Perspectives on Distressed Assets

Perspectives on Distressed Assets

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The report pointed out that 2010 represents something of a watershed moment, as banks in particular face pressure to acknowledge the true extent of distress in large asset portfolios, many of which come due for repayment or refinancing.

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Signaler un problème
Perspectives on distressed assets
Banking and securities outlook
Produced by the Deloitte Center for Banking Solutions
As used in this document, “Deloitte” means Deloitte LLP and its subsidiaries. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
1 Federal Reserve: Statistical release H.15, FDIC, Quarterly Banking Profile, 2009, Vol. 3, No. 4.
2 FDIC, Quarterly Banking Profile, 2009, Vol. 3, No. 4.
3 FDIC, Failed Bank List, http:// www.fdic.gov/bank/individual/ failed/banklist.html.
4 Testimony by Jon D. Greenlee, Associate Director, Division of Banking Supervision and Regulation, before the Congressional Oversight Panel Field Hearing, Jan. 27, 2010.
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In December 2009, Deloitte’s Center for Banking Solutions published its Outlook 2010, summarizing five trends that would dominate the banking and securities industry. Dealing with distressed assets was top of the list, and the report pointed out that 2010 represents something of a watershed moment, as banks in particular face pressure to acknowledge the true extent of distress in large asset portfolios, many of which come due for repayment or refinancing.
This follow-up piece looks at distressed assets in more detail. It first summarizes the market background. It then looks at the market through two different perspectives: lenders and investors. Much of the commentary is drawn from a symposium organized by Deloitte (in conjunction with Bloomberg LP) that took place in January in New York. A panel of industry experts from both buy and sell sides offered some powerful reflections on the state of the market and its likely evolution.
The market background There are some reasons to be cautiously optimistic about the ability of the market to work through the challenge of distressed assets. One positive factor is that there are large pools of money sitting on the sidelines, waiting for the right opportunities to be invested. With interest rates 1 at zeroor thereabouts, distressed deals can offer enticing returns if they are priced correctly. Private equity firms, hedge funds, offshore funds including sovereign wealth funds, and publicly listed REITS are all potential investors as and when deals emerge. Although it remains fragile, investor confidence has grown and there has also been a notable increase in merger and acquisition (M&A) activity pursuing distressed asset and debt opportunities.
However, there remain significant ongoing problems. Banks are still holding on to large pools of under-water loans, and there are structural and procedural reasons why this remains so prevalent. For example, there are 702 banks on the current Federal Deposit Insurance 2 Corporation list of “problem” institutions,on top of the 3 140 failed banks in 2009.Some of these banks’ distressed assets might interest private equity buyers if they were available on a stand-alone basis. But if the only way they can be bought is by buying a failed or failing bank, with the regulatory restrictions and political scrutiny that is associated with such a transaction, then much investor interest diminishes. While some observers point out that the FDIC is acting as a clearing house for distressed loans from failed institutions, many investors have
privately expressed frustration that there is no widespread mechanism such as a resolution authority for resolving this impasse. The Resolution Trust Corporation (RTC) was used to resolve the savings and loan industry crisis in the 1980s. It is possible that a new RTC-type body will be officially constituted some time in 2010 in an effort by regulators to speed up the process of market healing. However, according to some senior regulators, such an authority is not on the table, at least for now.
Further, there is the specific challenge for commercial real estate (CRE) loans. As the economy struggles to return to health and unemployment is proving stubbornly persistent at around 10%, there is enormous pressure on commercial real estate. Vacancies have been rising, rents are trending down and there has been a steady rise in the number of defaults, foreclosures, and distressed auctions. Default rates and delinquencies on commercial mortgage backed securities are rising. Over the next 12 months, some $500 billion of CRE loans come to maturity. Over the next four 4 years, that number is projected to balloon to $1.7 trillion.
Industry observers say that the bulk of this problem is concentrated in regional and community banks that were active in the markets between 2005 and 2007 and are now carrying many poor quality unsecured construction and jumbo AB loans on their balance sheets. These loans are expected to take the highest losses and to take the longest time to be worked through or written off.
Much depends on the state of the economy. A sustainable pick-up in the real estate markets, both commercial and residential, in the end is likely dependent on the creation of new jobs and the willingness of consumers to spend rather than save.
The lender perspective A big question as 2010 began was whether, and to what extent, banks would begin to make fresh loans available. There are signs that there is more credit available, but the picture is far from uniform. For example, investment banks, including those that became bank holding companies during the crisis in 2008, were and are required to mark their assets to market, which possibly meant they were faster to deal with their distressed assets. According to panel commentators at our symposium, they have been correspondingly faster to return to the market quoting prices on new loans. Some large commercial banks, foreign banks and large life insurance companies are willing once again to extend credit.
By contrast, some panelists noted that many regional and community banks are focused on improving their balance sheets and are less active in originating new loans than in trying to manage their existing portfolios. Paradoxically, the very act of rescuing the banking system has frustrated the emergence of a market clearing mechanism that would allow buyers and sellers to agree on prices and strike deals. This “deal gap” is one of the most striking aspects of the current market, and there are relatively few signs that the gap is shrinking at any great speed.
