Insights and Commentary from Dentons

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1 dentons.com Insights and Commentary from Dentons On March 31, 2013, three pre-eminent law firms Salans, Fraser Milner Casgrain, and SNR Denton combined to form Dentons, a Top 10 global law firm with more than 2,500 lawyers and professionals worldwide. This document was authored by representatives of one of the founding firms prior to our combination launch, and it continues to be Growing with offered to provide our clients with the information they need to do business in an increasingly complex, interconnected and competitive marketplace. The role of government has never been more critical

2 New Clean-up Regulations for Spanish banks (February May 2012) Will they create a new real estate market? 25 May 2012

3 New Clean-up Regulations for Spanish banks 1 Introduction On Saturday 12 May, the Spanish government passed a new set of regulations applicable to Spanish banks, in the aftermath of a previous reform on 3 February. These new pieces of legislation (which amend sooften-quoted Circular 4/2004, that sets forth accountancy rules imposed by Bank of Spain) are the Spanish Government s response to the clean-up and recapitalization needs of Spanish banks in light of their exposure to the real estate sector. New regulations (February May 2012) This exposure has been recently quantified in app. 310bn (of which threefifths are considered problematic, and 80bn are repossessed assets which are said to be a killer of core capital for banks). The overall goal, in terms of reducing this exposure, is to cover up to 45% of it (up to 137bn). Thus, the regulations of 3 February set an objective of 54bn, and the regulations of 12 May imply an additional cushion of 30bn that would add to the provisions already made until the end of Some consider that this cover will suffice for what many consider the ultimate goal: a soft landing from the peak of the property bubble for Spanish banks. The new regulations put in place two new tools to help Spanish banks achieve this real estate deleveraging (in addition to the new provisions and capital buffers): (a) A potential injection of capital by rescue fund FROB (new State money up to 15bn); and New tools: State capital injections and off-balance sheet property companies (b) the creation of property companies attractive to investors which would eventually deconsolidate from the banks balance sheets. 2 The New Regulations. The new rules passed on Saturday 12 May ( Royal Decree-Law 18/2012 ) are an extension of a set of previous ones dated 3 February ( Royal Decree-Law 2/2012 ), and both modify the regulations in famous (to many) Circular 4/2004, which has governed the books of Spanish banks since well before the credit crunch. These two new pieces of legislation need to be jointly construed, and therefore we will refer to both of them as the New Regulations, making an explicit reference to either of them, as necessary. The goals The declared goal of the New Regulations is to clean up balance sheets, and recapitalize Spanish banks. Another (more subtle) goal would be to invite banks to merge or sell their assets (their repossessed assets) to investors. Some hope that the ultimate goal is to mark-to-market property loans and repossessed assets and create a market as a result; the key issue is whether these New Regulations will be enough to create such an effect. From a more technical (and less commercial) point of view, the New Regulations put forward a new set of more demanding specific provisions How to achieve them: Further provisions and capital add-ons 2

