For a glimpse of the next NPL crisis, look to 2005-08 in Germany

When will the next bad loans crisis hit, and how could it compare to that caused by the 2007-08 global financial crisis? These questions have come into sharp focus due to the covid crisis.

Soft landing proponents argue real estate markets are fundamentally different to before 2007, with less risk on bank balance sheets. While there may be asset bubbles, there is not unfettered leverage. Some even question whether there will be a significant increase in non-performing loans anytime soon.

But to understand the likely driver of a rise in NPLs, look to Germany in 2005-08.

After reunification in 1990, incentives were put in place to promote lending to improve former East German real estate. What was not anticipated was mass migration, reducing demand for property and leaving beautiful buildings in emptying towns subject to a dramatic fall in values. German banks were forced to recognise €300 billion of NPLs. This was an NPL crisis independent of wider European and US banking cycles.

While the NPL crisis after the GFC was due to the sudden end of easy credit, the next NPL crisis will have more in common with Germany in 2005-8 – it will be driven by mass changes in end-user behaviour, in this case due to the pandemic.

For example, covid’s impact on offices is so far masked by long leases. But office worker behaviour may have changed forever, and few companies have committed to a full return. Around 15 percent of shopping has been lost from brick-and-mortar stores, possibly forever. In the hospitality industry, vacations may come back stronger, but will business travel?

How big will the problem be?

It is difficult to forecast how many European real estate loans will become distressed due to changes in societal behaviour. Covid relief programmes and lender forbearance have delayed this distress, but relief is due to end and lenders will need to recoup payments. In the most likely scenario, distressed commercial real estate loans in the UK and EU will begin to grow by the end of 2022, with the true magnitude of the problem becoming apparent in 2023.

A universe of new NPLs – in addition to Europe’s remaining legacy GFC NPLs – in the order of €1 trillion is possible as, among other trends, grade B office rents decline, the long-term prospects of partially vacant shopping malls become more dire, and central business district hotels continue to see high vacancies.

Those that least expect it may be the first to feel the pain. Lenders – including banks, insurers, and debt funds – that have exclusively focused on prime assets, may find their collateral most exposed to changing consumer behaviour. For example, a single-tenant office campus loan may no longer look blue-chip if the tenants’ workforce continues to work remotely. Then there are those lenders that have written loans under government covid programmes. The number of troubled small- to medium-sized enterprises may overwhelm their workout departments.

Europe’s traditional banks are also likely to be hit. Northern European banks have high exposure to shopping malls and offices, while Southern European banks may see more distress in their SME books, particularly in loans linked to real estate development.

The good news

If there is good news, it is this: there are a more refined set of tools available to address the NPL problem, when it emerges, than when the GFC hit.

There is a huge amount of liquidity in the secondary loans market, and bid/offer spreads are at an historic low. The secondary loans market in Europe is also efficient, with standardised documents, processes and platforms. Regulators are pushing forward in several areas, including data-tape standards. Crucially, banks and their regulators now understand that loan sales, especially NPL sales, are an effective means of protecting the health of the banking system.

So far, since the onset of the covid crisis, there has been limited motivation for lenders to realise NPLs. Regulators have encouraged leniency, banks have been eager to avoid the bad press of the GFC, and credit portfolio management teams have worried they might dispose of what could be ultimately healthy loans.

But the prudent path is for lenders to start reducing risk towards the most obviously impacted sectors. In the UK, NatWest has already conducted a sale of shopping centre loans in 2021. More lenders would be wise to get ahead of the inevitable rise in NPLs, driven by how covid is changing consumer behaviour. The alternative is to hold, and hope everyone will want to go back to the office and the mall when the pandemic is over.

Gifford West is a managing director of Alpine Tremont, a specialist advisory firm focused on non-performing and non-core asset acquisition and disposal strategies for banks, private equity firms, and government agencies. He is also a member of the European Commission NPL Advisory Panel.