The End of Extend and Pretend: Non-Performing Loans in CEE/SEE

→ Denise R. Hamer

The golden era of “extend and pretend” is officially over.

Due to the post-finan­cial cri­sis imple­men­ta­tion of Basel III reg­u­la­tions, which require banks to increase their Tier 1 cap­i­tal ratios, the Inter­na­tion­al Mon­e­tary Fund esti­mates that Euro­pean banks will reduce their bal­ance sheets by as much as EUR 2.5 tril­lion over the next two years. Euro­pean banks are esti­mat­ed to hold EUR 1.5 tril­lion secured and unse­cured non-per­form­ing loans (NPLs) on their bal­ance sheets. NPLs car­ry a high risk weight and there­fore neg­a­tive­ly impact a bank’s Tier 1 cap­i­tal ratio. As part of their delever­ag­ing pro­grammes, Euro­pean banks will be forced to sell NPLs. Already, over EUR 7.5 bln of per­form­ing and non-per­form­ing com­mer­cial real estate loan sales have been com­plet­ed by Euro­pean banks in the first three quar­ters of 2012, accord­ing to a study by glob­al real estate advi­sor CBRE.

An attractive investment opportunity

With an inter­nal rate of return (IRR) of 15 – 25% per annum, NPLs, either as a sin­gle loan or as a loan port­fo­lio, can pro­vide an attrac­tive invest­ment oppor­tu­ni­ty for funds, fam­i­ly trusts, uni­ver­si­ty endow­ments and foun­da­tions, strate­gic investors, and dis­tressed asset investors. The UK, Ire­land and Spain have thus far attract­ed the major­i­ty of Euro­pean NPL invest­ment. Buy­ers view these juris­dic­tions as hav­ing a famil­iar and sta­ble legal regime which reduces the coun­try risk com­po­nent of their invest­ment. How­ev­er, with a decreas­ing inven­to­ry of prime loans/assets and an increas­ing degree of mar­ket sat­u­ra­tion lead­ing to pric­ing pres­sure in these coun­tries, savvy yield seek­ing NPL investors are now look­ing to CEE and SEE.

“Extend and pretend”

CEE and SEE were sig­nif­i­cant­ly affect­ed by the finan­cial cri­sis, most par­tic­u­lar­ly in the real estate lend­ing sec­tor. The explo­sive growth of the region fol­low­ing 1990 gave rise to real estate devel­op­ment and prop­er­ty val­ue increas­es that were entire­ly unmatched by under­ly­ing eco­nom­ic growth, pur­chas­ing pow­er and employ­ment. Expan­sion­ist lenders exu­ber­ant­ly sup­port­ed spec­u­la­tive real estate projects while encour­aged bor­row­ers over­lever­aged, often in mul­ti­ple cur­ren­cies. Fol­low­ing the finan­cial cri­sis, lenders were reluc­tant to write down their loan port­fo­lios and thus emerged the notion of “extend and pre­tend”. For years, sub-per­form­ing loans have been restruc­tured, re-amor­tised and rolled over (often win­dow dressed by the accru­ing pre­mi­um default inter­est rates to appear even more rev­enue gen­er­at­ing than per­form­ing loans). How­ev­er, with one high pro­file CEE bank recent­ly dis­clos­ing an NPL ratio of 27 per­cent in a region­al loan book, it is clear that “extend and pre­tend” is no longer a viable busi­ness or reg­u­la­to­ry mod­el.

