The management of NPLs outside the banking system

The determining factors for new owners are the purchase price and the time to realise the value of collateral.

Terms like “non-performing loans”, “foreclosures”, “loan sales” and so on, entered our lives in the last decade as a result of the global financial crisis, as well as the financial crisis in Cyprus.

Cyprus might have been in the spotlight because of the high percentage in non-performing loans, but the rise in defaults had also put the entire European banking system at risk. In 2016 non-performing loans in the European banking system amounted to €1.13 trillion. In 2018, they fell to €750 billion and today they stand at €650 billion, without considering, of course, any new loans resulting because of the pandemic.

Much like a borrower who has no magical solutions at their disposal to manage their debt, a bank cannot magically reduce its non-performing loans, which impact its capital, its general economic strength and investors’ and consumers’ trust. An available solution is debt-to-asset swaps, which was implemented in Cyprus, where banks exchange their debt in exchange for real estate. However, this in many cases resulted in banks owning assets that required special management which banks were not designed to handle.

The only “magical solution” available is to sell these loans. This is a phenomenon we have witnessed in Cyprus in recent years, as the time was ripe and banks were ready, in terms of funds and provisions, to accept the losses resulting from such actions.

When banks are ready to dispose a portfolio of NPLs, they start negotiations with interested parties, mostly investment funds with departments specialized in the acquisition and management of problematic assets. Once the deal goes through, the new loan owner employs a credit-servicing business (the servicer) to realise the value of the loans, i.e. to recover the amount owed.

The operational structure of the servicer employs a wide range of specialties – in-house and freelancers – from bank employees to real estate experts, appraisers and so on. In the case of Cyprus, where most loans sold so far by banks are secured, consultants who specialize in their management have played a key part. This is because return on investment is determined by the difference between the price the loan was acquired by the new owner and the value recovered from the loan or its underlying collateral. So, if their real estate consultant has not suggested the best possible strategy for managing and disposing the collateral, the return will be lower than expected.

The strategy to manage a secured loan is neither simple nor one-dimensional. A lot of factors need to be considered, such us the value of the assets used as collateral, the legal framework allowing loans to be converted into real estate assets and the time required for the creditor to own the collateral (repossession). The legislation governing foreclosures, for example, is an important parameter to consider for anyone interested in acquiring these portfolios of non-performing loans.

In essence, the buyer of non-performing loans bets on the performance the disposal of their collateral will have and the speed they will make this recovery (i.e. how quickly the property will be sold). That is why, depending on the collateral, acquisition prices vary considerably. For example, secured loans are usually sold at 25-30% of their book value, whereas unsecured loans are sold at a much lower price, between 1-5% of their book value.

Today, while there are circa €10 billion in loans outside the banking system, they are still part of the Cyprus economy, with everything that entails. Their sensible management is key to reduce the country’s private debt and fixing the mistakes of the last decade.