Close to a decade after the Lehman Brothers collapse, Europe is offloading tens of billions of euros’ worth of distressed real estate loans every few months.
Here is what you need to know about the distressed loan market, which is more active than ever. With thoughts from Federico Montero, managing director of Evercore’s real estate portfolio solutions team, and Mark Caplan, managing director at commercial servicing firm Pepper Group, EG explains the history of NPLs, why they will not go away and how investors are making money from investing in them.
What are NPLs and why are they a problem?
Non-performing loans are loans borrowers are unable to repay. A glut of real estate-related NPLs triggered the Lehman Brothers’ collapse in the US, the effects of which crossed the ocean to Europe and beyond.
In Europe, Montero estimates that there are about €600bn to €750bn (£535bn to £668bn) of secured NPLs. But the problem is not as straightforward as banks selling all those loans. “A bank can have around 5-6% of its loans as NPLs or ‘unlikely to pay’. A bank can live with that. What a bank can’t live with is having 50% of their book with NPLs,” he says.
If a bank is overburdened with NPLs, disproportionate amounts of its resources will be spent on cleaning up its balance sheet, which stops it from carrying out its main functions: holding savings and lending money.
The goal for banks is to move their NPL ratios down to a sustainable level, where they can work through them in-house.
How do you fix the NPL problem?
There are two main options when a country is facing an NPL crisis. The government can either bail out the banks, placing all the distressed loans into a “bad bank” (or asset management agency) whose sole purpose is to sell them, or pressure the banks into clearing them up themselves.
Ireland and Spain are examples of the first option. In Ireland, the National Asset Management Agency was set up to work through €75bn of bad loans, which it has done at a profit for the government. The benefit of that approach is that it allows the asset management agency to consolidate loans into large portfolios and strategically market them.
Montero, who was part of the team working with Nama at the time, says: “Our first sale was €60m. They were testing the market. It was tiny. One of our last deals was €8.5bn. The market was pushing, saying, ‘We want more. We want more. We’re willing to fight for that big portfolio.’”
The European Central Bank stopped bailing banks out after 2012, which means Italy does not have an asset management agency to deal with its loans. Rather than offloading billions of euros’ worth of loans in single portfolio deals, Italy’s banks have to work through their NPLs on a less united and more granular level.
Who buys NPLs – and why?
Opportunistic investors buy NPLs because they do not have the stringent capital requirements banks do. Firms like Lone Star, Cerberus and Blackstone can take on the added risk but buy often at a substantial discount to the initial face value of the loans.
They can then work with the borrowers to turn the distressed assets the loans are secured against into performing ones, which can then fund the loan repayments or force borrowers into insolvency, asset manage the properties and sell them at a profit, possibly with the benefit over time of improved market conditions.
Meanwhile, loan servicers – the people who facilitate deleveraging – make a margin off the loans they work through. But that is sustainable only at scale. Caplan, who spent eight years at Lloyds’ workout team cleaning up the bank’s balance sheets, says: “Servicing businesses are built on scale. You need €5bn to €10bn under management.
“You have a standard amount of overheads. For example, you need to have a loan engine, you need to have a loan management platform, you need to have workflow management. To build that kind of infrastructure costs money.”
Servicers are able to leverage that platform more effectively if they have multiple portfolios and experts in multiple areas working on a range of loans.
What is the NPL wave and will it ever end?
The latest wave of NPLs originated in the US a decade ago, but it spread across Europe and is now making its way into southern and eastern Europe.
The UK and Ireland were among the first to act when the crisis reached their shores. Ireland’s Nama and the UK’s RBS and Lloyds banks started deleveraging their balance sheets.
Montero says part of it was cultural. Western Europe and the US tend to follow the concept of “first loss is the best loss”, which means banks would take the hit early on to make sure they were in a strong financial position when the economic cycle regained its momentum.
While the UK and Ireland have largely dealt with their problems, the NPL market is looking south to Spain and Italy. Spain, like Ireland, was bailed out and is now selling some of the largest-ever NPL portfolios to the likes of Blackstone and Lone Star. Italy’s activity will take much longer because its exposure is more dispersed and its banks are not yet properly set up to analyse their loan books properly and sell them.
Caplan moved with Pepper Group to Cyprus last October to provide the Bank of Cyprus with a loan servicing platform. He says Cyprus, which is working through about €15bn of NPLs, is a “strategic opportunity” to later move to Greece, which is just starting to work through its €60bn of distressed loans.
Although he expects the focus to stay on southern Europe for the next three to five years, he is already looking further to parts of eastern Europe, Turkey and China.
Eventually, another crash will happen in Europe, which will start the cycle all over again.
Caplan says: “For those with non-performing loan skills, I regret to say it and I take no pleasure in saying it, but I think there’s a job for life for pretty much all of us, if you’re prepared to travel.”
To send feedback, e-mail karl.tomusk@egi.co.uk or tweet @ktomusk or @estatesgazette
