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Western EuropeJuly 1 2016

Italy makes its NPL move

Italian banks are struggling to manage their non-performing loans. Can government measures such as reforms to the financial sector, a revamp of bankruptcy laws and a new fund that invests in NPLs help? Stefanie Linhardt investigates.
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Italy makes its NPL move embedded

A debt pile is looming over Italy’s financial sector. As banks’ non-performing loan (NPL) exposures grew following the global financial crisis and subsequent weakening of Italy's economy, few took immediate action to rectify the problem. But now, as regulators are becoming increasingly concerned about the country’s ‘bad’ exposures, banks are ramping up efforts to reduce the unserved loans on their balance sheets, supported by a reform plan by the Italian government.

“Banks have a fairly high stock of NPLs, which right now account for 20% of total loans – at the end of 2008 they were at about 8%,” says Luigi Motti, director, financial services, at Standard & Poor’s. “It has been a gradual deterioration.”

Italy, often dubbed the ‘largest NPL market in Europe’, had some €212bn of bad debts at the end of 2015, while another €127bn of loans were classified as likely defaults, according to the Bank of Italy. The level of bad loans has steadily increased from €78bn in 2010 to its present level. 

A systemic issue

The initial concerns of prime minister Matteo Renzi’s government were that the banking sector’s high NPL exposures could hamper lending to the real economy, according to Bruno Cova, restructuring lawyer and partner at Paul Hastings’ Milan office.

“Now it has really become more a systemic financial system issue – the need to avoid any further bank collapses in the country and a crisis of confidence in the banking system,” he says. “The wake-up call was the ‘bail-in’ of the four banks last autumn, which created a political uproar and still leaves a question mark over the ability of certain Italian banks to survive.”

The government has launched a major reform of the sector, entitled 'Resilient and modern banks to finance growth'. It is hoping that these reforms will tackle several problems. These range from Italy’s ailing co-operative banks, the so-called 'popolari' sector – the largest 10 of which will have to be converted into joint stock companies by the end of 2016, while smaller popolari banks will be consolidated – to a reform of the country's banking foundations, which will bring in, among other factors, rules limiting their equity investment in a single banking institution to 33%, as well as changes to the bankruptcy proceedings.

John Davison, the chief executive of Pillarstone, a platform that invests in NPLs in Italy, says: “I think the Renzi government needs to be applauded for what it has done. They have made a huge effort and spent a lot of time listening to people in the market, like us, and it is trying to make appropriate changes to legislation and the way the market operates.”

The high price of selling

An issue inherent in the Italian NPL problem is the low number of sales of non-performing portfolios. With a growing debt pile, Italy’s banks should, many experts argue, have decided to sell some of their exposures to recover some value earlier. But the gap between the price Italy’s banks are seeking for their NPLs and the amount that investors are willing to pay is significantly larger than in many countries.

Biagio Giacalone, head of the credit solutions group at Banca IMI, says that the new regulatory framework and the consequent re-pricing of the risk “puts pressure on improving banks’ capital buffer and the level of provisions”. 

Although banks are gradually raising their NPL coverage levels – from 48.7% in 2013 to 55.7% in 2015, which left some €89bn of net NPLs in December 2015 – even at 55.7% of provisions, the level still significantly falls short of what most banks are able to recover from the assets, creating a pricing gap of some 20% to 25%, according to market watchers in the country.

“If banks were to sell at the market price [of about 20%], some would take a big hit on the balance sheet and would have to recapitalise to be able to meet capital adequacy standards,” says Mr Cova.

Average length of repossession of property

This gap can partly be blamed on the uncertainty regarding the time scale of the recovery of bankruptcy proceedings in Italy. Prospective buyers of NPL portfolios are pricing in widely diverging timeframes as the average length of a repossession process in the country ranges from two years to close to eight years (see table). “The difference is related to each tribunal,” says Mr Cova.

He adds that international clients expect that “if you handle a bankruptcy, it is going to be the same wherever you are in the country, because it is subject to the same laws, but that is not the case”. 

