The U.S. commercial mortgage industry is in for another round of turmoil according to RBS (NYSE:RBS), with decreasing real estate prices and a wavering economy threatening defaults on a large chunk of loans modified over recent years.  The state-controlled British bank estimates that nearly half of the $48 billion in modified commercial mortgages will end up in troubled waters yet again. While this does not bode well for the banking group which has a notable presence in the U.S. under the Citizens and Charter One brand names, it is bound to significantly hit the country’s biggest mortgage lenders Wells Fargo (NYSE:WFC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) in coming quarters.
We have a $8.70 price estimate for RBS’s stock, around 30% ahead of its current market price – which is the effect of the significant bias against the European banks among investors as a result of the deteriorating debt situation in the region.
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RBS draws its conclusion that the commercial mortgage industry is going aground based on a series of indicators – most notably the fact that property prices have lost more than a third of their value since the peak they saw in 2007. A softening U.S. economy combined with the possible impact from a collapse in the economies of several key European nations also do not present a rosy picture for the future.
Another factor that reinforces their view is the fact that delinquency rate on commercial mortgages-backed securities were at a record high of 10.5% last month. The list of commercial mortgages handed over to ‘special servicers’ for deciding on whether they need to be modified or foreclosed also continues to swell.
So how does an increase in the default rates affect RBS’s value?
When default rates on loans increase – as in this case for commercial mortgages – banks set aside provisions for these losses, as a large part of the loans will have to be written-off. So increasing default rates will reflect in an increase in provisions for banks. You can see how an increase in the size of provisions for RBS’s Citizens & Charter One banks as a percentage of the loans outstanding changes our estimate of RBS’s value by making changes to the chart below.
Clearly, the fact that RBS’s involvement in the U.S. commercial mortgage market is but a fraction of the major American banks makes it obvious that the impact on their value would be significantly larger in comparison.Notes:
- Commercial Mortgage Repeat Defaults Poised To Increase, RBS Says, Bloomberg, Jun 11 2012 [↩]