More banks could be forced to re-weight portfolios like Metro

Metro Bank’s share price dropped to a record low earlier this month, down 75 per cent compared to January, a consequence of an error in risk weighting its commercial buy-to-let loans which came to light earlier this year.

As an alternative lender we were in a good position to observe some interesting developments in the commercial buy-to-let market over the past three years.

For example, in 2015 the majority of the bridge loans Fiduciam provided were related to buy-to-let. But progressively during 2016 and 2017 we lost this business as the challenger banks, including Metro Bank, became more aggressive in this segment, offering substantially lower interest rates.

This was incomprehensible to us as the international banking regulation framework, Basel III, requires a substantially higher risk weighting for commercial buy-to-let loans than for residential mortgages.

Basel III increased these risk weightings following the financial crisis to ensure that banks have sufficiently strong capital buffers when they have to write down loans during recessions and continue to have the confidence of savers at all times.

Eight per cent interest needed

According to reports, Metro Bank had erroneously put a risk weighting of 35 per cent on its commercial buy-to-let mortgages, which it had to increase to 100 per cent, as required by Basel III.

Considering the Basel III risk weighting and capital requirements framework, and assuming a 70 per cent cost-income ratio, which is an average for the UK bank sector, we have calculated that a bank would have to charge interest rates of approximately 8 per cent per year on commercial buy-to-let mortgages.

This would achieve a return on equity of 20% which would be a fair expectation set by bank shareholders.

Basel III did open a window for alternative lenders such as Fiduciam, which are financed by institutional risk capital rather than bank deposits or bank funding lines, to enter the commercial buy-to-let market, thereby reducing the demand on banks to provide such commercial buy-to-let mortgages, and consequently to lessen the risk on banks’ balance sheets.

Basel III did open a window for alternative lenders such as Fiduciam, which are financed by institutional risk capital rather than bank deposits or bank funding lines, to enter the commercial buy-to-let market, thereby reducing the demand on banks to provide such commercial buy-to-let mortgages, and consequently to lessen the risk on banks’ balance sheets.

More risk re-weightings to come?

We now understand better what has happened, at least at Metro Bank, however questions remain.  Some challenger banks continue to offer very low interest rates on commercial loans, which appear to be inconsistent with Basel III.

As an international lender we also observe that Basel III is implemented differently across the E.U., which is hard to understand considering there is an EU regulatory framework.

For instance, in the Netherlands a low risk weighting for commercial buy-to-let loans is standard, fuelling a frothy real estate market.

Finally, we notice an increasing number of challenger banks are lending to alternative (non-bank) lenders at low interest rates, which raises the question how those funding lines are risk weighted.

Metro Bank has tackled its Basel III risk weighting issues and has since raised more than £375m in equity, assisting in a recovery of its share price, but based on the above observations the question arises whether we will see similar risk re-weightings in the wider challenger bank sector and even internationally.

The complexities and opportunities of the bridging market in Europe

You might be forgiven for thinking that the opportunities in Europe will be under threat given our situation with the UK’s exit from the EU.

But, as a business that has been working in Europe for the past two years, we know that this is not the case.

Lending in Europe is not always easy, and in some countries not really possible, but we have made it our business to find ways to lend whenever, and wherever, we can. In some countries, other than local banks, there are very few lenders able to help investors and developers looking to obtain leverage over real estate in continental Europe. In fact, there are some countries where we are possibly the only other option.

When lending in a new country, the first step is to work out if it is indeed possible for a UK lender to lend, and if it is, then it’s a case of working out how. There are many nuances and almost every country has different rules and regulations, which can be quite different to the way we lend in the UK. There are similarities to the UK in Ireland, as you’d expect, but elsewhere lenders have to be very sure they are working in the right way. 

For instance, we can’t lend directly to French entities because French banks have a lending monopoly, but we can assist where borrowers have corporate entities outside France, but have French assets which can be used as security. 

