stock Exchanges around the world yesterday, HBOS shares took a huge battering again in the UK. Quite why still baffles me, although this article suggests that one reason is that the bank is ‘ so exposed to the mortgage market and falling house prices ‘.

In the current climate, the relevance of falling house prices in relation to HBOS is not that important – the ability of mortgagees to meet their payments is the critical issue. Over the life of a mortgage, a house value can fall below the amount of the mortgage (known as ‘negative equity’) and rise well above it. It has happened to me. This is not a cause for concern so long as the borrower can make payments. Therefore, interest rates and the job market should have a greater impact on HBOS’s position, rather than the state of the housing market. When panic spreads throught markets, logic and common sense seem to go out of the window.

The same applies to commercial property loans, but since they are for a much shorter period, the state of values and the market is relatively more important than for residential mortgages. Nevertheless, so long as a borrower can meet their income payments, only a foolish or desperate bank will force the sale of properties in a weakening market. It will only make things worse – for them and everyone else.

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Bankers’ bonuses get mentioned in the media again and again and again and again and yet again. Much gnashing of teeth and wearing of hairshirts isn’t going to solve the problem, although it is better than ignoring the problem altogether. Whilst it is good that UBS has acknowledged that bonuses should be based on profits, rather than income earned, I find it depressing that in these articles no-one is focussing on two of the points I made in my previous post:-

  1. The differentiation between investment and lending bankers. Not only are their activities quite different and need to be remunerated accordingly, but their contribution to profits (more on that in another post) is quite different.
  2. Any changes must be made across the whole of the financial services industry – not just the banking sector, So long as those who manage capital funds who invest in (and alongside) banks are rewarded with bonuses based on short-term performance, they have no interest at all in seeing changes in the way bank bosses and employees are remunerated.

The BBA have some right to ask that discussions take place behind closed doors (but there is always the suspicion that they might be protecting bank bosses, who they effectively represent), but their implication that any changes must be global is the crucial point: any one country bringing in tightening of regulations can expect to see their financial services industry moving to another country pretty quickly.

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Estimates of job cuts in the City are increasing week by week (and have now started). This is no surprise. Financial institutions have always viewed staff as a liquid commodity and as the easiest overhead to cut when the going gets tough.

This article points out one implication for the commercial property market: that of empty office space. However, whether this will lead directly to a ‘ plunge in property rents ‘ is rather uncertain. That depends if the job losses are as a result of company failures (which would lead to empty non-revenue producing space that landlords would be keen to re-let as soon as possible) and on the strategies of surviving organisations.

They will (in most cases) still be left with the obligation to pay rent, whether they occupy the office space or not. Space rationalisation can sometimes be an expensive proposition, so if the organisations expect an improvement in market conditions that may lead to them hiring new staff within a year or so, some will judge it prudent not to seek to sub-let the space. There are undoubted efficiencies from contiguous occupation and breaking up such hard-fought for continuity can cause problems in the future. Sub-letting a couple of empty floors in a building you occupy may mean that future expansion will have to take place in separate buildings, reversing a trend that financial institutions in the City have been striving for a long time: to get everyone under the same roof.

Of course, there could be a flurry of mergers and takeovers that might lead to whole buildings being put up for let. However, in the current climate of fear, uncertainty and lack of available credit, I would be surprised to see this happen.

So I would not expect a ‘ plunge in rents ‘, but anticipate a decline. The impact of City job losses on the commercial property market concerns me for other reasons altogether.

In the early ’90s, initially the attitude of many banks’ towards troubled loans was generally supportive. In particular, one of the High Street banks was notable for this. However, it suddenly changed its policy. Receivers and liquidators were appointed to take control of many of their customers. Another bout of doubt hit the commercial property market, values fell further as some of the appointees sought to sell assets quickly and other banks found it convenient to follow suit.

I thought I knew why this had happened and had an informal meeting with some of the bank’s lending team, which confirmed my worst suspicions: they were overwhelmed with work. Troubled loans take more time administrating than putting on new business (contrary to general belief in the lending world). This, coupled with the fact that banks earn far less from restructuring loans than granting new ones, made the choice inevitable – appoint a receiver to do the work, whose costs are proportionately borne more by the borrower’s unsecured creditors.

The obvious suggestion was to take on more staff – there were plenty of suitable staff available following cuts elsewhere and it could be done on short-term contracts – but this was deemed unacceptable ‘ for security reasons ‘. Cynics might say such an approach would show few benefits for banks and neither they nor their shareholders care about that much about lending losses in the longer term.