What could break this deadlock? Bankers say that regional bank examiners could increase the pressure on their regulated banks to be more aggressive in cleaning up their balance sheets and moving bad loans into the market. But this seems unlikely to happen in the current environment. Because markets are so illiquid it is difficult to gauge the extent of the difference, but many market participants believe it is substantial, perhaps as high as 50 percent. Further, some bankers have long memories. In the real-estate crisis of the early 1990s, driven partly by new capital rules and regulations such as FDICIA, many banks were quick to foreclose and sell off troubled assets at firesale prices, the result being, as one banker puts it, “We made a lot of folks rich.” In today’s environment, many bankers see it as rational to try to hold on as long as they can in the hope that markets recover. Accordingly, the distressed loan market remains effectively frozen.
There have been important structural changes in credit markets. In 2009 there was roughly $40 billion of leveraged loan issuance, whereas in 2007 there was $700 5 billion, muchof which was sold directly to collateralized loan obligation (CLO) structures or to hedge funds. Today the CLO market remains broken. Before the crisis, banks typically warehoused lots of loans on their balance sheets so that when a CLO raised capital it could immediately deploy its funds by putting together a portfolio. Banks are no longer willing or able to act as a warehouse, so it can take time — perhaps several months — to assemble a portfolio of loans, meaning that the capital sits idle, wrecking the economics of the CLO – the negative carry on the costs of the financing eats too deeply into the equity returns. In addition, there is widespread investor skepticism about a return of securitized vehicles in the absence of better market practices and greater reliability of credit ratings on complex structured products.
Investor perspectives Some investors made stunning returns in the last quarter of 2009. In the leveraged loan and high yield markets,
spreads had ballooned out to as wide as 1500 basis points a year ago, but then recovered strongly and today are around 680 basis points. Some experienced investors have commented that in late-2009 there was a once-in-a-lifetime buying opportunity in corporate credit markets. Things are not so rosy today. “You don’t see desperate sellers, so it’s hard to get things cheaply,” comments one investor.
This is true for the CLOs, which hold much of the relevant debt. As one banker at our symposium, who specializes in restructurings, notes, CLOs are “highly leveraged vehicles, so they will look to renegotiate, push out maturity, get a better interest rate.”
Furthermore, there are plenty of potential buyers who are seeking better than the current zero or near zero yields on cash. Chief among them are sovereign wealth funds, which are cash rich and eager to deploy their capital, despite feeling that they might have missed the best returns. Hedge funds, by contrast, have been selling down their distressed portfolios and reallocating their money to other investment strategies that offer better risk-return trade-offs. Where opportunities remain, they are increasingly industry specific. For example, there is widespread distress in the global transportation industry, particularly in the shipping industry. There are also opportunities in the tourism and leisure sectors, for example in the gaming industry. However, as liquidity has gradually returned to asset markets, prices have recovered, sometimes sharply, from rock-bottom levels. One investor cites the example of a trucking company’s bonds, which last year were trading at 20 cents on the dollar, but have now come back to 90 cents on the dollar, despite little obvious improvement in the cash flow and general health of the company. “Markets are running well ahead of any recovery in underlying earnings,” he notes.
The overall market is dominated by real estate, and commercial real estate in particular. It is important to put the amount of available investor capital into perspective. The U.S. public REIT market has roughly $227 billion of 6 equity supporting some $500 billion of assets.But that represents a mere 5 percent of the U.S. real estate market. And because many private transactions made in the run-up to the crisis were highly leveraged, their subsequent declines mean they have no equity value, so there is little prospect of IPOs. There has been a trend instead towards so-called “blind pool” REITS, roughly 20 of which have raised capital from investors on the premise that they can seek out good buying opportunities.
5 U.S. Leveraged Finance Quarterly Review, Feb. 4, 2010.
6 NAREIT, REIT Watch, Dec. 2009.
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To date, there has been no single vehicle to facilitate a widespread resolution of distressed loans and, consequently, there has not been much activity. The FDIC loan sales program has been slow, and many banks are not actively selling loans. What will change in the marketplace so that banks get closer to resolution of their portfolios of distressed loans? It could come from one or more of several directions. Government regulations, the effect of accounting standards, or a new and as yet unannounced government program all might take effect, providing a significant uptick in refinancing markets. It remains to be seen whether 2010 will prove to be the year of resolution for distressed loans held by the banks.
Copyright © 2010 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu DCS0643902
Industry Leadership Jim Reichbach Vice Chairman U.S. Financial Services Deloitte & Touche USA LLP +1 212 436 5730 jreichbach@deloitte.com
Deloitte Center for Banking Solutions Don Ogilvie Independent Chairman Deloitte Center for Banking Solutions dogilvie@deloitte.com
Andrew Freeman Executive Director Deloitte Center for Banking Solutions aldfreeman@deloitte.com +1 212 436 4676
The Center wishes to thank the following Deloitte professionals for their contributions to this report:
Chris Faile Hugh Guyler Tom Kaylor Guy Langford Lisa Lauterbach