The coronavirus pandemic has caused a sudden and unexpected slump in economic activity since March 2020 and triggered unprecedented support measures for companies and households from governments and central banks around the globe. The IMF has warned that the global recession could be the deepest since the Great Depression, with a c.6% decline in output for advanced economies (-7.5% in the euro area). Consequently, the focus on NPLs – both current and forthcoming – is set to intensify.

How will the COVID-19 pandemic impact outstanding NPLs and how is this being reflected in valuations on your platform?

 

At this stage, despite initial signs of the pandemic abating and countries starting a partial re-opening of the economy, it is difficult to predict the full impact on NPLs. There is still great uncertainty about the severity and length of the crisis. US and European banks have reported increased provisions in their first-quarter financials, but we expect that the full impact of loan default and loss will only reveal itself over time.

With the world economy in lockdown and government measures such as unemployment income support, tax deferral or waivers, moratoriums on loan payments, suspensions of judicial activity, and measures to support credit supply to businesses, recovery plans and cash flows of existing NPL portfolios are undergoing significant disruptions and have clearly been negatively affected. This is having a clear impact on valuations, leading both buyers and sellers to take a break from the heavy activity initially planned for 2020. Although we are still seeing some activity, in the short term our clients are waiting to get further clarity on the impact of these measures, and more importantly trying to understand how long it will be until the economy reopens and some level of a new normality being reached.

In our latest research – Forecasting NPL ratios after COVID-19 – we have calibrated a simple model in each country with the unemployment rate and real GDP as inputs to predict the NPL ratio for 2020 and 2021. This has given us the following results:

Although our users can rely on our analytics tools to run portfolio valuations across jurisdictions and assets, at present they are mainly running stress test scenarios. Banks and investors are looking very closely at our pricing parameters, all visible and adjustable. The current crisis has definitely pushed market players to a more conservative set of parameters to incorporate – among other things – longer foreclosure time, collateral value decline, and longer collection plans; but also to adjust scenario probability related to re-performing, DPO and prepayments, for both non-performing and UtP (unlikely to pay) loan portfolios.

What will be the specific drivers/causes of an increase in NPLs and which sectors will be most severely affected?

 

While one can identify the drivers and causes of an increase in NPLs – such as real GDP growth, the unemployment rate, real interest rates, lending rates, inflation, house prices, trade and energy costs – it is hard to model all of them consistently for each country and economic sector in order to analyse the impact of these drivers on NPL levels by sector across Europe. While our sector-specific research continues, it is clear that house prices and commercial real estate prices will drive the extent of secured NPLs and the unemployment rate is most predictive for retail consumer NPLs. Airlines, transport, leisure, hotels and hospitality, as well as construction, real estate and manufacturing, will be hard hit – whereas less cyclical sectors such as healthcare, information and communication and public-sector activities may grow in response to the crisis.

NPLs overall will grow, but each sector will be impacted differently. We believe that due to the way the crisis has developed, it will impact certain loan portfolios more severely, i.e. those with higher concentrations of corporate and small and medium-size enterprise (SME) borrowers, NPL portfolios secured by commercial real estate collateral (particularly retail and hospitality), and unsecured NPL portfolios. Recoveries in Northern and Eastern Europe are holding up better than those in Southern Europe.

Do you think NPLs resulting from the current pandemic will reach the levels of the last crisis, and are banks/the economy in a better position to withstand this crisis?

 

The volume of legacy NPLs was still elevated in some European countries when those countries were hit by the pandemic in early 2020. Fortunately, during the past four years the asset quality of EU banks has improved significantly. In 2019, the weighted average NPL ratio stood at around 3% compared with 6% in 2015 (a reduction from about €1trn to €500bn). For sure NPLs will increase materially over the next two years. Our analysis, taking into account the latest IMF macroeconomic predictions, leads us to believe that NPL stocks in Europe will reach previous peaks and in some countries exceed previous highs.

Overall banks are in a better position this time round to tackle the crisis. Asset quality for most European banks has improved and banks have much stronger capital positions than during the last crisis: therefore they are definitely in a better position to withstand this downturn, certainly in the short to mid-term. New problems may arise if the downturn is prolonged.

Which countries are potentially at greater risk than others, and why?

 

The downturn will hit many economic sectors and countries, but with different intensity.

In Europe, the high-NPL countries of the last crisis – Italy, Spain, Portugal and Greece – are badly hit by the economic fallout. However, we estimate that the peak in Portugal and Ireland will be much lower than the recent historical highs, whereas for Italy, Spain and Greece the projected increases are more concerning. For France, Germany, the UK and the US the increase in NPLs is unlikely to pose a systemic threat.

