Investment banks build up property financing presence

Through the use of investment banks’ conduit technology – an entity through which banks issue securities backed by mortgages they have bought from other financial institutions or that they have originated themselves – the capital markets have become a growing force in the real estate financing business. Growing numbers of investment and commercial banks have begun setting up their own non-US conduit departments to issue commercial mortgage-backed securities (CMBS).

The move, though potentially lucrative, does raise questions – one being whether the most recent entrants are too late to join the party. And how does this move affect banks’ risk profiles? Is a conduit business compatible with the traditional lending relationships of commercial banks?

European timing

The US conduit market was kick-started by the collapse of the local real estate market almost 20 years ago, when traditional bank lenders abandoned the financing business. With no competition from the commercial lenders, investment banks set up conduit programmes and were able to pick and choose among borrowers, building up their businesses gradually.

The development of the European conduit market comes against an altogether different backdrop. The real estate market is buoyant and the investment and commercial banks are pitted fiercely against each other for lending business. This begs the question of why there is any need for a European conduit business at all.

Stephen Green, managing director of real estate finance at Merrill Lynch, says that although many investment banks – including the market local leader, Morgan Stanley – have been active in this area since 1999, it is only now that there is a real argument for being so. He says: “In contrast to the US, in Europe we had a well-developed and healthy industry that was dominated by the German mortgage banks (see covered bonds supplement with this issue), so there was no particular competitive advantage in us entering the origination business. The economic problems that have since arisen in Germany have meant that the local lenders are much less aggressive and powerful than they used to be. Meanwhile, the sophistication of the capital markets has increased, costs have come down and the competitive dynamics have shifted.”

Like Merrill, Credit Suisse First Boston (CSFB) has a formidable presence in the US conduit market, where it claims to have held the leading position for the past five or six years, extending $9bn-$10bn a year in loans. But it has only recently set up a business in Europe. In June, the bank raided Morgan Stanley’s ranks, bringing on board Arvind Bajaj, who went in as managing director and head of European CMBS distribution to set up the European franchise, joining Arnand Gajjar, who has been with CSFB since 1996. Mr Bajaj says: “We have been a pioneer in the US CMBS market and see huge growth potential in Europe and Asia. At present, the US conduit market is worth $75bn-$80bn a year, compared with just $15bn in Europe – but we think Europe presents a fantastic growth opportunity and will ultimately reach US levels. Although the conduit business has had starts and stops here in Europe, we believe that it is now here to stay.”

Competition heats up

Both Merrill and CSFB believe they have a strong chance in Europe where they are investing heavily, despite the hefty competition posed by the more established players in the region and the growing number of local commercial banks entering the business.

“In instances where commercial banks are willing to hold loans on their balance sheets for uneconomic returns, then we obviously will not compete; but otherwise, we are on an equal footing with them,” says Mr Green. “Borrowers tend to be unconcerned about whether they are borrowing from commercial banks or investment banks, and similarly about whether the loans are later securitised or syndicated. Their principle concerns are leverage and pricing.”

Mr Bajaj says: “We are in the process of building up our European team, which is already over 20 strong. We plan to leverage CSFB’s position in this business in the US and effectively collaborate across the firm to establish ourselves as a top three player in this market in Europe.”

Formidable competition

One of the most formidable new entrants to the European market will be following an altogether different model from those of both Merrill and CSFB, and is particularly illustrative of how a commercial bank can profit from the establishment of a seemingly competitive conduit offshoot. The Barclays Group recently set up a conduit business which sits within its Barclays Capital division, but which is based largely on business generated by Barclays Bank.

Lynn Gilbert, the newly appointed head of the European mortgage-backed securities group at Barclays Capital in London, and another former Morgan Stanley staffer, says: “We are unique because of this set-up. The CMBS team’s transactions at Barclays Capital are all done together with Barclays Bank. We work with the bank’s lending team, help them develop their client base, look for new business and source loans in the UK and across continental Europe.”

