The Eurozone: Opportunities During the Impending Troubles

by Dechert LLP
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[author: Rick Jones]photo of Rick Jones

Following up on last week’s cheerful exegesis into the data which is the dropping of the impending European banking and sovereign meltdown, I recommend Dechert’s Euro Crisis Website. It contains a series of Dechert OnPoints and White Papers providing in-depth analysis of the impact of Grexit and the rest on asset managers and other financial players. Shocking but true, it’s now time to say that every financial market participant needs to develop executable contingency plans for the possibility of one or more exits from the Eurozone. (See the very good article "Europe must prepare an emergency plan" by Robert Zoellick in the Financial Times on June 1 about lenders' need to get ready to “break the glass” on contingency planning.) Maybe some sort of fix, temporary or otherwise, will be embraced at the edge of the precipice to keep Greece in the Eurozone and prevent contagion. Maybe we bump along and somehow oodles of liquidity, a promise of a bit of structural reform and a little growth will let us skate over the broken ice, but I think not. Grexit happens, several other countries will follow Greece out the door and the EU banking system will be profoundly damaged. A deep EU recession will result and international banking functionality will be impaired. (See the article "Banks Park Record Funds with ECB" by Todd Buell in the Wall Street Journal on January 5 on the rapid retreat of the interbank lending market.)

With a true crisis on the door step, we need to think about the impact of all this on commercial real estate finance markets here in the U.S. and elsewhere, make plans to weather the storm and perhaps, as importantly, look for opportunities. Crisis inevitably, albeit painfully, begets opportunity. While admittedly there is more than a whiff of The Decameron in the search for financial success in this financial black plague, come on, enough doom and gloom. Today, we’re hunting opportunities. So where is the arb? Where are the opportunities?

  • There is a reasonable possibility that the contagion from the European banking crisis will cause a vicious down draft in assets and deposits which will impair U.S. bank appetite for risk and limits the ability of the banking system to provide necessary liquidity for the U.S. domestic commercial real estate marketplace. Does that mean there are opportunities for a non-bank financial sector growth in the U.S.? It seems it does.
  • Even as CMBS spreads continue to gap out in this terminal interest rate environment, might demand return for structured product during the continued pendency of this crisis? After all, where does the world go for manageable risk and a modest return? Maybe EU participants will buy U.S. structured product again. While Article 122a does bite (this prevents EU banks from buying securitization product without 5%, or more, risk retention) and even with the financial equivalent of post-traumatic stress syndrome still common, you’ve got to find a return on investment somewhere, right?
  • What’s to be done with Euro denominated credit exposures? Most Euro denominated exposures need to be reviewed for the risk that the holder will be paid in a conversion currency even if the legal documents specify payment in Euro. If U.S. or UK law applies to the transaction, the situation is certainly better. However, prior Greek bond non-default-default suggests that sovereign chicanery can still make parties absorb massive losses regardless of structure. Are there trading opportunities around this uncertainty?
  • Will we see continued bank downgrades? Almost certainly. What will these downgrades mean in terms of counterparty exposure? What institutions can hold deposits or manage accounts under PSAs? What are acceptable counterparties for swaps and other derivatives? Most legacy transactions birthed in the era of AAA and AA financial institutions are now a minefield as the banking system has been broadly downgraded. What are the fixes? Who might be the winners as this progresses? Can strong institutions Hoover up these orphaned accounts or get paid to backstop?
  • Will the banking jog devolve into a banking run, resulting in major outflow from the periphery and a knock-on influx into dollar denominated U.S. assets? While it may be that it’s only the Euro that makes the dollar look good, right now investments denominated in dollars have a competitive advantage against anything denominated in Euro, and certainly anything where the ultimate payment obligation is subject to currency conversion into a new, non-Euro currency. Check in with AFIRE. Its annual meeting is coming up in September. We’ll be looking for a lot of enthusiasm in parking wealth in U.S. CRE at that meeting.
  • Will EU banks actually, finally, unlock their vaults and monetize the purported €2.5 trillion of “non-core” assets in the EU banking system? Is there really $60 billion of hedge fund private equity dry powder (both as recently reported by PWC) salivating over this opportunity? As banks, of necessity, are re-capitalized and/or backstopped by sovereigns or international financial institutions like the ECB, is that the point where the banks may have the right sized safety nets and the right incentives to take marks, sell assets, raise Euros or, even better, dollars and cleanse the balance sheets?
  • Is there really an opportunity for healthy U.S. financial institutions to do business in the EU? It has been widely reported that the EU banking system will not be able to provide necessary credit to finance its commercial real estate market. Some U.S. financial institutions are there now. Many more will try their hand at EU lending (at least in northern Europe, where lenders might actually be able to enforce their loan documents).

The process of prophylactically preparing for further damage to the Eurozone and Eurozone financial institutions will, at a minimum, generate interesting transactional activity throughout the U.S. (and the UK). This mess in Europe will, with a certainty, deliver some enormous opportunities. So between fixing the negative externalities and benefiting from the positive externalities of the European meltdown, with my U.S. centric hat firmly on my head, maybe there’s something to do here.

By Rick Jones.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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