Drop in housing prices may put further strain on banks, boosting capital needs

Greek banks are fully aware of the need to boost their capital base to cope with more bad loans and potential losses in their bond portfolios as they strive to maintain liquidity at satisfactory levels. However, the biggest threat to their equity capital may come from an unexpected source: the real estate market. Greek banks are understandably concerned about liquidity on the back of the country’s new and expected rating downgrades by major credit agencies, their shrinking deposit base and their inability to tap wholesale markets. Fitch Ratings downgraded Greece’s credit rating to «junk category» of BB+ on Friday, becoming the last of the three major credit agencies to do so. Moody’s is likely to proceed with further downgrades in the next few weeks, reducing the potential liquidity local banks can get from the European Central Bank (ECB). This is so because the value of the collateral in the form of government bonds, asset-backed securities, senior bank bonds and even covered bonds is adversely affected. Of course, local banks are concerned about liquidity because their deposit base continues to shrink as some households and companies withdraw cash to pay for imported goods and services or transfer them abroad for safety reasons as uncertainty over the future of the economy still lingers. But the so-called troika, the representatives of the European Commission, the ECB and the International Monetary Fund (IMF), have shown that they will not let a systemic banking crisis ensue by authorizing the issue of new state guarantees worth 25 billion euros last time around. Banks can «attach» the state guarantees to their new bonds and take them to the ECB for cheap funding. Although liquidity appears to be a major problem, banks have turned their attention to raising capital to cope with expected loan and bond losses. Major banks, such as National Bank of Greece and Piraeus Bank, have either completed or are in the process of implementing rights issues. National Bank and EFG Eurobank are eyeing the sale of either minority of majority stakes in foreign subsidiaries to do the same. Other banks are also due or expected to follow suit. The reasons usually cited to justify these actions range from the imposition of stricter regulatory requirements to the challenging macroeconomic environment in Greece, and potential losses related to any future rescheduling of the Greek public debt in private hands. It is well-known that more and more households and companies find it difficult to service their loans as unemployment rises, incomes are cut and sales suffer as the recession bites. So-called non-performing loans (NPLs) are rising almost steadily and expected to peak to around 14-15 percent of total loans either in 2011 or in early 2012 in Greece. Banks obviously do their best to not see their clients go bust because this will force them to write off these loans and hurt their regulatory capital and capital adequacy ratio. NPLs could peak at a higher rate if it were not for the widespread practice of loan rescheduling. Although NPLs and bonds are two sources of concern for banks as far as capital adequacy requirements are concerned, little attention has been paid to another source of concern: the local real estate market and most notably house prices. The rapid expansion of the housing markets on the back of a surge in mortgage loans contributed almost 1 percentage point to annual GDP growth in the previous decade until the end of 2008, according to an older study by the National Bank of Greece. However, the residential market has been declining since 2009, according to central bank data, and 2007 according to real estate agents. According to Bank of Greece, the index of apartment prices fell 4.3 percent year-on-year in the third quarter of 2010. It had dropped 4.0 percent in the last quarter of 2009. The real estate market has direct and indirect effects, such as a negative wealth effect on consumption, on the economy and therefore affects the banks. The latter are in so-called cyclical play, that is, their performance depends on the ups and downs of the economy. However, banks may be affected even more if house prices decline further on the back of the recession because they have to set aside more capital for the mortgage loans they provided in the past if the LTV (loan-to-value) ratio rises above 75 percent. The loan-to-value is an important risk factor which expresses the balance of a mortgage loan to the appraised value of the house pledged. At the end of November 2010, the outstanding amount of housing loans stood at about 80 billion euros. Theoretically speaking, if house prices were to fall by 10 percent in 2011, this could have led to an additional capital requirement of 3.2 billion euros if the average LTV ratio rose above 75 percent. In reality, this is not likely since some mortgage loans have been given many years ago and therefore their LTV is much lower. Yet, a good portion of the loans may be affected if prices fall considerably, according to people with knowledge of the matter. The latter point out that appraisals are done by experts working with banks for years and therefore it is in nobody’s interest to make things worse by marking prices very low. Also, the increase in capital requirements due to a potential significant drop in house prices should not be confused with the increased provisions for non-performing mortgage loans taken by banks. The latter hit the banks’ P&L (profit and loss) statement first. All-in-all, the real estate market may represent another source for capital needs to local banks if house prices fall steeply in 2011 on the heels of the recession. It is therefore in everybody’s interest to take initiatives and measures to get the real estate market out of its slump.