4 to be applied on problematic assets on the balance sheets of Spanish banks, a new generic provision on normal (performing) property loans (which become problematic now), new capital add-ons, and the creation of bad bank-like property companies where Spanish banks will ultimately allocate and warehouse all repossessed assets. 3 Further cover on problematic assets The New Regulations elaborate on two main concepts: cover and problematic assets ( problematic assets which need to be further covered by provisions and capital buffers). 3.1 The real estate sector problematic assets The New Regulations impose new cover on problematic assets warehoused in the balance sheets of Spanish banks (as of 31 December ). Traditionally, Bank of Spain has classified banks assets (loans and other assets) based on their level of risk ( nivel de riesgo ), as follows: (a) (b) (c) (d) (e) Healthy, normal loans (with no significant risk); Sub-performing or sub-standard loans ( subestándar, which are still performing but show weaknesses, such as loans to social groups going through difficulties or entities/individuals in problematic geographical locations); Non performing, delinquent or doubtful loans ( dudosos por falta de pago ), on payment default for longer than 90 days; Non performing or doubtful loans ( dudosos ) for reasons different to a payment default; and Repossessed assets ( REOs ), activos adjudicados taken by Spanish banks as a result of enforcement of loans, debt-for-asset swaps ( daciones en pago ) or otherwise. Problematic assets Under the New Regulations, all these assets (including normal loans) are deemed problematic insofar as they relate to the property sector. 3.2 Further cover The New Regulations impose higher levels of cover for all those problematic assets (property loans, even normal ones, and repossessed assets). This cover translates into three different mechanisms that Spanish banks will need to apply onto their legacy problematic assets (as of 31/12/2012): (i) additional specific provisions, (ii) a new generic provision on normal property loans and (iii) extra capital add-ons. New levels of cover This is important: when the press (and Bank of Spain itself 2 ) published, after the passing of Royal Decree-Law 2/2012, that the new cover would be up 1 The New Regulations apply to these so-called legacy assets, on an one off basis; any new or existing asset that qualifies as a problematic asset in the future will be subject to Circular 4/2004 but not to the New Regulations, with one exception: new repossessed assets will be provisioned up to 40% after their fourth year on the bank s books, as in the New Regulations. 2 New measures for the Spanish Banking System ; Banco de España / Eurosistema (4 February 2012). 3

5 to 80% (land), 65% (developments) and 35% (finished developments/housing), this cover needs to be implemented, in practice, through a combination of the three mechanisms (specific provisions, generic provision, and capital add-ons) Additional specific provisions (against banks P&L) The New Regulations (namely, Royal-Decree Law 2/2012) incorporate new specific provisions in addition to the existing ones (those in previous version of Circular 4/2004). These specific provisions apply to problematic assets (other than normal ), are different for each asset (in light of the different exposure or situation ) and take into account the security in place (are determined in light of the value that Bank of Spain allocates to the security in place). This is something specific, probably unique: accountancy rules imposed on Spanish banks allocate value to the real estate under each loan on payment default irrespectively of their market value. These specific provisions apply to the assets, very broadly, in the context of three different exposure scenarios or property situations: (a) (b) (c) Land Developments Finished housing On each of this three (generally speaking) situations, the specific provisions apply on the alive risk ( riesgo vivo ) of each loan, taking into account the value that Bank of Spain allocates to the relevant collateral (mortgage). In situations (property-related or not) where there is no collateral in place, the provisions apply on 100% of the alive risk of the loan (the outstanding book value of the loan); this situations (no collateral in place) are rare in the Spanish property finance market but may explain the new market created around consumer loans, as we will dwell on further in next section 5.1. Specific provisions depend on the type of real estate situations under the loan (and on whether the loan is secured against such real estate) The specific provisions imposed by Bank of Spain in Circular 4/2004 (as amended by the New Regulations) are very detailed and rife with exceptions and special rules and categories. We are attaching as an Annex to this note a chart with the rules and how they apply; it is a matrix that combines the different problematic assets with each specific situation (its specific exposure to real estate, in terms of land, development or finished property) and the value allocated to the relevant collateral. The result can be broadly summarized as follows (please refer to the Annex for more specific guidance): 3 The cover was later increased by Royal Decree-Law 18/2012, but in this case through one of the mechanisms (specifically, the new generic provision for normal property loans, to be increased up to 30%). 4

6 Land Circular 4/2004 (before New Regulations) New Regulations Substandard: Subject to calculation on a case-bycase basis (10% on average) Doubtful (payment default): 25% during the first six months 50% during months 7 to 9 75% during months 10 to 12 months 100% after the first year If the loan is secured, then the provision will be reduced in the amount of the collateral (the collateral will be equivalent to the mortgage coverage less 50%) At least 60% Doubtful (other than payment default): 25% Incomplete Developments Circular 4/2004 (before New Regulations) New Regulations Substandard: Subject to calculation on a caseby-case basis (10% on average) Between 20% (if the works are in progress) and 50% (if the works have been interrupted) Doubtful (payment default): 25% during the first six months 50% during months 7 to 9 75% during months 10 to 12 months, 100% after the first year If the loan is secured, then the provision can be reduced in the amount of the collateral (the collateral will be equivalent to the mortgage coverage less a percentage ranging from 20% and 40%, depending on the type of asset). 50% Doubtful (other than payment default): 25% 5

