There is a clear pipeline of jumbo disposal Non-Performing Loans (NPLs) in Italy, thanks to the ECB push, however vendors will need to take into careful consideration a few factors in their decision, such as recent regulatory reforms of insolvency and foreclosure and a possible EU bad bank.
1. ECB Push
Europe’s NPL assets are now €1trillion, of which one third is held in Italy.
Italian banks directly supervised by the ECB are currently formalizing their quantitative target of NPL vol-ume to be reached in 3 years’ time, as per the ECB Guidelines released in September 2016.
The starting point is the current ratio of NPL on the total gross loan exposure on the balance sheets of Italian banks. This ratio, according to ECB statistics, amounts to 16.4% versus an EU average of 5.4%. The supervisor is asking banks to commit to a target of reduction up to a maximum level of 10% in 3 years’ time and to embed such a target into their business and operational plans.
According to their YE16 results, we estimate Italian banks are committed to disposing of at least €80bn of NPLs in order to reach the announced target for NPL loans, €50bn of which will be in 2017. Such a pipeline refers only to Bad loans, the most risky class within the NPL umbrella definition, i.e. basically loans to firms and individuals in insolvency or similar situations.
2. Reducing the pricing gap: increase in the coverage ratios
We consider the recent increase in coverage ratios to be an enabler of NPL deals. In 2016, five banks that in aggregated terms hold 50% of Italian NPLs, realized a total of €15bn of losses. Such losses were the re-sult of more stringent provisioning approaches that led to an increase in coverage ratios of 5%, 6% and 7% for Bad loans respectively, Unlikely-to-pay loans and total NPL (resulting in final coverage ratios of 61%, 32%, 50%).
3. The vendor’s dilemma: sell today or wait for action by the public sector?
The huge volumes at stake, coupled with the operational complexity of realizing and processing NPL deals in Italy is such that a systemic solution has been suggested by many as the only effective approach to be pursued. In fact, the public sector is currently proposing the setup of an EU Asset Management Company (AMC), which would support the creation of a secondary market for the loans, as declared by Mr. Enria on 30 January 2017. Financed with private funds, such an entity would buy loans at market value and sell them for the same. If the nominal value isn’t obtained, the bank will have to take the market price, with a likely significant loss. Assets would have to be sold within three years. The difference between current market prices and real economic value could be the theoretical extent of state aid under precautionary recap, but in this interim period financed by AMC capital and private investors.
Another development that banks are monitoring before deciding to sell is the hypothesis of a possible supervisory incentive to sell: The Bank of Italy recently put forward a proposal to neutralize the negative implications in terms of capital absorption that would result from losses upon exceptional NPL disposal. Currently the extra losses contribute to worsen the history of loss rates that are used to estimate capital absorption for performing loans.
4. The vendor’s dilemma: sell versus workout?
Statistics on recovery rates are not easily available. However, the Bank of Italy recently released aggre-gated statistics that show the recovery rates of Italian Banks in 2016 have been 20% in the case of NPL disposals and 45% in the case of workout activities, the latter being a level that is much more consistent with current provisioning levels than what the observed prices in the market have been.
When looking into the determinants of the “sell versus workout” decision, we also have to consider the intensive work that the banks have been doing since September 2016 (when the ECB NPL guidelines were released) in assessing their compliance with the supervisory expectations of credit management and evaluation processes. Banks are required to adopt a pro-active attitude towards their NPL portfolios; to optimize internal workout strategies; to put in place appropriate incentive schemes for managers and to address conflicts of interest. Last, but not least, they have to improve data quality.
The by-product of this hard work is a learning curve for the vendor: dedicated organization units with ap-propriate skills and resources will reasonably be able to better perform pre-sale internal work (on data quality, portfolio segmentation and pricing). As a result, and thanks to the ECB findings, banks are going to be more aware of the real economic value and less willing to accept any price from investors.
5. Unlikely-to-pay loans: an investment opportunity?
Apart from the pipeline of Bad loans of large portfolios described above, selected investment opportuni-ties may be found in the case of single name loans classified as “Unlikely-to-pay”: 37% of Italian NPLs are in this risk category (€120bn), the rest being Bad loans (60%) and Past due impaired (3%). Unlike Bad loans whereby the debtor is insolvent, the Unlikely-to-pay debtor is not; however, there is a low probability that obligations will be paid in full, without recourse by the bank to actions such as realizing security. Eighty per cent of Italian defaulted counterparties are firms and 61% relate to individual exposures above €1m of gross value, so this category may offer interesting opportunities in terms of value creation, such as in the case of debt restructuring and business turnaround. A dedicated structuring approach is essential for successfully completion of these deals.
6. Recovery times: good news expected from reformed insolvency and foreclosure procedures
Insolvency and foreclosure procedures in Italy are particularly long. The increase in volumes of Bad loans on banks’ balance sheets is the combined result of new defaults and long-lasting recovery procedures on layers of pre-existing Bad loans. Law 132/2015 and Law 119/2016 have significantly improved the regulato-ry framework for managing NPLs, introducing targeted measures to reduce recovery times and improve recovery rates.
• Law 132 amended the insolvency procedures, facilitating the use of out-of-court restructuring agreements, introducing competitive restructuring plans and bids involving new investors. It also created a registry of administrators and introduced stricter deadlines for liquidation. The same law also amended the foreclosure regulation, requiring the mandatory involvement of experts, introducing shorter deadlines. These measures lower the likelihood of multiple auctions and make the assignment of the collateral to creditors easier. Additionally with this law, the market for foreclosed assets goes online. Impact assessments run preliminary to the introduction and it is estimated that the average recovery time in case of insolvency may drop from above 6 to 4 or 3 years and average recovery time in case of foreclosure from 4 to 3 years.
• Law 119/2016 has introduced into legislation two new guarantee mechanisms, the non-possessory pledge and the transfer of real property as guarantee (Marcian Pact) for loans to firms. In addition, an online register of pledges has been introduced. The expectation is that the Marcian Pact may reduce the foreclosure to only 6 months. However it will affect only new loan contracts. The same law also creates a register of bankruptcy and enforcement proceedings, which promotes transparency on information relating to judicial property foreclosures and insol-vency proceedings.
• Finally, the Government is currently working on a proposal for the creation of an online market place, a sort of “Clearing house” for all assets being sold within insolvency and foreclosure proce-dures.
All these developments may impact timing and amount of cash flows of existing NPLs, thus may play a role in the vendor decision.