The projected €360bn volume of NPLs in France is perhaps surprising. If the projections from the Bank of England – a 14% drop in GDP and a doubling of the unemployment rate – come true for the UK, then the UK NPL levels may be worse than initially indicated in our projections, and it may become the country in Europe with the highest stock of NPLs after the crisis.

Many countries in Eastern Europe such as the Czech Republic have successfully managed the COVID-19 problem. While the projected peaks in NPL in Eastern Europe are material, they are mostly well below historical highs. We do not consider the impact of exchange rates nor the potential capital flight to safe havens, which tend to impact Eastern Europe more than the rest of Europe. At this early stage of the crisis we are cautiously optimistic that Eastern Europe will not suffer as much as Southern Europe.

What are investors currently doing in the NPL space, and how has the pandemic affected live deals on your platform?

 

Many investors have switched to a wait-and-see mode, with many discussions focused on the duration of the COVID-19 impact, the shape of the economic recovery and fiscal stimulus and – of course – on what they need to do to better cope with such a huge market dislocation. Great attention is also being given to forecasting NPL market trends and the expected pipeline, but also to recovery plans of existing investments and risk premium adjustment.

Some investors have moved their focus from large secured transactions to smaller and unsecured portfolios, in line with a risk-off mode. International investors tend to be more sidelined, unless they have a strong local presence in local markets. Established relationships with local servicers or captive servicers locally can be proven to be a great investment decision under current market conditions.

By contrast, local specialists are still open for business in their home markets, mainly looking at unsecured assets and/or smaller portfolios. Other investors are instead trying to select deals where reasonable – or unreasonable – price adjustments are expected.

On our platform investors have remained engaged on smaller sized transactions since the start of the pandemic and their priorities were to update us about their new investment targets and contingent strategies and to make sure that their dialogue with us and sellers remained open. This was more about requesting deadline extensions than dropping out of deals. No one dropped out from announced transactions and the feedback was consistent across jurisdictions.

Our mission to simplify the portfolio disposal process has been valuable. Investors and sellers remain engaged also because the platform reduces their administrative burdens and minimises their time requirements to manage deals. Many potential sellers have slowed down the process of accessing the market and they have increased time and focus on our analytics to run stress test scenarios, portfolio data preparation and valuation.

How are investors preparing for the coming wave of new NPLs created by this pandemic?

 

Investors have raised a significant amount of cash in dedicated NPL funds in the last few years, so they are cash-rich and in a position to invest. They want to remain very close to the market, seeking a more stable backdrop to look again for new business opportunities.

Before that phase starts, however, they need to be able to go through this huge market dislocation where recovery plans and IRR targets must be revised down due to asset depreciation and longer recovery plans.

A large increase in NPL stock – as we noted in our recent analysis in “Forecasting NPL ratios after COVID-19” – is making investors think positively about future investment opportunities but with some caveats related to increasing speculation of potential bad banks and other systemic solutions that could reduce the expected pipeline.

We expect investors to be more open to secondary market transactions and a wider range of deal sizes. Some larger investors are also negotiating more flexibility in their investment options. We have seen large international players try to combine a wider range of distressed asset classes in the same distressed fund, to be able to benefit from larger investment opportunities. As we have seen before, investment flexibility always pays in volatile market conditions.

What are the unknowns and what data should investors monitor closely to get a better understanding of the full impact of the crisis on the NPL and distressed markets?

 

Currently the unknown is larger than what we do know: this is why the equity market has experienced an all-time high spike of volatility up to 75% and dropped – at its worst, about 40% in value – in a very short timeframe. Even if investors know that this is an event-driven crisis and many of them expect a quicker recovery compared with the 2007 crisis, they are still unable to quantify the pace and timing of the recovery.

There are several relevant data points that investors need to look at. On one side, idiosyncratic indicators such as the relative health of corporate balance sheets and economic prospects of individuals; on the other side systemic data such as real GDP growth, unemployment rates, lending rates, inflation and house prices to analyse the economy as a whole. All of the above is pushing investors to consider a more conservative set of pricing parameters to be implemented.

As previously mentioned, investors also need to keep monitoring the implementation of potential systemic solutions at European level – including bad banks – that can move the future pipeline away from them, and any political local initiatives involving support for collateral value decline, delay in collection or interest payment moratorium.

More strategically, investors, servicing companies and banks will need to re-assess how they can become more efficient and increase their returns by looking at their internal costs. Ultimately, we hope this unexpected crisis will stimulate market participants to rethink their business models and also increase efficiency through technology and innovation.

Photo by KOBU Agency on Unsplash | Coronavirus / Covid-19 cases in the world. (9.04.2020) Source: Center for Systems Science and Engineering (CSSE) at JHU