Another aspect of concern is job cuts in lending teams, which can see troubled loan portfolios handed over to a ‘ debt recovery ‘ team who have little to gain from supporting customers in difficulties. In fact, in the last recession, we were disappointed to have representatives of a High Street bank’s debt recovery team attend a meeting of various borrowers for a troubled company. Not surprisingly, they led the demands for liquidators to be appointed and when there was clear disquiet at this approach in the room, their senior representative – and I’ve always admired his frankness – said “What else do you expect us to do ? Why should we risk our jobs by voting to support the company for another year or two, only to have it then fold with bigger losses ?”.

Disturbing times indeed. Not surprisingly, I’m also concerned about the loss of skills and experience, having seen it happen before. However, I have to acknowledge this is essential for recovery and another boom: fresh meat without burns from the past is the staple diet of financial institutions when rehiring.

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It gets tiring seeing the same issues coming around again with each economic cycle. Once more it’s yet bankers’ bonuses, now viewed with a mixture of horror and indignation at payments made to ne’er-do-wells who do little more than mess up the economy. It may make good copy, but such an attitude is hardly helpful.

First, we should distinguish between bonuses paid to investment bankers and lending bankers. Whilst both are generally paid on ‘performance’, this means something different in each case. Investment bankers can earn money for their organisation through such activities as corporate advice, putting together M&A deals or creating innovative financial instruments. Their bonuses are usually a percentage of the fees earned by the bank, so, if people consider them excessive, they should think about the fees that investment banks charge their clients.

Lending bankers get paid for putting loans on the bank’s books and usually they also will receive a bonus based on the earnings produced. However, because of competition – particularly from the capital markets – earnings from lending are far from substantial and to earn meaningful bonuses (which would still be way below those earned by investment bankers) it is necessary to do a large number of deals.

There is a prevailing view that “big bucks attract the best brains” and I will leave you to judge how well the market works at placing the best people for the most critical functions in the marketplace.

Criticism of bankers’ bonus structures is nothing new. In the past, I have been known to have a go myself. In the late ’80s there was at least one individual who made a good living through heading a property lending unit, putting a large number of ‘ competitive ‘ loans on the bank’s books, earning large bonuses and leaving before any of the loans matured, getting a similar position at another bank before his reputation was damaged by market knowledge of any possible bad loans.

My criticisms of this ‘ hit-and-run ‘ activity were vocal for a time in informal discussions with colleagues and fellow bankers. In fact, one ex-colleague who was establishing a new lending unit at another bank asked what my ideas were for staggering payments of lending bonuses. They were rather similar to those expressed by Joseph Stiglitz in relation to investment bankers’ bonuses. That doesn’t make me a genius (unlike Joseph Stiglitz) – it’s just applied common sense. What matters is the attempt failed. The reason was competition: banks compete for staff and any bank introducing such an ‘ uncompetitive ‘ scheme will not attract staff.

Some might say that it is fat cats and bank bosses that justify criticism over their bonuses. Whilst I find these payouts repugnant, it is patently unfair to have a go at those whose bonuses are deal related – they’re doing what they are supposed to be doing – and remunerated accordingly. They cannot be held wholly to blame for their actions and the large bonuses they earn: that is purely a function of the schemes that were put in place for them.

It’s a result of what I call ‘ Management Mechanics ‘. No doubt, some Management guru has come up with a better name for it, but get used to the term – I will be returning to it time and time again in Building Wisdom.

Ultimately, the blame lies with shareholders who approved these remuneration schemes. They wanted big earnings and big growth and were prepared to incentivise managements to provide that. Partly, this is because most Fund Managers’ remuneration is also based on performance and to maximise their own bonuses, they were prepared to overlook the long-term consequences of putting such ‘ mechanics ‘ in place.

Rather than pointing the finger at one group in the City, those who criticise – and far more importantly, those looking at increased regulation – must acknowledge that the problems lie at a far more fundamental level than the Credit Crunch: it is the business culture that looks for rapid short-term gains and thus rewards, encouraging ‘ hit and run ‘ behaviour.

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The previous article points out that banks invariably cause themselves harm by restricting lending when markets need liquidity and – based on recent announcements and revelations in the UK – they appear to have found a new way of hurting their customers and thereby, themselves.

There are 3 main choices for banks when seeking to cut down on levels of new lending:-

  1. Stop lending and close down a particular lending unit (the favoured choice in a recession for commercial property lending units);
  2. Impose tougher conditions for loans, so that fewer borrowers qualify;
  3. Make the cost of lending markedly greater to deter potential borrowers, possibly making other sources of finance more attractive.

Interestingly, many have opted for a fourth choice: temporary suspension of lending, ostensibly to deal with an overwhelming load of applications. This both flatters the lending institution (‘We’re so popular”) and holds the promise of a forthcoming return to the market, hopefully avoiding a further collapse in confidence that could harm their existing loans.