7 Completed Developments Circular 4/2004 (before New Regulations) Substandard: Subject to calculation on a caseby-case basis (10% on average) New Regulations Between 20% (if the loan is secured) and 24% (if the loan is non-secured) Doubtful (payment default): 25% during the first six months 50% during months 7 to 9 75% during months 10 to 12 months, 100% after the first year If the loan is secured, then the provision can be reduced in the amount of the collateral (the collateral will be equivalent to the mortgage coverage less a percentage ranging from 20% and 40%, depending on the type of asset) 25% Doubtful (other than payment default): 25% This is the main framework for provisions on property loans. When a Spanish bank enters a property in its balance sheet, it is obliged to take provisions on the entry value of the property, which would be the lowest of (i) the outstanding debt under the loan whose enforcement has given rise to the repossession or (ii) the appraised value of that property at entry. The rules compare basically as follows: REOs REOs Circular 4/2004 (before New Regulations) New Regulations 10% during first year (1-12) 20% during second year (13-24) 30% during third year (25-36) 40% from the end of third year (+37) 25% during first year (1-12) 30% during second year (13-24) 40% during third year (25-36) 50% from the end of third year (+37) Land: 60% at once On-going developments: 50% at once 6

8 3.2.2 Additional generic provision (against banks P&L) on normal property loans The New Regulations include also a new generic provision to cover normal positions in the property sector, which are generally considered now problematic. The New Regulations refer to an average additional provision of 30% (it was of 7% in February, increased to 30% in May), which translates into the following specific rules, depending on the property situation underneath each normal (performing) loan. Healthy ( normal ) property loans are consider problematic and subject to a new provision Normal (performing) loans secured with mortgages Normal (performing) non-secured loans Completed developments: 7% On-going developments: 22% 45% irrespectively of the type of asset. Land: 45% Capital add-ons (against banks core capital) In addition to the new provisions imposed by the New Regulations, Spanish banks will have to further increase their core capital. This is a consequence of the weightening of the risk allocated to each asset in terms of its core capital consumption. These capital requirements, imposed by Basel III, have been considered a killer in terms of Spanish banks capitalization and probably explain why some Spanish banks put portfolios of repossessed assets in the market (accepting beforehand that they would be sold below their book value with a loss): problematic assets (particularly, repossessed assets) weight far too much in the very much coveted core of the banks capital. Spanish banks will have to increase their capital buffers up to an average of 20% of the value of the loan in case of doubtful and substandard loans secured by land (15% in case of development loans) and of 20% in the case of repossessed plots of land (15% in case of repossessed developments). Risk-weightened assets and new core capital consumption Existing capital add-ons Increased capital add-ons Between 8% and 10% 20% (land) 15% (developments) 7