Both the Inter­na­tion­al Finance Cor­po­ra­tion and the Euro­pean Bank for Recon­struc­tion and Devel­op­ment have long been active in the NPL mar­ket, financ­ing numer­ous acqui­si­tions of NPLs, either bilat­er­al­ly or through joint ven­tures with NPL ser­vicers, in Rus­sia and Turkey. Now the two supra-nation­als are specif­i­cal­ly focused on NPL sales and acqui­si­tions in CEE and SEE, hav­ing recog­nised both their invest­ment val­ue and the fact that bank bal­ance sheet liq­uid­i­ty is essen­tial to a func­tion­ing mar­ket econ­o­my. Tar­get coun­tries include large mar­kets like Bul­gar­ia, with an esti­mat­ed NPL ratio of 15 per­cent (a large por­tion of which is tied to Greece) and Roma­nia, with an esti­mat­ed NPL ratio of 16 per­cent (as opposed to an esti­mat­ed 10 per­cent NPL ratio in Spain), and small but strate­gic mar­kets like Slove­nia (the first for­mer Yugoslav nation to join the EU and the first for­mer Com­mu­nist nation to adopt the Euro), which as of July 2012 had an esti­mat­ed EUR 6.4 bln of NPLs, up 55 per­cent on the same peri­od pre­vi­ous year.

The key com­mer­cial ele­ments of a suc­cess­ful NPL sale are bid­der cred­i­bil­i­ty and financ­ing, a well organ­ised sale process and real­is­tic price expec­ta­tions between sell­er and buy­er. In CEE and SEE, bid­der cred­i­bil­i­ty and the avail­abil­i­ty of financ­ing have increased in 2012, with a steady influx of estab­lished NPL investors (includ­ing from the US and the UK) and with lenders (and ven­dors) offer­ing attrac­tive senior debt acqui­si­tion financ­ing over a 3 – 5 year peri­od. How­ev­er, the sale process remains weak and opaque, result­ing in sev­er­al high­ly pub­li­cised abort­ed NPL sales in 2012, and the gap between the bid and ask prices remains wide and often unbridge­able. The lat­ter issue, of course, is due to the com­pet­ing man­dates to banks to increase cap­i­tal ratios while simul­ta­ne­ous­ly fire sell­ing assets.

A strong legal framework

From a legal and reg­u­la­to­ry per­spec­tive, how­ev­er, there exists a rel­a­tive­ly strong and sup­port­ive frame­work in CEE and SEE for the sale and acqui­si­tion of NPLs. This sig­nif­i­cant­ly mit­i­gates the per­ceived coun­try risk of CEE and SEE invest­ment. In such eco­nom­i­cal­ly mature juris­dic­tions as Poland and Czech Repub­lic, where NPLs have been trad­ed for over a decade, the local legal regimes facil­i­tate the trans­fer of NPLs by exempt­ing such trans­ac­tions from cer­tain bur­den­some data secre­cy, bank­ing licence, con­sent of debtor and oth­er sim­i­lar require­ments. In Poland, NPLs are typ­i­cal­ly acquired through a secu­ri­ti­sa­tion fund invest­ment vehi­cle, which fur­ther enjoys cer­tain tax ben­e­fits. Even such less eco­nom­i­cal­ly mature juris­dic­tions as Hun­gary and Roma­nia, which still impose on NPL trans­ac­tions strict reg­u­la­tions as to data secre­cy, bank­ing license, con­sent of debtor and oth­er sim­i­lar require­ments, offer legal and reg­u­la­to­ry advan­tages in the form of ease of enforce­ment of cred­i­tor rights and reme­dies. Any cred­i­tor who has spent years try­ing to enforce a res­i­den­tial mort­gage in Spain or Italy will cer­tain­ly wel­come the con­trast.

Conclusion

NPL invest­ment in CEE and SEE as a region is still nascent. It is hoped that as CEE and SEE mar­kets gain more expe­ri­ence, the sale process will improve, and that as banks recap­i­talise, they will have more flex­i­bil­i­ty on pric­ing. It is also hoped that legal regimes across the region will har­monise to facil­i­tate such invest­ment. But one devel­op­ment has already occurred: In CEE and SEE, we have seen the end of “extend and pre­tend”.

In CEE and SEE, bidder credibility and the availability of financing have increased in 2012, with a steady influx of established NPL investors.