Lynn Gilbert: ‘We see our positioning and offering as totally unique’

Ms Gilbert aims to have an integrated approach and be involved in every stage from the origination of deals – on which her team will work together with the real estate relationship directors at Barclays Bank, through the provision of term sheets – to the closure of the transactions. “This allows us to provide bespoke financing solutions with fast turnaround,” she says. “Moreover, everyone in the 11-person CMBS team works across all the functions so that we all are involved in origination, credit analysis, execution, rating agency [discussions], securitisation execution and distribution of the eventual bonds.”

Since few of Barclays’ investment banking competitors have the same origination network and historic relationships, the group will have an unusual advantage. “We see our positioning and offering as totally unique,” says Ms Gilbert. “In contrast to our set-up, many of our competitors are just originating to securitise; for instance, some investment banks are not natural lenders, and are effectively taking on additional risk when entering this business.”

Barclays’ set-up also puts it in the fortunate position of being well-placed to compete with other commercial banks. Ms Gilbert says: “We also have unique advantages over and above the other UK clearers, none of which have our capital market distribution capabilities – and some of which have not been involved as extensively in the real estate lending market as Barclays has. It is still early days, but because Barclays has much more in-depth involvement in the market than our competitors, we should be well placed to ensure that we secure a good share of the real estate transactions that come to the market.”

Barclays’ move into the conduit business allows the group to exploit existing synergies within its two divisions and, at the same time, to free up valuable capital and credit lines. “We see the business as a client-led method of allowing us to recycle capital, increasing our ability to work with new and existing clients. Because Barclays Capital has such strength on the bond distribution side, it was also a logical way to extend our real estate lending business. Ultimately, the CMBS business will reduce our exposure as well as expand our ability to lend,” says Ms Gilbert.

Other players

SG Corporate and Investment Banking (SG CIB), which launched its CMBS conduit activities in late 2003, has a similar set-up to Barclays, although the whole of the bank’s real estate business is contained in its investment bank and is not a joint venture with parent Société Générale.

The bank established a joint venture between its securitisation and real estate finance teams, which are both part of SG CIB’s debt finance group. Under the arrangement, both groups work together at an early stage of the deal to analyse the eligibility of loans, while the real estate finance team manages the origination side and the securitisation teams manage the structuring and distribution of the bonds. Prior to setting up its conduit business, SG CIB’s real estate finance group originated and syndicated the loans. The group is still doing this but to a lesser extent – the idea is that the capital market model/conduit route will take over.

The French bank launched its first transaction of just over Ł200m in March this year. It was composed of five loans on seven different buildings concentrated in the London area. One of the distinguishing characteristics of the portfolio was that it was high quality with a good share of government related leases in it. The quality of the portfolio allowed the bank to come to market at a spread of 28 bps at the AAA level – which at the time was the tightest pricing of any UK CMBS.

Risk reduction

Much like the Barclays Group and another new European market entrant, Citibank, SG is effectively reducing its overall risk and is able to reach a new class of investors, as well as being able to benefit from the higher margins prevalent in the capital markets. An additional benefit – and one of the main drivers for participating banks – is the growing focus on risk management and capital requirements. Keeping the traditional 20% of loans on balance sheet is increasingly expensive and the capital markets therefore provide a clear exit route. Being able to leverage their origination capabilities in real estate finance and the distribution capabilities of their capital markets and securitisation teams is an added bonus.

From a risk perspective, the all-service banks are also on a better footing. Far from originating to securitise – with the inevitable risk that the take-out might fail – the banks are conducting business as usual, while reducing risk. Ms Gilbert says: “Because we look at every potential lending transaction on a client-led basis, we make loan decisions based on whether they are suitable for CMBS bonds or not. This provides us with huge flexibility but also ensures that we are all clear at the origination stage of where the risk is best placed, and are able to make informed lending decisions on that basis.”

In the near future, these banks have their work cut out to compete with the established franchises of Morgan Stanley and the other investment banks. But compared with the pure investment banks whose commitment to the conduit business is more likely to fluctuate along with the inevitable ebbs and flows of investor appetite, the all-service banks’ conduit businesses – if they prove successful in the near term – are likely to be here for the long-term.