9 This new capital add-ons represent a capitalization challenge for most Spanish banks. The New Regulations offer a capital injection mechanism through public fund FROB ( Fondo de Restructuración Ordenada Bancaria ), of up to 15bn, in the form of convertible bonds ( CoCos ). Other terms and conditions of this public money contribution are not detailed in the New Regulations, but this is a key new element in the Spanish Government s plans to recapitalize the banking sector. Injection of capital by FROB The result: an estimated 84bn additional clean-up The New Regulations are easier to understand when taken in light of the big numbers (the estimated result in terms of billions of clean-up that they try to achieve) than when analysed (and then applied) in detail, on a case by case basis. Royal Decree-Law 2/2012 aimed to achieve an overall result amounting to 50bn, of which 25bn were the estimated result of new specific provisions, 10bn of the new generic provision on normal property loans and 15bn of new capital add-ons; the increase of the general provision on normal property loans required by following Royal Decree-Law 12/2012 pursues an additional 30bn effort. The general hope is that this would be enough 4. The big numbers of the new clean-up 3.3 Steps / deadlines for implementation The New Regulations will apply to all problematic assets on the banks, balance sheets (including new problematic normal property loans) as of 31 December 2011, on a one-off basis. Banks are required to apply the New Regulations, as a general rule, before 31 December 2012, and present an implementation plan to the Bank of Spain before 11 June However, banks with a plan to merge approved by Bank of Spain (a plan which needs to be submitted for approval before 30 June 2012) will have a further 12 months, as from the approval of the merger plan, to implement the New Regulations 5. This includes the provisions (specific, generic) and capital add-ons analysed so far, but also the creation of the new affiliate property companies. Clean-up of legacy assets and creation of new property companies by 31 December 2012 (generally) 4 The new bad bank-like property companies Banks are also required to create property companies ( Sociedades de gestión de activos ) where they will allocate and warehouse all repossessed assets. According to Royal Decree-Law 12/2012: 4 On 25 May 2012, the date when we issued this note, the newly appointed chairman of the board of Bankia, Spain s forth retail bank, announced a request of 19bn of State funding to recapitalize Bankia and its main shareholder BFA. This public capital injectian, which adds to the 4.3bn already lent by rescue fund FROB, is due to the extra 8.7bn that Bankia (BFA need to comply with the new provisions and capital add-ons imposed by the New Regulations (the rest of the 19 bn will cover other losses within the Bankia group). 5 In the context of this clean-up plans, the Spanish Government has also decided to prepare an independent audit of all Spanish banks (that will cover all assets in the balance sheets of the banks, and not only those which are problematic or, more generally, property-related). The media are consistently saying that the Spanish Government has already appointed Oliver Wyman and Roland Berger as independent auditors. New property companies to deconsolidate and attract investors 8

10 (a) (b) Plain Vanilla Companies. They will be private corporates ( sociedades de capital ), with no regulatory or other requirements; Value of REOs at entry. The entry value of the property assets will be equal to their reasonable market value or, if no "reasonable" value can be calculated, to their book value minus the provisions applied under the New Regulations (the assets will be transferred after the provisions have been effectively made by the banks); (c) Deadline. The transfer shall be completed by 31 December 2012 (with the exception of merging banks, which will have 12 months after the merging plan is approved by Bank of Spain); (d) (e) (f) Business plan. The property companies will be obliged to sell at least 5% of their assets every year (which implies a de facto maximum 20-year duration); Off-balance sheet. These companies will deconsolidate if (i) they hire an independent manager and (ii) other investors unrelated to the bank hold a stake of at least 51%; and Tax neutrality. There are some other benefits including tax neutrality and reduced notary and Land Registry fees. 6 5 Will these New Regulations create a market? The key question, for both Spanish banks and investors is whether these New Regulations will create a market. We dare to anticipate different situations depending on the kind of product. 5.1 Consumer loans We have already witnessed trading of big portfolios of consumer loans between Spanish banks and specialized international investors, even prior 6 The special rollover relief regime for corporate reorganization transactions mergers, spin-offs, contributions of assets, exchanges of securities, will be of application to the transfers of assets and liabilities made to the new property companies, regardless of the way in which the transfer is carried out. This regime is based upon two basic principles: neutrality (taxation must not promote or obstruct corporate reorganizations) and absence of administrative intervention (the regime is applied without a previous administrative authorization). The application of the special rollover relief regime to the new property companies means basically the following: The income derived from the transfer of assets and rights will not be taxed. The taxation is deferred until those assets and rights are transferred by the new property company. As a consequence, the assets and rights received by the new property company will be valued for tax purposes, at the same value as they had in the transferring bank before the transaction was performed. No indirect or local taxes (e.g. Municipal Tax on the Increase in Value of the Urban Land) will be levied. Subsequent transfers of a significant stake in the new property companies would not be subject to Transfer Tax. The general rule establishes that the direct and/or indirect acquisition of more than 50% of the shares in a real estate entity is subject to Transfer Tax, payable by the purchaser. This test must be conducted at fair market value on the company s balance sheet at the date of the acquisition. Finally, Royal Decree Law 12/2012 introduces a 50% exemption on the taxation of the capital gain obtained in the transfer of urban real estate acquired from 12 May 2012 to 31 December This exemption applies to resident and non-resident individuals or companies and is of application regardless of the year in which the capital gain is obtained this is, regardless the date in which the urban real estate acquired during the abovementioned timeframe is further transferred 9

