Known Unknowns: Debt Refinancings in 2011

When does a financial institution write down an asset?

To those in the banking industry the answer has always been, “Not until I am not responsible for that portfolio anymore.”

My experience with lenders is that when making a loan they tend to be pessimistic and, in addition, require collateral. Unless, of course, they are securitizing the asset created and selling it off.

However, when overseeing a loan portfolio, lenders tend to be very optimistic. “Well, the borrower is just experiencing a slight setback, but things will get better.” “The economy is going to improve soon and then the loan will be alright.” “Yes, the borrower made a mistake, but he has learned from the mistake and is getting his act in order.”

Lenders (bankers) are reluctant to write down anything if they don’t have to. And, this applies to all aspects of their asset portfolios.

But, a big cloud is hanging over the financial industry going into 2011 in the United States, and also in Europe. The big cloud relates to number of bank assets that will need to be refinanced during the year. These numbers are staggering.

My guess is that this is one of the major reasons why commercial banks are not lending now. (See “Little or No Life in the Banking Sector,” http://seekingalpha.com/article/241507-little-or-no-life-in-the-banking-sector.) Banks do not want to write off any more assets now and are reluctant to add any more funds than they have to in order to build up their loan loss reserves. They add to these reserves as little as possible, as little as the regulators will let them get away with, so that they can build up their equity capital positions. If they then let the loans that are maturing run off without replacing them, their capital positions improve. The debt/equity ratio can fall as debt can be reduced while capital is being increased.

Making new loans does not fit into this strategy because the new loans will have to be financed and that will tend to raise the debt/equity ratio. So commercial banks are not lending now.

So what is this cloud and why is it so scary?

There are two specific areas that are being highlighted these days that stand out as potential problems for the banks: the first is the commercial real estate sector; and the second is governments, local, state, and nation.

In all cases a lot of loans or securities are going to mature in 2011 and the bet is that a large number of these assets that are found on bank balance sheets will either not be sufficiently credit worthy to be able to refinance or will not be able to handle the interest rates they will have to pay on the new debt to be issued..

In November 2010, commercial real estate loans made up almost 40 percent of the loan portfolios of the banks not among the largest 25 commercial banks in the United States and over 25 percent of their total assets. If these “smaller” banks had to write down 10 percent of their commercial real estate loans that would amount to about 3 percent of their assets: a substantial blow to their capital positions.

The problem is not so great in the largest 25 banks in the country as commercial real estate loans make up only 14 percent of their loan portfolios and about 8 percent of total assets.
This situation is the one pointed to by Elizabeth Warren in congressional testimony when she stated that 3,000 commercial banks, primarily the smaller ones, faced substantial problems ahead in this part of their loan portfolio.

The other problem mentioned has to do with government securities. More and more concern is being expressed about the condition of the finances of state and city governments in the United States. Layoffs are taking place all over the place, with many of the layoffs threatening health and safety. Yet, there is still substantial concern that the unfunded commitments of these state and city governments embedded in their pension funds have not really fully been addressed.
They may have to be addressed in 2011.

And so we get articles like “Bankrupt City, USA” (http://www.ft.com/cms/s/3/07eabcdc-06c8-11e0-86d6-00144feabdc0.html#axzz185wrM18g) which carry statements like this, “A Congressional Budget Office report reaches a conclusion to terrify investors in America’s $2.8 trillion municipal bond market. Municipal bankruptcy, permitted in 26 states, should be considered by city leaders to restructure labor contracts and debts.”

And the yields on municipal securities are the highest they have been in over a year. (http://online.wsj.com/article/SB10001424052748704681804576018022360684088.html?mod=ITP_moneyandinvesting_0) The situation related to state-issued securities is not too different.

The smaller banks, as defined above, have around 25 percent of their securities portfolio in state and local political issues. This makes up about 5 percent of the total assets of these banks. Again, a write down in this area could cause substantial damage to bank capital positions.
But, this problem relating to government debt is not constrained to United States banks. “Eurozone countries will have to refinance more debt next year than at any time since the launch of the euro amid investors’ warnings that the debt crisis in the region will intensify in the new year….Eurozone nations will have to refinance or repay €560 billion ($740 billion) in 2011, €45 billion more than 2010 and the highest amount since the launch of the single currency in January 1999.” (http://www.ft.com/cms/s/0/f9d781f6-0619-11e0-976b-00144feabdc0.html#axzz1860QqksJ) Much of this debt is held by banks.

What would you do if you were running a bank and were facing the possibility that a substantial portion of your portfolio would have to refinance in 2011? Oh, by-the-way, you also have foreclosures and business bankruptcies running at a relatively high rate as well.

You probably would stop lending, try to shrink you balance sheet as much as you could without damaging profitability and build up as much capital as you could before the time of refinancing arrived.

The question that we don’t have an answer for at the moment relates to whether or not the bankers, themselves, have a good handle on which assets will present the biggest refinancing problems and just how much will have to be written off due to these refinancings. Are they still just “hoping for the best.”

In addition, a rising interest rate environment would be one of the worst scenarios possible given all the refinancings that are going to have to take place.

Happy New Year!