In Spain, we face a different challenge. Although lending follows a more standard civil law process, assessing property values is much more problematic. Previous sales data is limited and often unreliable. This makes it difficult to compare anything but the most standard of property types. We set up our Spanish arm, with a full Spanish-speaking team, to deal with exactly these types of problems. 

In continental Europe, loan transactions are often cross border, for instance the loan being provided for a finance company in one country and the security being taken in another country. In Ireland and Spain, many loans are being used for debt restructurings, assisting in cleaning up the aftermath of the financial crisis.

One area we are particularly active in is enabling the directors of UK businesses to raise equity against their European property.

It has taken us a lot of time to develop our continental European bridging capability, but now that we are fully operational in Ireland, the Netherlands, Spain and France, we expect to double our lending volumes in these countries next year, with Germany, Switzerland and Luxembourg coming on top of that. Most of the jurisdictions we lend in are currently experiencing rising property markets, and the opportunities are multitude. We are there for the long run.

London brokers increasing their amount of international bridging

Based on observations and conversations over the past year, there appears to have been an increase in the search for international funds coming through London brokers.

A growing number of London brokers it seems, are being asked to access money by borrowers keen to do one of three things: either purchase an international property, carry out work on a property based overseas or, increasingly, release money from a property based in continental Europe in order to spend on property or business in the UK. In each of these cases there is another property that is being leveraged on a short-term basis in order to satisfy a development or business need.

There could be a number of reasons for this uplift, but it increasingly seems to be the case that if you have an international property and can’t find funds abroad then you look to London as an international finance centre. For flexible, short-term funding, London is still the place to come, even despite Brexit.

What is interesting is that the people turning to London brokers for help are not even all UK nationals, they are a number of different nationalities all of whom have property on the continent that they need to leverage on a short-term basis.

It makes sense that international brokers like Enness and Knight Frank will be approached for this business as they have international connections so may be contacted in multiple jurisdictions, but the demand seems to be wider than this with a much wider range of brokers being approached. It is not exclusive to London brokers either, but the demand does seem to be predominantly in this region.

The key reason seems to be that short-term finance is not generally available across the continent, but as awareness grows of bridging finance and how useful it is, this is increasing demand. And the key place to realise this demand is in London and the UK.

There has also been an uplift in UK business people releasing capital from properties they may own abroad in order to capitalise on business opportunities here. Many UK business people, especially developers, will have unencumbered property abroad. They are now seeing the opportunity to leverage it for their business or for property development. It is this segment of the market that is showing the greatest potential. This fast turnaround of short-term money can really make a difference to businesses needing to invest, or even needing working capital.

It is an exciting market and what that looks set to increase throughout the year as awareness of the possibilities increase, not only in the UK but across Europe.

The importance of knowing your lender – Part II

In part one, we discussed why it is important to know your lender. Now, we explain why this is even more relevant today and what can be done to reduce lender risk.

In our opinion, 2019 will be a challenging year for the bridging industry — for three reasons:

Widening credit spreads:

We have benefited from a very benign credit environment for the last few years and this will inevitably change. This may dry up the funding sources for some lenders.

Falling property prices:

 We have not really had a proper real estate correction in the UK since the early 90s. We may be witnessing one in London right now. 

Brexit:

 If there is a hard Brexit, we believe the UK economy could go into recession and major dislocations and disruption in the capital markets could occur, also directly affecting the credit markets. It is also possible that the can is kicked further down the road, in which case the ongoing uncertainty could cause investment to be subdued. The ongoing Brexit situation also means that politicians may come to power who otherwise would have no chance.  

As a result of this environment, we believe that other lenders could become more conservative, making it impossible for certain borrowers to refinance. 

In good times, the choice of lender may not be that critical but, in bad times, it is. 

What can borrowers do to avoid lender risk? 

