Unhedged Commentary: Giving European Credit its Due

March 16, 2016  


   
   Stuart Fiertz

With continued market volatility in early 2016, the collapse in oil prices, shocking acts of terrorism and waves of migrants seeking refuge from war, at Cheyne we believe Europe deserves more credit - literally. The anticipation of a flood of credit opportunities in the euro zone has existed for several years but proved fleeting. However, we think the time is ripe for compelling and scalable opportunities in alternative credit within Europe because of the combination of well-meaning but poorly designed regulatory reforms and the fact that efforts to address the looming need to shrink the banking system have only just begun.

To profit from the recent dislocation and increase allocations to Europe, investors will need to accept that we have reached the level of political and economic distress necessary to trigger effective policy responses. We think we have: European Central Bank president Mario Draghi has dusted off the quantitative easing playbook, U.K. Prime Minister David Cameron appears to be getting closer to securing sufficient concessions from the European Union to neutralize the risk of Brexit, and the EU is building fences on its external borders to stem the flow of migrants.

The global financial crisis highlighted that the European banking system was far too large relative to the size of the European economy. This means that European banks remain overly reliant on wholesale funding and are too big to either be left to fail or bailed out again. Regulators have recognized this and responded with measures to force banks to shrink their balance sheets, including increased capital requirements and explicit leverage limits.

Alternative credit has the opportunity to offset the withdrawal of liquidity that will result from shrinking European bank balance sheets. Consider that the total assets of U.S. banks are some $14 trillion, whereas the assets of European banks total $41 trillion although the underlying economies are approximately the same size.

The transition toward alternative credit is now being supported by the EU, which has gone from vilifying nonbank sources of credit to actively promoting them. Furthermore, the European distressed-­corporate-credit cycle is shifting toward opportunity. Postcrisis, many investors thought there was going to be a fire sale of European corporate loans. This flood of sales didn't occur, as European banks proved more willing to sell real estate assets than corporate loans. One of the motivations was political pressure to safeguard jobs and avoid putting companies into the hands of private equity, which would look to rationalize operations. Another factor was the surprising growth in the European high-yield market, which allowed the orderly refinancing of most of the largest and most leveraged companies.

It is also evident that European banks were not in a position to absorb the hit to their capital that would have been necessary to mark the corporate loans down to their clearing level. While still undercapitalized, European banks are today in a much improved position to sell down their corporate exposure, which will now begin to increase the supply of distressed corporate opportunities.

In the wake of the crisis, the impact that unemployment rates had on forcing real estate borrowers into receivership was muted. Banks were therefore in a much better position to sharply reduce their risk appetite for real estate loans as the crisis unfolded.

The most attractive opportunities can be found where the new regulatory capital regimes are most punitive and where the local regulator has a particularly negative bias. Bank loans to fund new construction, for example, are more readily available than loans for refurbishment. The opportunity to make this type of loan is underlined by the fact that the availability of credit in European real estate has been severely constrained since as far back as 2007, leaving a generous supply of assets in need of capital expenditures. What's more, there are an estimated €745 billion ($826 billion) of loans that will need to be refinanced over the next three years. It is estimated that European banks still need to work out some €333 billion of noncore real estate loans.

The total of nonperforming corporate loans that are likely to be sold by European banks now dwarfs the remaining noncore real estate on bank balance sheets. It is an indication of how far attitudes toward alternative credit have changed that the Italian government recently chose to securitize €350 billion of nonperforming corporate loans rather than sell them outright. a

Stuart Fiertz is president of London-­based Cheyne Capital Management (UK) and chair of the Alternative Credit Council of AIMA. This article is based on his findings from a recently published white paper.


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