Depressingly, a number have opted to make lending more expensive, either by raising interest rates or by increasing arrangement fees, sometimes both. This appears to be a such a lurch towards self-harm that it might justify psychiatrists being offered seats on bank’s Board of Directors. It automatically increases the likelihood of default for struggling existing borrowers and makes any Bank of England reduction of Base Rate somewhat pointless. What’s the point if the reductions don’t get passed on to the people they are trying to help ?

Is this greed or stupidity in action ? Possibly neither, yet perhaps inadvertantly both. The banks that have chosen to do this may have other things on their mind. It’s interesting to note that those who have ‘ temporarily closed ‘ residential mortgage lending are generally Building Societies whilst those who have tightened lending criteria and also raised interest rates are banks. Commentators have suggested that this may be because these banks are seeking to build up deposits and capital reserves. This could well be true and may even be essential in a few cases.

However, as anyone who has been involved in UK property lending knows, the ability to service the debt grows more important than the underlying asset value the longer the loan period. So, for commercial property lending, where loan periods are from 2 to 7 years, both are critical to the repayment risk. Yet, for residential mortgages, where loan periods are typically between 20 to 25 years, the ability to pay interest is far more important than comparatively short-term movements in the property’s value.

So the banks that have raised interest rates on residential mortgages may help themselves in the short-term, but run the risk of creating serious problems for themselves down the line. Bearing in mind the old adage that one bad loan can wipe out the profits of a hundred good ones, increasing the likelihood of defaults by raising interest rates may not please the more discerning of their shareholders.

Why do banks behave like this ? On Robert Peston’s excellent blog he talks of stable doors and horses bolting, which is partly true, but the fundamental issue is that banks never pay enough attention to the skills of lending to property markets – of which knowing how to behave at different phases of the market is one of the most important ones.

What is so baffling and infuriating is that they have had painful lessons in the past, yet still refuse to learn from them.

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One of the most critical components of a downturn in property values is a fall in liquidity. Bank lending has been the largest component in market liquidity for a long time in the UK, usually leading institutional investment and independent equity (frequently from overseas investors, but often with a component of bank loans involved). So a decision to ‘ turn off the tap ‘ by banks is a major factor in a market turndown, as well as an accelerator of a fall in values.

This may seem an obvious statement, but few appreciate all the reasons for this, particularly the banks themselves. Banks tend to see themselves as ‘ lenders to the property market ‘ rather than realising that they are an integral part of it. Their actions affect not only other players in the market, but often also harm themselves.

Before the creation of APB, I would regularly address meetings of creditor banks to point out that precipitous action in liquidating property companies would harm the market and cause presently secure loans to become risky. On one occasion, a colleague pressed me back in my seat as I rose to speak and announced “Can we take it as a given that Richard has made his ‘responsibility to the market ‘ speech ?”.

It was then that I decided I had to go ahead with the creation of APB – an idea that had been in my mind for years. If the message had become routine – and therefore in danger of being ignored – another way of making it had to be found. Whilst there were a number of reasons for starting the Association of Property Bankers, one of my intentions was to make the banks understand their involvement in property markets and therefore to consider carefully their actions when fuelling a boom and exacerbating a crash. It has to be said that I have failed, but I still live in hope.

So what is it about ‘ turning off the tap ‘ that causes problems ? Consider these reasons:-

  1. It makes new purchases difficult .

    The obvious one. It is what most people think of when one talks about liquidity and severely restricts what Economists call ‘ real demand ‘. Less credit available means less organisations able to buy property investments or owner-occupied property.

  2. Banks finance both supply and demand.

    The often forgotten one. Buildings are primarily a factor of production and have a secondary function as an investment product. Before banks face financing the purchase of them as an investment, they finance their construction and also lend to the companies that wish to occupy them. A halt to new building arising from a restriction of available finance may eventually help counterbalance a downturn in values, but any cut-back on general lending immediately affects the ability of occupiers to take new space and may even threaten their ability to pay for the space they already occupy. Tenants going out of business is not uncommon in a recession, affecting returns and undermining confidence in the commercial property sector.

  3. Borrowers are unable to refinance existing loans.

    The generally unappreciated one. Most commercial property loans are for 3 to 5 years and sometimes 7 years. When they reach maturity, the borrower can find the bank is unable/unwilling to renew the loan and alternative sources of finance are unavailable. This can force investors to sell at the weakest time in the market and perfectly stable property investment companies can become vulnerable. Furthermore, since past increased market activity produced a lot of new lending, loan maturities can come in large clusters, forcing a lot of property on a market at a time when there are few purchasers, tipping a falling market into periods of freefall.

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