Market faces bad (and good) debt wave

Just as Europe’s lenders are under increasing pressure to deal with non-performing loans, so, too, will they be encouraged to divest performing debt, argues DebtX's Gifford West.

Driven by a confluence of events in 2018 and 2019, European financial institutions are likely to become more proactive in managing their non-performing loans, while simultaneously selling performing loans to investors hungry for yield.

In terms of NPL sales, the market is being driven by three forces. First, the European Central Bank’s 2017 initiative to resolve Europe’s NPL overhang is pressuring the largest banks to sell defaulted loans. Pressure from the ECB has resulted in several jumbo loan sales in the past 18 months. The size and success of these sales will encourage other banks to explore a range of transaction structures, from outright sales to securitisations.

Second, the European Banking Authority will turn up the heat on smaller banks to address their NPLs in 2019 as part of a broader drive to rein in troubled assets. While the EBA’s guidelines on NPLs do not force action, they suggest an increasingly inhospitable regulatory environment for banks that leave toxic loans on their balance sheets for years or decades. The message from European regulators on NPLs is clear; the question is, how long banks can afford to ignore it?

Third, increased bank profitability is giving management more room to manoeuvre in terms of taking losses and managing their portfolios. As well as external pressure from the regulators, banking boards accepting that action needs to be taken to address their organisations’ legacy loan books will be a crucial driver of activity.

PERFORMING LOANS

For performing loans, the changing regulatory treatment of certain types of loans, as well as growing investor demand for real estate debt, will act as an impetus for lenders to sell, possibly at a premium. The net effect of strong buy-side demand and the need to sell NPLs will create mega-deals as well as tactical sales by lenders eager to exit non-core debt positions. Expect to see more loan sales activity than in many years.

Less obvious than the drivers of NPL sales, two factors are quietly prodding banks to consider offloading performing debt. The first is a regulatory change that will make some asset classes more expensive to hold. Regulators are increasingly focused on risk management to prevent a repeat of the global financial crisis. They are urging banks to hold more capital across all loan classes. At the same time, they are reducing the ability of banks to use internal risk models to build up unhealthy concentrations.

As institutions migrate from internal risk assessment to industry standard models, loans that were formerly considered attractive may create a drag on earnings. We have received an increasing number of mandates to place performing portfolios from the banking industry into non-bank financial institutions that have greater balance-sheet flexibility, for instance.

The second factor is a competitive shift prompting traditional banks to re-examine their existing businesses. In the past five years, nearly all banks have scaled back into their historical core footprint. Among other notable examples, Barclays withdrew from Italy and Spain and Citibank exited several foreign retail markets. The next phase will be an even greater focus within those markets where incumbents have a competitive advantage. This will increase the prospect of European banks considering selling business units or seasoned performing loan portfolios.

The good news is, the pressure to sell non-performing and performing loans is coming as the loan-sale industry in Europe is maturing and capable of executing such transactions. It has become less complicated and costly to sell loans than it was a few years ago. For example, non-disclosure and asset-sale agreements no longer generate crushing legal bills and consume months of management time.

The due diligence process has become standardised. Most sellers understand what they need to provide and the effort required to deliver it. Importantly, centralised platforms play a role in driving down deal costs and satisfying regulators seeking greater transparency.

DebtX is an online marketplace for whole loans.

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