As the world continues to get to grips with the fallout from COVID-19 and we start to witness the gradual removal of fiscal stimulus measures and government support across the globe, banks will also start to assess the damage to their balance sheets as a consequence of the pandemic. It is inevitable that in the coming months there will be a significant increase in the quantum of non-performing loans (NPL’s) and therefore it will be critical for the good health of the banks that these are removed in an extremely efficient and timely manner. Having been stigmatised for the excesses of the past, securitisation has all the positive attributes to be a healer of the banks in the future.
The past ten years or so has proven to be a tumultuous period for the banking sector, as banks across the globe have not only gone about repairing the damage inflicted by the global financial crisis (GFC) but also learning to operate in its wake. Meanwhile, a myriad of other challenges has graced the sector including a sustained period of ultra-low interest rates, a heightened level of regulation as well as the emergence of a multitude of shadow banks.
In recent years, the banks have certainly had a rocky ride, but their challenges have not all been external. Indeed, one of their major issues has been the presence of significant volumes of NPL’s that have caused a real drag on profitability as well as the absorption of valuable internal resource. Inevitably, the neutralisation of these loans has been a top priority and despite there being a number of tools to do this, the most effective method to date has proven to be the disposal of portfolios of loans to distressed debt investors through competitive auction processes.
For the banks, NPL disposals have demonstrated that they are not for the faint-hearted given that these processes are not only time and resource intensive, but also involve banks crystallising losses through agreeing eye-watering discounts. The corollary of this is that although a bank may be keen to embark on such a deleveraging exercise, the harsh reality is that it is not always in their gift given the need for a strong balance sheet that is capable of absorbing the resultant losses. Inevitably, to facilitate this painful but essential task, restructurings and re-capitalisations have gone hand in hand with these disposals.
Since the GFC, banks have undertaken these disposal exercises at varying paces which have largely been driven by the jurisdiction of the bank in question, as well as the location of the underlying assets. In recent years, NPL reduction targets set by the European Central Bank has acted as a catalyst in deal flow. The consequence being that certainly in Europe, there has been year-on-year growth of NPL activity as banks have gone about the messy business of realising their losses and trying to reposition their businesses on a more profitable trajectory. Indeed, 2020 was all set to be another bumper year for disposals had COVID-19 not caused NPL processes to stop in their tracks or, at best, stagnate.
Although in the short-term COVID-19 has clearly had a profound impact on NPL disposal activity, in the medium to long-term, the pandemic will inevitably generate an entirely new wave of NPLs as individuals and businesses succumb to the economic fallout from the virus. For those banks that already have a significant volume of NPL stock on their books, then they will no doubt be rueing with the prospect of having to address a heightened volume of bad debt.
As COVID-19 NPL’s begin to stack up, it is important to be mindful of some of the lessons learnt from the GFC and, in particular, the fact that the sooner banks deal with NPLs, the better for not only their own profitability but also for the greater benefit of those economies in which they operate. In an ideal scenario a robust and efficient mechanism can be identified to efficiently offload NPLs, restore balance sheets and return banks to a more even keel. Although in some quarters the suggestion of identifying such a mechanism could be considered fanciful, nevertheless it is quite possible that securitisation, as the foe of the banks in the past, could prove to be their friend of the future.
How does the application of securitisation work in practice?
Conceptually, the application of securitisation technology is the perfect solution for the cleansing of bank balance sheets. In essence, these structures involve a bank selling a portfolio of NPLs to a shell company that funds such an acquisition by issuing debt securities into the capital markets. The vehicle will in turn appoint a servicing entity that will manage the underlying loans on a daily basis with a fee structure that incentivises them to maximise recoveries on the underlying loans.
The use of securitisation makes a lot of sense. This technology has the capacity to enable a significant volume of NPLs to be removed from the banks in one fell swoop. Given the only limitation in sizing a transaction is the magnitude of the universe of investors that can competitively price and absorb an issuance, then we could be talking about pretty hefty deals. The opportunity afforded by securitisation of offloading NPLs in either one large deal or a series of large transactions is infinitely more appealing than the alternate scenario that we have witnessed to date of a protracted period of auction processes.
Securitisation technology also counteracts one of the major stumbling blocks that has traditionally made banks reticent about off-loading NPLs: the pricing. Although NPL securitisation cannot guarantee decent pricing, it does possess a number of features that load the dice in favour of the banks when it comes to trying to achieve the best possible return.