For these reasons, the government has only limited scope to adjust these recovery times. However, the reform of the bankruptcy law is still expected to help tighten the pricing gap, according to Mr Cova, along with measures such as the government’s state guarantee on the senior tranche of a bank’s securitised NPL exposures – the GACS, or garanzia carolarizzazione sofferenze – and a new fund investing in NPLs called Atlante.

Atlante the saviour?

Atlante was established through some €4.25bn of investments by Italian banks in April 2016 – the largest shares of €1bn each were contributed by the largest banks, UniCredit and Intesa Sanpaolo – and also includes contributions from insurance companies, banking foundations and asset management firms. The fund, managed by Quaestio Capital Management, initially aimed to raise between €4bn and €6bn and as of mid-June it was already making investments of €2.5bn.

So the question is, will the new Atlante fund be able to solve the problem of Italian NPLs? “No,” say most market participants. One expert, who asked not to be named, says: “The Atlante fund is effectively a safety net for the smaller structural banks in the market. It is a way of not requiring [the likes of] UniCredit to step in and be the funder of last resort for the small banks that get into trouble and cause a structural risk to the banking market in Italy.”

That certainly is what Atlante has done so far. Of the €4.25bn raised across banks, some €1.5bn was used to buy shares in Banco Popolare di Vicenza (BPdV), initially underwritten by UniCredit – making the Atlante fund, with 99.33%, the majority shareholder of BPdV. Another €1bn was expected to help with the share capital increase of Veneto Banca, which did not attract sufficient demand, according to Carlo Messina, chief executive of Intesa Sanpaolo, which led Veneto Banca’s initial public offering.

There is speculation that Atlante will want to merge the two banks, and it has already announced that it aims to sell BPdV in the coming 18 to 24 months.

The fund’s first NPL transaction is expected for mid-July and is anticipated to invest at least €2bn, the manager of the Atlante fund, Alessandro Penati, announced at the Festival of Economics in Trento at the beginning of June. Yet as this means that Atlante’s cash would already be extinguished and investments were in part relying on an anticipated fund leverage of 110%, according to the fund’s presentation, calls for additional seed capital are likely. 

Rating agencies Standard & Poor’s and Fitch warn that should this mean that banks have to stump up more money, it could put the sector’s financial profile under pressure and cause contagion across weaker and stronger banks. “In the long term, if banks were required to increase their contribution [to Atlante] or were asked to keep supporting the weakest banks in the system, we could see some negative impact on the financial profile of the banks that currently have a stronger creditworthiness,” says S&P’s Mr Motti.

Management at several Italian banks have already publicly stated that the sector has made its contribution and others should now be tapped – most importantly foundations, but also international investors, such as private equity firms.

But with any investment stake in Atlante being limited to no greater than 20% of the fund size, and a return target of 6% a year – reflecting potentially higher purchase prices for NPLs than the market offers – private equity funds are largely deemed unlikely to get involved.

Range of solutions

Private equity firms are more interested in purchasing NPL portfolios themselves. And while the pace of sales has been slow, pressure on the banking sector means it is now accelerating. 

Between 2014 and the end of March 2016, a relatively low €11bn of gross NPLs was sold, according to data collected by Quaestio Capital Management. But split by year, 2014’s poor performance of only €76m NPL sales was outshone by 2015’s leap to €8.19bn of disposals. After the first quarter of 2016, some €2.31bn was sold, and Banca IMI’s Mr Giacalone expects the cumulative stock of Italian NPL sales to increase further, reaching about €80bn for the period 2012 to end-2017.

The largest buyer of Italian NPLs so far is private equity firm AnaCap Financial Partners, which has bought some €8bn (face value) of non-performing exposures since 2012 from UniCredit, the Royal Bank of Scotland and GE Capital – most of which comprise claims against small and medium-sized enterprise (SME) borrowers, secured partly against residential or commercial property.

The bulk of NPLs is related to non-financial corporations (some €158bn at the end of 2015), while consuming and producing families made up €35bn and €16bn of the exposures, according to the Bank of Italy. Financials (€3.5bn) and public administration (€220m) account for the smallest share. 

