HOUSING MARKET AND THE REAL ESTATE BUBBLE

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Commercial Mortgage Backers Face $1.6 Billion Loss (Update1)
Chris Bourke
Oct. 22, 2009
Bloomberg

Investors in the first U.K. commercial mortgage bonds to be liquidated since the financial crisis began may lose as much as 1 billion pounds ($1.6 billion) after values of properties backing the two deals collapsed.

Epic (Industrious) Plc issued bonds on 1,500 warehouses, which fetched 44 percent of their peak value in sales that completed this month. White Tower 2006-3 Plc packaged bonds against nine London office buildings owned by Simon Halabi, six of which went into administration this week.

Banks, insurers and pension funds that hold the bonds face losses from the 35 billion euros ($52 billion) in European commercial mortgage-backed securities that are set to expire over the next three years. Bank lenders have been willing to extend loans to help borrowers avoid default, while commercial mortgage bond issuers must repay investors by a set deadline.

“If they’re not nervous now, then they’ve been hiding under a rock,” said Hans Vrensen, interviewed in his role as head of European securitization research at Barclays Capital Inc, which he left last week.

Loans against hundreds of buildings were securitized throughout Europe, with more than 60 percent packaged near the market’s peak. They include Paris’s Coeur Defense, the largest office complex in Europe; London’s city hall; German apartment blocks; and British hospitals and care homes.

“There’s very little appetite among banks to recognize losses on their property loans, but CMBS doesn’t have that luxury,” said Jeffrey Rubinoff, a London-based real estate finance lawyer at Freshfields Bruckhaus Deringer LLP. “If maturity is looming, you’re up against a hard date.”

Banks, Funds, Insurers

Owners of European commercial mortgage bonds include Citigroup Inc., Merrill Lynch & Co Inc., DekaBank Deutsche Girozentrale, the fund manager for Germany’s savings banks, insurer Allianz SE, BlackRock Inc. and Banco Santander SA, according to Bloomberg data. Royal Bank of Scotland Group Plc, which manages the Epic bonds, owns 2.2 billion pounds of European CMBS, according to its half-year results.

By splitting the loans into layers of differing risk, the banks could sell them to investors and profit from the difference between the interest received from borrowers and its payout to CMBS investors. Other loans tied to the assets, but ranking beneath the bonds for repayment, were also sold.

Canada’s biggest pension fund manager, Caisse de Depot et Placement du Quebec, is likely to lose 285 million pounds as the holder of a loan subordinate to the White Tower bonds, two people familiar with the situation said in a Bloomberg story published Aug. 26.

Typical Deals

Epic and White Tower are similar to most CMBS issues, which packaged loans equal to about 80 percent of the properties’ value near the market’s peak in 2006 and 2007.

Property values have since slumped -- by almost half in the U.K., according to Investment Property Databank Ltd. -- shrinking the collateral needed for refinancing as loans expire or come near default.

British commercial property prices may not rise for at least five years, according to CB Richard Ellis Group Inc.’s derivatives unit. More than half of the 140 billion euros in European CMBS bonds outstanding are held against U.K. properties.

“The market’s very worried about the mountain of property loans to be refinanced post 2010,” said Michel Heller, head of strategy at CBRE-GFI. Property derivatives indicate an 8 percent fall in U.K. building values from 2010 to 2014, said Heller.

The losses won’t be shared equally. Senior bonds are the safest in a CMBS deal because they rank first for repayment. Holders of junior bonds and loans backed by the properties may lose all their money.

Varying Risk

Investors in Epic will lose about 60 percent of their money after the warehouses are sold, Standard & Poor’s said in an Aug. 11 report. Royal Bank of Scotland funded the purchase of the buildings in 2006 with a 585 million-pound loan, before securitizing most of the debt. The bonds defaulted last year.

The buildings were sold from July to October. Senior bondholders will get 51 percent to 70 percent of their 300 million pounds, Fitch said in an Aug. 6 report. Junior bondholders will lose all of their 173 million-pound investment, according to Fitch Ratings. Another 170 million pounds of loans tied to the deal rank beneath all bondholders for repayment.

Aoife Reynolds, a spokeswoman for RBS, declined to comment when contacted by Bloomberg. Nigel Woods, a spokesman for Epic (Industrious), also declined to comment.

“It’s just the tip of the iceberg,” said Vrensen, who was appointed this month as global head of research for DTZ Holdings Plc. “Most investors are expecting further defaults and further losses.”

Maturities Loom

About 6.5 billion euros of European commercial mortgage bonds are due to mature by the end of next year, according to Barclays Capital. That will rise to 16.5 billion euros in 2011 and 12.1 billion euros in 2012.

“The focus is increasingly shifting to loans maturing during 2010 to 2012,” Moody’s Investors Service Ltd. said in an August report. It will be difficult to refinance or repay most of those loans, the ratings company said.

The prospect of costly legal fees is deterring many investors from suing over their losses, according to Kevin Cooper, managing partner of Longbow Real Estate Capital LLP, a London-based CMBS investor.

“There’s a lot of noise about litigation, but who are you going to sue and what for?” said Cooper. “The structures don’t support the costs of litigation and it’s a brave call for an investor to fund their own costs.”

Tower Falls

White Tower packaged 1.15 billion pounds of bonds against nine London properties. The buildings, valued at 1.83 billion pounds at the time include offices leased by JPMorgan Chase & Co. at 125 London Wall and 60 Victoria Embankment. The bonds defaulted in June after the value of the offices fell by 50 percent. The properties would probably fetch about 900 million pounds on the market, Barclays Capital Inc. estimated in July.

Junior bondholders are likely to lose about 300 million pounds in a sale at that value, the bank said.

CB Richard Ellis Group Inc., the debt’s manager, has placed six of the buildings into administration. CBRE must liquidate White Tower within three years, said David Martin, a director of the broker’s real estate finance unit. The sale is likely to start next year, he said.

“The properties, or their holding companies, will eventually be sold,” Martin said in an interview. “Some interest is already being shown.”

New Phenomenon

Prior to Epic, the only European CMBS deal to be liquidated was HOTELoC, which in 2002 packaged mortgages of 28 U.K. hotels. The properties loss almost half their value by the time they were sold in 2007.

The securitization market shut down in the second half of 2007 as the credit crunch froze bank lending. The highest-rated CMBS bonds sold for as little as 70 pence on the pound this year, before recovering to around 85 pence as confidence grew that the worst of the slump had passed. Prices of BBB-rated bonds are at about 40 pence in the pound, the lowest ever.

Glastonbury Finance 2007-1 is a derivatives product that sold about 350 million pounds of notes secured against a pool of 19 CMBS transactions, according to its prospectus. Standard & Poor’s downgraded the most junior notes to junk status on Aug. 20, saying some creditors were unlikely to be repaid in full.

“Where an investor hasn’t been making realistic mark- downs, a crystallization of the position and an actual loss will come as a wake-up call,” said Paul Rivlin, joint chief executive of Palatium Investment Management Ltd, which manages Glastonbury.

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