European NPL: a maturing market ripe with opportunities
In the decade following the Global Financial Crisis (GFC) of 2007-09, European banks grappled with its consequences on the quality of their asset books. The proverbial can was kicked down the road several times rather than crystallising the issues straight away as was the case in the US and to a large degree, the UK. That approach spread the pain over a number of years, avoiding some of the sharper consequences during the GFC but allowing further problems such as the two Eurozone crises that followed to be swallowed. It also hindered the reform of the banking system and the supply of new credit to support economic growth opportunities during that longer timeframe.
Successive steps were taken by regulators from the middle of the decade to accelerate the pace of restructuring and bolster the strength of the banking sector. This structural trend creates two opportunities for alternative lenders and financing sources like the structured credit markets: providing new loans to the most adversely affected sectors given the lower available supply of new credit, and taking some of the assets deemed to carry a higher risk off the banks’ balance sheets. The most notable type of assets in the latter is the Non-Performing Loan category, pushed to third party investors by a combination of punitive capital charges and accounting treatment, and financial incentives through government sector guarantees.
Given the large ongoing supply of risk, an entire ecosystem has emerged - from investors to servicers and service providers - improving the efficiency in transferring NPL portfolios to the alternative finance sector and in managing that risk away from less flexible bank balance sheets, providing a useful tool for banks in the future and attractive risk-adjusted return opportunities both in purchasing and financing these exposures for institutional investors.
To date, NPL equity investors have benefited from low interest rates keeping their financing costs low and increasing the incentive to hold an asset for longer. Many NPL deals are financed with floating rate debt. Once interest rates rise, the opportunity cost increases, and holding onto the same asset might not be as attractive anymore unless, for those deals with significant residential real estate in their pools, house price appreciation compensates for the higher debt cost in the longer term. With the ECB bringing quantitative easing to an end first before considering rate hikes, a significant tightening of monetary policy still looks unlikely until 2023 and with house prices having risen in many countries, and Covid-19 restrictions likely being removed, NPL deals will likely see an acceleration in paydowns.
In 2022, we anticipate another active year for the transfer of NPLs from the banks, with the most notable opportunities for investors to be found in Southern Europe once again as a steady recovery in the economies as the Covid-19 shock and associated lockdowns ease, together with rising real estate prices, should be more supportive for collections.
Evolution of EU/EEA banks’ NPL ratios by jurisdiction
Source: JP Morgan, EBA