11 to the New Regulations ( consumer loans without a collateral, are almost alien to the property market). These deals will continue, in all likelihood, driven by the following: (a) Pricing. Spanish banks have to provision 100% of delinquent consumer loans after one year. Any offer price received for them after that one year would be attractive. This is the thirty (or less) cents on the dollar slot in the Spanish banking market. (b) Strategy. Specialist investors count on their affiliate servicers to manage these portfolios: they have the track record and the expertise. The business plan demands a very intensive management and a medium, long term exit strategy: returns take time. Consumer loan portfolios at big discounts and managed by professional servicers (c) Fundamentals: Investors are well advised on the legal particulars of this kind of deals, such as Spanish law protection to debtors in terms of mínimum amounts which are not seizeable ( cantidades inembargables ), conditions for a valid transfer of credit rights (notice to the debtor, where in so many cases the debtor in untraceable), etc. 5.2 Mortgage-secured loans So far, there have been a few deals on mortgage-secured loans out of Spanish banks (with residential underneath; as we will explain further below, Spanish banks barely have exposure to commercial real estate). (a) Pricing. The New Regulations, with stricter requirements in terms of provisions and capital buffers, will help bridge the gap between the book value of these residential, mortgage-secured loans and the bids that investors have been able to place. (b) Strategy: A loan-to-own strategy through the acquisition of mortgage-secured loans can be expensive (stamp duty is triggered upon the acquisition of the mortgage) and its servicing is far more complex than that of unsecured consumer loans; it requires expertise on foreclosure procedures (something which cannot be taken for granted, and this includes legal advisors and local servicers). Enforcement procedures are rife with legal issues and loopholes, and timing is difficult to assess (since it depends, among other things, on the workload of the relevant Court). Loan to own strategy through mortgage enforcement (c) Fundamentals: This kind of transactions are heavily driven by legal requirements. The underneath product may not be very interesting either (loans on residential units scattered all throughout Spain and barely liquid, in poor condition). We have seen more interest from investors in cherry picked developments which can be taken through the execution of the mortgage (or, preferably, through a debt-forasset swap with the defaulting developer), and subsequently completed by investors with a retail bank on their back ready to finance the end buyers when the development is completed. 10

12 5.3 Commercial Real Estate Inspired by similar deals with international banks in Spain, investors show a great interest in loan-to-own acquisitions of commercial real estate debt from Spanish banks. These deals are not happening (or not so significantly as to consider that there is an open market here), mainly for the two following reasons. Limited exposure to commercial real estate (a) Limited exposure. First of all, Spanish banks do not have a significant exposure to commercial real estate (with a few exceptions). Developers and investors preferred to use international banks to finance their commercial real estate ventures in Spain, for a number of reasons (pricing, but more importantly, bullet financings; international banks were keen to provide financings on an interestonly basis, assuming the refinancing risk at maturity; Spanish banks were very much reluctant to do so, and offered financings with amortization schedules which were much less attractive to sponsors). With a few exceptions, Spanish banks deal with their limited commercial real estate exposure on a case-by-case and offmarket basis. (b) Pricing. Assessing the price of these few commercial real estate positions may be difficult. It is unclear how Spanish banks treat them accounting-wise. Some experts even argue that Bank of Spain provisions (Circular 4/2004 and/or the New Regulations) do not or should not apply to commercial real estate (or to some sectors within the broader commercial real estate market, like hotels, for instance) Acquisitions of repossessed assets There has been a lot of noise in the market in the aftermath of the press release of Project Scuderia (the potential sale of a 3.8bn, initially, portfolio of repossessed assets by Santander); this deal (still on-going?) was supposed to be a benchmark for more REO disposals to come. Other Spanish banks (La Caixa, BBVA) have recently announced their plans to sell REO portfolios of similar size and shape (residential units and developments, plots of land on their balance sheet or in their property subsidiaries). REO portfolios: a credible trend? (a) Pricing. It is common knowledge in the Spanish market (echoed by Spanish press) that these deals will not happen until REOs are further provisioned, since their book value is still far North of the bids put by investors; the New Regulations would be an important push in this direction. On the other hand, the main driver of these deals, and the reason why Spanish banks may have consider to sell these assets for prices below their (already heavily provisioned) book value (which implies taking a loss) is the unsustainable impact of these repossessed assets in their core capital (new capital add-ons). The main reason behind a decision to sell would be solvency (core 7 See IREA Inmobiliario of May Ley de Saneamiento del Sector Financiero, by Juan García. 11