This still-significant spread between different kinds of NPLs requires banks to use a range of different measures to recover some value – and Italy’s banks have seen their options grow.

“With the exception of smaller banks, I don’t see any institution going for just one solution [to address NPLs],” says Mr Cova. “The banks now have a very broad range of instruments they can use on top of the general process of reform of the Italian banking system.”

UniCredit is leading this approach, with its diverse tactic of portfolio sales to the likes of AnaCap, as well as disposals of single names, as in the case of its claims against shipping company RBD Armatori bought by Goldman Sachs.

Popular model

UniCredit was also one of the initial partners of KKR’s NPL platform Pillarstone, alongside Intesa. Pillarstone’s proposition is a different one: it exclusively targets NPLs of larger corporates, takes over the corporate governance of the asset and, together with the company’s management, shareholders and lenders, the fund decides on the best recovery proposition, including capital injections. 

This different approach, which sees the investment stay with Pillarstone for longer, usually allows banks to achieve higher returns on their NPLs than a straight sale. The banks then recover their value thanks to a waterfall from a four-tier securitisation structure, which first repays investments made by Pillarstone, then 100% of the agreed book value of the NPL at transfer of the loan. The third tier sees the bank recover the original loan amount (the par value of the debt), a proportion of which is shared with Pillarstone, while in the fourth tier, any recovery above the par value of the loan (effectively equity value) is shared between the banks and Pillarstone, but at an increased proportion.

“I am extremely encouraged that more than 50% of our current pipeline of new deals has not come to us from the banks, but from companies – whether that is the entrepreneurs, the shareholders, the management team or advisors representing one of the three groups. That, for me, is a very positive sign that the model we have put in place is getting a lot of traction in the market,” says Pillarstone’s Mr Davison. “We hold the governance rights in the companies on our platform but we are trying to find a solution that everybody is comfortable with, that works and is the best solution for the company, the banks and for the management, too.”

Since inception in June 2015, Banca Carige has also joined the platform, through Pillarstone's investment in Italian stock exchange-listed shipping company Premuda. Upcoming deals mean that two additional lenders were also due to join within months of mid-June 2016 (any Italian bank is eligible to do so).

Mortgage move

Meanwhile, new bankruptcy legislation also improves the workout of mortgage-backed NPLs as the measures allow real estate securities to be sold outside of court, allowing for a quicker resolution while relieving the judicial system.

Already the pricing gap for portfolios of overdue residential mortgages or consumer loans is often smaller than that of other assets, according to Mr Cova, as the portfolios usually include large numbers of positions spread throughout the country, which allows potential buyers to calculate recovery ratios on the basis of historical data. 

But also in the case of SME or corporate exposures, it is widely accepted that banks can do more to improve the price for their assets, by collecting and providing more data on their assets. “As an arranger, we have experienced that a comprehensive database which the investors can rely upon can increase the overall pricing of NPL disposal transactions by up to 30%,” says Banca IMI’s Mr Giacalone. “Without a complete database, investors are forced to use conservative assumptions, penalising the expectations of the sellers.”

Transparency is crucial

As any uncertainty is likely to cost the banks in NPL sales processes, so institutions are advised to be as transparent as possible. Every little helps, which means that banks are also counting on an improving economic situation to lower the NPL burden. Gross domestic product growth in Italy of 0.76% in 2015 and International Monetary Fund expectations of an increase of 0.95% in 2016 only promises a small economic rebound, but this could also bring a slight improvement in the borrowers’ abilities to service their debts.

Still, experts agree banks should not rely on the economy as a quick fix but tackle the issue head on with the ever-growing tools available.

“Italy has gone from being behind the rest of Europe [in terms of dealing with NPLs] a few years ago to having some of the most innovative solutions in the market,” says Mr Davison, who has just extended the Pillarstone platform to Greece. “There are now quite a few countries looking at what has been happening in Italy and saying: ‘We should think about applying that to our own markets.’ As an overall development for the European market – and that is what the European Central Bank is concerned with – that is very positive.”

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