Whereas an auction process will involve just a small handful of investors, debt securities issued by a securitisation can be mopped up by a whole range of investors of varying size and different risk appetites whilst at the same time not having to incur prohibitive levels of due diligence costs. In other words, securitisation expands the universe of investors and, by doing so, will create a greater level of competition which the banks will be able to reap the benefit from through better pricing on issued NPL securities. At a time when central banks are keen to stimulate the economy through increased quantitative easing, whilst at the same time interest rates remain painfully low, then the chances are that there is likely to be plenty of appetite for the product.
By their very nature securitisations are highly bespoke structures and can be tailored in such a way to put a bank’s best foot forward to achieve their desired pricing. An example of this is the inclusion of credit enhancement measures (tranching, credit lines, derivatives) in the structure. Through this structuring, risks can be mitigated which in turn will be reflected with improved pricing. Similarly, if a day one discount for the bank is proving to be a tough pill to swallow, then it is quite possible to structure a transaction in such a way to ensure that the bank could benefit from certain performance hurdles being met in the form of receiving some deferred consideration.
Potential stumbling blocks of NPL securitisation
NPL securitisations do come with their own shortcomings. Indeed, in the aftermath of the GFC one of the major criticisms of securitisation was the profound complexity of many of the structures. These concerns were well-founded and accordingly have not only been addressed in post GFC issuances but the European regulators have actively encouraged such a shift through regulatory measures (such as the European Securitisation Regulation) which actively encourages structures to be simple, transparent and standardized (STS). Although some of these STS aspects certainly hold true for an NPL securitisation, the stark reality is that NPL securitisation structures by their very nature are the complete antithesis of this, with the underlying collateral comprising a massive portfolio of NPLs without a steady payment stream.
The complexity of an NPL securitisation arises from the presence of multiple distressed loans. Given these loans are non-performing and have not been specifically originated for the purpose of a securitisation, it is likely that many of their key payment terms (amortisation profile, payment dates, interest rate provisions and even currency) will vary and therefore have to be harmonised as part of any transaction. In addition, the terms and conditions of the debt securities are likely to feature complex redemption conditions as well as other structural features to cater for varying payment profiles as well as the non-performing nature of the underlying loans.
Without question, securitisation does have the potential to enable significant volumes of NPL’s to be removed from the balance sheets of banks on an extremely timely basis through the employment of certain structures to achieve the best possible pricing. As for the reservations surrounding NPL securitisations, then none of these are insurmountable and therefore there is no apparent reason why NPL securitisation should not only be actively embraced but should, in fact, positively flourish.
Reaping the benefits
There is also strong precedent that NPL securitisation has been successful in aiding the banks with their NPLs. In Europe through “GACS” (“Garanzia Cartolarizzazione Sofferenze”) and “HAPS” (“Hellenic Asset Protection Scheme”), the Italians and Greeks have already successfully harnessed this technology to address those NPLs that have been hampering their banks. We have also witnessed a number of NPL investors successfully utilise securitisation technology as a form of leverage to maximize returns on NPL portfolios that they have acquired. Similarly, if you turn to the United States, there is a strong precedent for this following the establishment of the Resolution Trust Corporation (RTC) in 1989 to liquidate assets once owned by the savings and loans associations. Although the RTC used a range of disposal methods, securitisation technology played a key role in connection with this.
The widespread use of NPL securitisation technology as a means of mopping up NPLs residing in the banking sector certainly makes a lot of sense and the fact that there is strong precedent for this, is living proof that it certainly has a role to play in addressing NPLs. On account of its structural flaws as well as the widespread stigmatization of securitisation, it was inevitable that it had no role to play in the immediate wake of the GFC as a method of offloading NPLs. Just as the banks have gone through a period of rehabilitation, securitisation has also evolved and adapted so that it is stronger, more robust and has already demonstrated that it has a role to play in healing the banks.
Ultimately, time will only tell whether widespread NPL securitisation will be deployed as a weapon to resolve the woes of the banking sector, and with it provide a much-needed boost to the economies that they serve. One thing that is clear, is that the banking sector have a new and enhanced tool to their armory which was not available in the immediate aftermath of the GFC. Given its huge latent potential, and the fact that it has a proven track record as well as the ability to deliver immediate pain relief, then banks risk ignoring this technology at their peril. Securitisation could provide the answer to their woes.
About the Author
Iain Balkwill is a partner in international law firm Reed Smith’s structured finance team. His practice covers the restructuring, enforcement and securitisation of debt secured by commercial real estate (CRE). Iain has also been heavily involved in acting for sellers and investors in relation to the acquisition of non-performing CRE loan portfolios. Iain is a strong advocate for the establishment of a fully functioning European CMBS market as a means of financing European CRE, but also the deployment of this technology as a mechanism for banks to off-load significant volumes of non-performing loans.