The key is to use a well experienced broker which understands the health and reputation of the different lenders, and which can lead the borrower to the right one. While as a broker, you need to really get to know the different lenders, to help establish those that will treat your client right.  

Pick a lender with stable funding

Lenders that are excessively funded by wholesale funding, hedge funds or leveraged vehicles may face serious balance sheet pressures when the going gets tough. They may therefore be more likely to trigger default as this is one way to reduce balance sheet pressures.  

Select a diligent lender

Yes, there may be a few more forms to be completed and information to be provided as part of the application, but a diligent lender’s loan book is less likely to get into trouble.  

Select a sustainable lender

Glitzy offices may be nice, but you want to make sure the lender is cash-flow positive.

Consider the reputation of the lender 

Choose a lender that truly cares about long-term client relationships. 

Resist the temptation to over leverage

It may make it more difficult or impossible to refinance if the lender which accommodated the very high leverage disappears.

Make sure the exit strategy is realistic with enough buffer embedded in the loan

Delays are normal, but you do not want to be in a situation where the loan expires before the exit has been achieved.

Have the borrower meet with the lender to develop a relationship  

Not only will this make it easier for the borrower to work out problems if they occur, it also helps to get a better feeling for who your lender really is.

Diversify across lenders

Never become too dependent on one single lender.

The importance of knowing your lender – Part I

Last year, we suddenly received an increase in loan applications from developers in the midst of projects who wanted a new loan.

Such applications make us wary as typically a borrower looking for a new loan in the midst of a project means something has gone wrong. We soon discovered the reason was that the borrowers could no longer make further drawdowns under their existing facilities as their lenders had funding issues.

The press has widely reported the fate of Amicus, but we have also seen other lenders which seem to have funding issues. As everybody may remember from the RBS small business loans controversy, a lender with problems can destroy a lot of businesses.

There are principally three types of lenders that can threaten a borrower: those that lose their funding, and those that are either not sustainable or not ethical.

Lenders who lose their funding

Some bridging lenders depend on bank funding lines, some on P2P funding and some on institutional funding. Bank lines can be pulled easily, while P2P funding can dry up rapidly as a consequence of negative press and herd behaviour.

This will usually happen at the worst moment for a borrower: when it is difficult to get a loan from another lender. It may leave a borrower with a half-finished development, unable to make drawdowns or with an inability to extend their loan if the exit is delayed. The consequence is enforcement with a loss of equity in the process. 

For borrowers, it’s often impossible to understand a lender’s funding model, but brokers frequently have this insight. Lenders with non-diversified funding and loan book performance problems are most at risk of losing funding. 

Non-sustainable lenders

The fintech and P2P boom meant a lot of venture capital came flowing into our sector. This meant a lot of lenders were able to pursue a cash-burn business model.

The problem arises when venture capital investors run out of patience before the lender has become cash flow positive. A lender fearing something like this happening can create a vicious circle: the lender, knowing it needs to demonstrate growth to meet its original business plan projections, grants loans it should never have granted and portrays a much rosier picture than reality — until the card house collapses.

An enormous number of bridging lenders have been established over the past few years, and not all of them will prove to be sustainable. The broker plays an important role here, as he or she knows from industry gossip who is doing well and who is in trouble.

Non-ethical lenders

Unfortunately, we believe that some lenders’ business models are based on making money out of defaults or, even worse, lend-to-own. This does not mean they break the rules. It is easy enough for a borrower to have a project or exit delay, or to fail to comply with an administrative covenant. Indeed, the loan documentation is typically drafted to protect the lender, allowing it to easily declare a default.

Ethical lenders will work with the borrower to resolve the issue; others find it hard to resist the temptation to charge default interest and hefty fees. We continue to be amazed by the number of borrowers who fall into this trap. Clearly, more education is required on an industry level, although associations such as the ASTL have done good work to improve standards.

In part two we will look at why, particularly in 2019, knowing your lender is important, and give some practical steps for avoiding lender risk.