Draft derivatives rules may still be a blow to property, despite EU concessions, writes Jane Roberts
Progress on derivatives legislation going through the European Commission holds bad news and good news for property. The fear at the start of the year was that European Market Infrastructure Regulation (EMIR) would be an “Armageddon scenario” for property. At a January breakfast seminar, JC Rathbone Associates’ Bill Bartram said it could cost European investors £50bn if they had to post cash collateral for existing interest rate swaps.
That ‘backloading’ threat has now gone, Peter Cosmetatos, finance policy director at the British Property Federation, told the Commercial Real Estate Finance Council conference in London on 30 March. “The strong message we are getting is that it will only apply to post 2012 contracts,” he said.
But the regulation still requires property funds to clear swaps through central exchanges and post cash collateral, increasing investors’ costs of hedging commercial risks, such as interest rate rises or currency movements. This is because property funds are defined as financial rather than non- financial counterparties under the Alterna-tive Investment Fund Manager Directive definition, which EMIR has imported.
It is still not clear whether property companies will be regarded as funds and therefore as ‘financial’. In an attempt to win property businesses an exemption from the ‘financial’ definition, the European Property Federation has devised its own definition of a financial counter-party, which clarifies the non-finan-cial status of all property businesses. This proposal has been supported by UK MEP Kay Swinburne, who has tabled it as an amendment to the regulation.
Cosmetatos warns: “EMIR is on a really fast track. The European Parliament votes on it on 24 May, with a European Council vote about the same time. There will be horse-trading between Parliament and Council, but by summer it should be done and dusted.”
Cosmetatos says several more MEPs have supported the EPF amendment, but the council’s position is less certain. JC Rathbone has worked with its clients to garner support, especially those with continental businesses. Bartram says: “We are asking them to check their MEP is representing them in the UK and Europe, because it is very important that the proposal is backed at a European level.”
Risk of a meltdown
He adds: “My fear is policy makers will say the grandfathering exemption should suffice. But there’s just as much potential for a future meltdown. If these rules had been in force in late 2008, when property values and real estate share prices fell rapidly, while low interest rates pushed up liabilities on hedging, then property companies would have suffered across the board. There would be further problems for publicly quoted property companies if the liabilities exceed the market capitalisation of the business.”
Even if the 2008/09 crash does not recur, posting cash collateral for future swaps would still raise real estate investors’ costs. “Anyone taking swaps will have to reserve equity in case of a margin call, or buy a cap,” says Bartram. “Fixed-rate loans do offer an alternative, but I suspect their pricing will rise as the bank will effectively be assuming liability for collateralising the swap.”
At the CREFC conference, Mark Battis-toni, managing director of Chatham Financial Europe, said: “If balance-sheet lenders circumvent swaps by offering fixed-rate loans, they will look to make up for lower swap volumes somewhere. CMBS issuers will not be exempt, resulting in a potential shift towards the US fixed-rate CMBS style. “For borrowers, there will be less flexibility in future. It is not a stab through the heart with a 12-inch blade, but it is another of many cuts.”
Financial distinction is the heart of the problem
In September the EC published draft European regulation to introduce greater transparency and risk management to over-the-counter derivatives. It adopted the financial and non-financial user distinction from the US’s Dodd-Frank legislation.
Dodd-Frank’s final OTC element exempted real estate from margining requirements, but in Europe, the financial counterparty definition still includes real estate firms as well as credit institutions, pension funds and insurance firms – which are also alarmed about the implications – and UCITs.
Clearing derivatives through a central counterparty requires an initial margin of 1-5% of the notional principal, plus a variation margin, where the derivative’s fair value is negative, to be posted in cash as protection against counterparty default.
When Lehman Brothers collapsed, the bank had huge uncovered derivatives trades. Property businesses generally use derivatives to make cash flows more stable and predictable and to protect them from volatility. Moreover, property industry interest rate swaps usually benefit from security over the underlying property.
An obligation to provide margin would undermine the whole purpose of hedging to achieve greater cash flow stability – and the illiquidity of property would make it particularly hard for property businesses to comply with margin calls.
Property derivatives are not affected by the EMIR regulation, because users already post an initial margin and any additional collateral required to equal the prevailing mark-to-market value.