ANALYSIS: European Bank's AQR marks end of 'extend and pretend' era

The looming Asset Quality Review by the European Central Bank will mark the end of the ‘extend and pretend’ era as banks are forced to divulge the true state of their loan books, predicts Jos Short, founding director of London-based investment manager Internos Global Investors.

The deadline for the European Central Bank’s (ECB) Asset Quality Review (AQR) is fast approaching and, with the risk of being named and shamed, there has been, and continues to be, a rush by banks to unload their loan books, often at discounts close to 50%, within a relatively short period.

In fact, it is estimated that €584 bn of real estate loans remains to be worked out, against €41 bn sold to outsiders in the first half of 2014 and €31 bn in the whole of 2013. This means that there is going to be a large amount of distressed real estate assets coming onto the market. US investors, in particular, are looking to take advantage of this rush, and it is estimated that 77% of the money that is buying into the eurozone loan book is attributed to them. Moreover, they are buying into loans largely secured against secondary real estate assets.

While this review will certainly sting in the short term, accelerating the decline in aggregate bank lending to real estate, it is an essential step in clawing our way out of eurozone stagnation and achieving ‘real’ real estate growth again, Short argues in the latest issue of the company's strategic bulletin, The Decisive Eye. Short explains that it is real money from new sources ready, and possibly more able, than the banks to ‘work out’ what they have bought.

A total of 760 bank loan portfolios have been selected for detailed examination as part of the ECB’s AQR process which started in November 2013 and is due to complete in October 2014. This covers total bank book risk-weighted assets of approximately €3.7 tln representing 58% of the total of €6.4 tln credit risk-weighted assets of the in-scope banks, of which corporate loan portfolios make up 65% of selected assets.

Short, a founding partner of Internos, a €4.1 bn pan-European owner-managed real estate fund management business, claims it is 'virtually certain and widely acknowledged' that aggregate bank involvement in commercial real estate will be a fraction of its 2008 level. 'But what is not agreed within real estate is whether this is a good thing or a bad thing. Indeed, the overwhelming views of those I meet emphasise the bad – a yearning perhaps for the glory days of 2004-2007 when IRR achievements of 20-30% were commonplace, driven by a then unacknowledged bubble and 80+% bank funding.'

Short goes on to explain that a more reflective view would observe that the popularity of, mainly core, commercial real assets over the last three years has been the product of financial market imbalances. What economists know is that occupier demand for real estate is, over the long term, a function of the real economy. Unless we can grow GDP, and emerge from what looks like stagnation, real estate will fall prey to different financial market imbalances.

Short claims it is just beginning to look as if we have learned to do this in the UK. 'Bank involvement has been key - but most of the eurozone lags. If we are to avoid the type of moribund economy that afflicted Japan from 1991 to 2013, revitalised Eurozone bank lending to commerce and industry is vital.'

There is every reason to fear, and fight back against, the threat of European economic stagnation, Short continues. 'To achieve economic growth, the diversion of bank lending away from safe real estate assets into the productive economy is vital. It is now being achieved in the US and beginning to be achieved in UK but the eurozone banks are lagging.'

Banks’ unwillingness to take the hit from acknowledging the true value of their loan books, a dragging on of ‘extend and pretend’, is clearly a target for the AQR. It is reasonable to suppose that it is just such an outcome, an American as opposed to a Japanese future, which Mario Draghi at the ECB is seeking. It will hurt short term but the benefits for the real economy and for the long term real future of real estate will be significant, Short concluded.