13 capital requirements) rather than liquidity (capacity to take further losses). (b) Strategy. Investors have declared a clear, straightforward strategy, driven by volume (REO portfolios need to be big) and a fire-sale business plan (massive sale of product at knock-out prices, which limits the portfolios to residential units and excludes illiquid product like land). (c) Fundamentals. Volume and timing excludes intensive due diligence; the perimeter (a key word these days) captures only liquid assets with no cloud on title (legal DD is limited to title and charges). The deal is tax-inefficient per se (direct acquisition of residential units triggers non-recoverable, non-financeable Transfer Tax at an average 8% rate to be paid by the buyer). Investors may require vendor financing from the selling bank (which will be qualified as substandard by Bank of Spain in all likelihood). Investors may also require an equity layer from the selling bank (through an equity participation in the purchasing vehicle, which makes deconsolidation very difficult for the selling bank, or through an alternative subordinated financing, of doubtful accounting treatment since it would be subordinated to the already substandard vendor financing). The subsequent fire sale of the portfolio will require very intense asset management (in the context of strong competition, even on the part of the selling bank which is trying to sell its remaining assets to the public on a fire-sale strategy as well). And, finally, the key issue remains who will finance the end buyers; some investors may have back-up retail banks ready to fund the buys, but liquidity-drained Spanish banks will not provide financing to individuals interested in buying houses other than those on their own balance sheets. 5.5 Investors in property companies The New Regulations impose on Spanish banks the creation of property companies where they will have to allocate their REOs in the short term (by 31 December 2012 as a general rule). These property companies will deconsolidate once the participation of the banks (their sole shareholders on day one) dilutes to 49% or less of the share capital. This is a clear invitation to bring investors on board, but whether this new clean-up, market-making initiative will be successful remains anybody s guess. Some doubts and general queries have been already raised, like the following: The new real estate companies: investors are welcome! (a) Financing. Who will finance these off-balance sheet-to-be property companies? The banks themselves, through substandard loans? These property companies will be formed with credit to non-income producing assets, so they will need some interim financing. If investors do not participate in these vehicles at a very early stage, their short-term financing is going to be a key issue for their viability in the longer term. 12

14 (b) (c) No backstop for investors. Some investors have already raised their concerns about one of the weaknesses of the initiative: there is no backstop for them, since the New Regulations do not envisage any asset protection scheme to back-up losses. Investors already anticipate further losses; in their view, the assets will not be markedto-market enough when their allocation into the new property companies takes place (even considering the previous provisions). Bad land banks. These new property companies will have to warehouse the big portfolios of land currently held by banks. Land is a very illiquid asset these days, no investor seems interested in buying land in Spain, and the new coverage requirement does not look like an incentive; some investors argue that land in Spain has a negative value and that the banks should pay the buyer instead!!. Land will probably remain a big issue which goes beyond accountancy and to which Spanish Authorities at all levels should probably give some thought. 13

15 Madrid, 25 May 2012 Jesús Varela Partner Real Estate & Banking Phone: José Miguel Domenech Senior Associate Banking Phone: Phone:

16 Madrid Office Barcelona Office José Ortega y Gasset 29 Avenida Diagonal, 456, 7º Madrid Barcelona Spain Spain Phone: Phone: