Testing times may not be over just yet

The problems that affected profits in the banking and property sectors last year have not gone away. And they could make 2010 another year to remember.

The Central Bank Governor Sultan al Suwaidi has said that bad loans could reach as high as 6.5 per cent of overall loans this year.

Last year was a forgettable one for banks and property companies, with profit declines, tight lending markets, loan defaults, lower property prices and an unprecedented number of projects put on hold. This year, however, could be even worse.

"This year there won't be any new investment gains, margins can't expand and revenues are going to be stressed, ultimately leading to weaker results with high provisions," says Deepak Tolani, a banking analyst at Al Mal Capital in Dubai. That is a stark assessment, but one shared by many analysts. Despite strenuous efforts by banks and property companies to cut costs and increase revenues in the face of a debilitating global crisis, there are still many obstacles to overcome.

"We, too, expect this year to be tough, if not the most difficult," says Janany Vamadeva, an analyst at HC Securities in Dubai. The crux of the problem this year for banks is that they have already squeezed what revenues they can from existing loans by raising interest rates and fees. Fundamentally, banks make money from the difference between the rates they pay customers on deposits and the interest they charge when they lend those deposits.

By raising rates on loans, banks have maintained healthy margins, but it is unclear whether they can push them much further without seriously stressing customers and leading to more defaults. With margins at a natural limit, banks would normally look to increase lending activity to boost profits. But while banks have funds to lend, thanks to Dh120 billion (US$32.67bn) of government stimulus money, activity still is not as strong as it once was.

For one thing, banks are still reluctant to make loans that could lurch into default, and are especially wary of lending to property companies that once accounted for a large share of loans but are now wreaking havoc on loan portfolios as prices decline. For another, borrowers are paying down debt and being more conservative after the global downturn, which translates into a slackening demand for loans.

Adding to the stresses, banks are still coping with loan defaults that have yet to work their way through the system. Sultan al Suwaidi, the Governor of the Central Bank, said recently that bad loans could reach as high as 6.5 per cent of banks' overall loans this year, an increase of 50 per cent over last year. In spite of setting aside an additional Dh13bn to cope with bad loans last year, according to Central Bank figures, it would appear that more trauma lies ahead. And analysts say it is not apparent when the pain will end.

"In developed markets, for credit card loans, auto loans and mortgages there are loan-loss curbs, they've issued mortgage-backed securities, and they have a track record of how loans perform and when non-performing loans peak," Mr Tolani says. "Our market is young and we don't have a track record." Yet another source of uncertainty for banks lies in the negotiations over a $22bn debt restructuring at Dubai World. Local banks have lent heavily to the government-owned group, but they have not yet written off any of their exposures because the company continues to make loan payments as the talks progress. If the restructuring entails anything less than full repayment, however, banks will have to treat it as a loss, which could put a major dent in profits.

"My take is that the first half of the year is going to be determined by Dubai World and its associated creditors, because none of the banks has taken provisions [against the debt] yet," Mr Tolani says. If the Dubai World restructuring involves banks not being repaid in full, he says, then provisioning - the practice of setting aside cash as a buffer against an expected rise in bad loans - could increase sharply towards the end of the year.

With the Dubai World saga unresolved, loan defaults still plaguing the banking system and lending not returning to pre-crisis levels any time soon, analysts foresee a difficult time for banks this year. The only sunny spot: banks are stable and well capitalised, meaning they have the capacity to absorb any losses on loans, although the Central Bank recently asked them to take further precautionary measures by retaining their profits instead of paying out dividends.

Analysts say property companies are also in for a tough year and their future is in some ways intertwined with that of the banks. The property giants are busy shifting towards managing existing assets by focusing on rental portfolios, and relying increasingly on government contracts to tide them through the troubled times. This shift has come about largely because of the problems at banks, which played a central role in financing the country's five-year property boom. With banks still reluctant to lend and property investors largely unwilling to buy into projects before they are built, property companies have found themselves short of financing.

So while they may want to restart projects that have been put on hold - in Dubai, a fifth of projects are in a holding pattern, according to one recent study - and get moving on projects they have not started, many developers cannot find the money from banks to do so. And that, analysts say, may presage another year of inactivity and profit declines. Analysts have yet to make projections on property prices this year, but rental rates continue to sag in Dubai and Abu Dhabi. Rates in the capital have recently gone down by about a quarter, according to one recent estimate. That could scuttle plans to generate profits through rents in the absence of bank financing.

Add it all up, and it looks like banks and property companies are in for yet another challenging year, despite signs of a recovery from the financial crisis and recession as developed economies return to growth. As depressing as last year was, in fact, there are plenty of signs that there will be little cause for economic celebration in the next nine months. [e-mail]