Just how sizable are the losses being hidden by banks?

Following the confession by RBS's Stephen Hester that with permission from the regulators his bank is hiding losses on and off its balance sheet, the logical follow up questions are:

• How sizable are the losses being hidden at each bank, throughout the UK, Eurozone and global banking system?

• How long will it take to work through the hidden losses?

A Bloomberg article provides some insight for the size of the losses from the European commercial property market and how long it might take for the Eurozone banking system to work its way through these losses.

European landlords have 582.7 billion euros ($779 billion) of commercial property debt maturing by the end of 2013 at the same time regulators are urging banks to shrink their balance sheets. 

The maturing loans could trigger writedowns for banks that need to meet stricter capital standards under international accords and as the region’s sovereign debt crisis threatens to dent lender balance sheets. 

If banks demand repayment, it may lead to a surge in foreclosures and restrain economic growth in Europe. 

That’s why regulators are instead encouraging gradual sales of the loans to private-equity firms including Blackstone Group LP (BX) and Dallas-based Lone Star Funds....

European lenders can both avoid writing down the loans and shrink their balance sheets at the same time.

For non-performing loans that the banks want to continue to hide, they simply rollover the loans at maturity.

For performing loans, the banks either demand repayment or sell the loan.  Either way, the banks' reported risk adjusted assets decline and their Tier 1 capital ratio improves.

As this blog has said before, by not requiring the banks to realize their losses before they increase their capital ratios, the numbers reported by the banks are meaningless.  What is meaningful is that to achieve these meaningless numbers, banks are cutting back on extending credit to the real economy (the regulator driven credit crunch) and restraining economic growth.

Most European real-estate debt originated before markets plunged in 2007 is being held on bank balance sheets at 90 percent or more of face value, according to Conor Downey, a partner specializing in real estate and financial reform at law firm Paul Hastings. Potential buyers value them at 50 percent to 60 percent, he said. 

If we say the value is 50 percent, then, based on the 582.7 billion euro exposure, banks are sitting on roughly 291 billion euros of unrecognized, hidden losses.

A substantial “rebound in capital values appears to be at best delayed with no immediate prospects for any strong growth, so I think the banks are probably feeling fairly uncomfortable at the moment,” said Colin Lizieri, a real estate finance professor at Cambridge University.

So much for the gamble on redemption.

European commercial property prices rose 5.3 percent in 2010, according to data from Investment Property Databank Ltd., the latest available. That followed declines of 15.9 percent in 2008 and 2.2 percent in 2009 that left borrowers struggling to repay loans and banks trying to sell soured assets. 

New regulatory requirements mean banks have to increase core capital to 9 percent by June, which may restrict lending. That’s “not a very fortunate plan,” given current market conditions, European Central Bank Governing Council member Ewald Nowotny said last month....

It is worse than a not very fortunate plan.  It is a deliberate action by regulators that is causing significant damage to the real economy.

While relative yields on European commercial mortgage debt packaged into securities narrowed in the last two months, the spreads are wider than a year ago and five times the level in November 2007, according to JPMorgan Chase & Co. (JPM) data. 

Investors demand 505 basis points, or 5.05 percentage points, above lending benchmarks to hold the securities, down from 575 basis points at the end of 2011. The spread has widened from 365 basis points a year ago, the data show. 

European banks hold most of their loans on their books with just 112 billion euros, or 6 percent, securitized at the end of 2010, according to the latest figures from DTZ Research. 

Banks sold 20 billion euros of real-estate loans across Europe and the Middle East last year and a further 13 billion euros is on the market, CBRE Group Inc. said Feb. 21. A total of 20 billion euros will probably be sold this year, according to the broker.

Most of the property debt owned by European banks is secured against properties in unfavorable condition or unattractive locations. 

Suggesting that a 50% loss rate might be optimistic.

In the U.K., two thirds of the properties financed by banks are secured against non-prime property, according to a Dec. 30 report published by the Bank of England. 

Potential acquirers are instead focusing on prime assets, Natale Giostra, CBRE’s European head of debt advisory, said in December. 

Banks may add to the problem if they foreclose on borrowers because more inferior real estate would come onto the market and push down values, said Lizieri at Cambridge University. 

Banks that historically bundled property debt for sale are being discouraged by new rules that mean securitizations require higher levels of capital. Instead, they’re seeking to team up with other banks to package their loans into funds that can be sold. 

Funds “diversify - and therefore improve - each investors’ risk position,” Simon Gleeson, a lawyer at Clifford Chance LLP in London specializing in markets and regulation, said in an e- mail. “You need quite a large number of banks involved, and they need to trust each other only to put in assets of the specified quality. Building that trust may take time.”

Regulatory arbitrage to try to get rid of non-performing assets.

Banks are being “nudged” by regulators toward recognizing bad real estate loans, “but it’s going to end slowly,” said Bob Penn, a partner at Allen & Overy LLP in London. “Regulators report to their political masters and are sensitive to their wishes. They don’t want to drive economic growth off a cliff and they don’t want to trigger another crisis.”

So the blame for not adopting the Swedish model and requiring banks to recognize all of their losses up front is really on the politicians who were adamant that the banks hide their losses and fiscal and monetary policies be adopted that maximized the destruction of the real economy.

Honestly, the regulators pushed for the banks to hide their losses.  As this blog has previously stated, having financial institutions hide losses is the regulators default position.  Example of this abound including the US Savings and Loans.

Private-equity firms are seeking to pick up some of the slack. Royal Bank of Scotland Group Plc sold 1.36 billion pounds ($2.14 billion) of commercial real-estate loans to a Blackstone fund in December at about 29 percent less than face value, two people with knowledge of the talks said, who declined to be identified because the deal was private.... 

Lloyds Banking Group Plc (LLOY), Britain’s second-biggest government-aided bank, sold more than 900 million pounds of mortgage-backed loans to Lone Star Funds in December. The loans may have been bought at a 40 percent discount, two people familiar with the matter said.

 For assets like non-prime shopping malls in Spain, “there’s virtually no buyers or at least there’s none unless there’s significantly lower prices,” said Harm Meijer, an analyst at JPMorgan in London. The investment bank expects “falling property prices or at best a flattish market for a long time” across Europe, according to a Jan. 11 note to investors.

Banks will put more distressed real estate up for sale in some parts of Europe this year, Meijer said, and Dutch offices and secondary U.K. properties will be among the assets sold. 

U.K. banks would have to write off billions of pounds if they “seriously attacked” their commercial property loan books through sales, Michael Marx, chief executive officer of Development Securities Plc, (DSC) said by e-mail. RBS said yesterday that its non-core division’s commercial real estate assets were impaired by 3.4 billion pounds in 2011.

Germany, the largest economy in Europe, is not immune, based on the performance of commercial mortgage backed securities issued there. Only 22 percent of German CMBS loans were repaid when they matured last year, compared with 74 percent in France and 38 percent in the U.K., Standard & Poor’s said in a January report.... 

PwC said that it will take 10 years for banks to sell up to 3 trillion euros of assets and expect a similar timeframe for their troubled real estate loans. 

That echoes earlier crises, said Meijer of JPMorgan. “We’ve heard from bankers in Germany that they only worked out the last of their problem loans from the 1970s in recent weeks.”

Please re-read the previous two comments about how long it will take to work out from under the commercial property exposure.

There is a reason that Japan has been pursuing the monetary and fiscal policies it has been for the last 2+ decades.  The reason is it takes forever for the banking system to generate enough capital to absorb the losses.