The agreement reached by the government with the EU to clear the mass of non-performing loans from the books of Italian banks has not gone down well with the stock market. The operators consulted by MF-Milano Finanza are convinced that the benefit, in terms of a better price, that banks could obtain from selling portfolios of securitised non-performing loans, thanks to the purchase of a public guarantee (GACS), would be minimal and therefore practically irrelevant to the successful outcome of a sale to a specialist investor.
Several points are criticised. First of all, there is uncertainty as to whether a senior tranche of a securitisation of bad loans originated by an Italian bank can obtain an investment-grade rating. For years, in fact, since the subprime bubble burst, the international agencies have stopped assigning NPL ratings, and the very negative performance of the latest NPL securitisations has not helped either.
There is also the weight of the belief that in the past the investment-grade rating had been given without investigating too closely the nature of the securitised loan portfolios, substantially underestimating their risk. It is clear that today the approach of the rating agencies would be much stricter, but obtaining a rating on the senior tranche of the securitisations is precisely the first condition set by the EU for it to be possible to apply for the guarantee.
Even assuming that this rating can be obtained, the fact remains that “the State will guarantee only the senior tranches of the securitisations”, that is, the safest ones, which bear any losses arising from recoveries on the loans that fall short of expectations last. “It will not be possible to proceed with repayment of the riskier tranches (junior and mezzanine) unless the senior tranches guaranteed by the State have first been repaid in full”. And this is certainly not secondary from the standpoint of the final investors, that is, the specialist credit funds that are expected to subscribe the riskiest tranches. If the fund, in fact, reasonably expects not to see a single euro of return on its investment, say for the next 5 years, it cannot but discount this expectation in the price at the time of purchase, regardless of whether the senior tranche has a guarantee.
It would have been better, say the banking sources consulted by MF Milano Finanza, if the possibility of modulating the repayment had been provided for, certainly always to the benefit of the senior tranches, but for example providing that for every euro of loans collected, 70 cents could go to the senior tranche and the other 30 cents to the junior and mezzanine ones. But there is also another critical issue concerning the guarantee, the price of which, the Treasury note explains, “will be calculated by taking as a reference the CDS prices of Italian issuers with a level of risk corresponding to that of the guaranteed securities”.
Which in itself is a distortion, because the idea is to take as a reference the premium paid on credit default swap contracts to protect the debt of liquid issuers at 3, 5 and 7 years, from 110 at 3 years up to 200 bp on average, but today Alessandro Rivera, head of the Banking and Financial System directorate at the Treasury, in an interview with Reuters spoke of 90 bp for the first 3 years; is that instead the cost of protecting securitised portfolios of loans that are varied both in type and in level of collateral? (see also today’s Treasury press release giving details on the calculation of the guarantee price).
But what does the average cost of protection against default on the debt of those issuers have to do with what should . But what does this mean in the economy of the whole structure? Little or nothing, say the banking sources; we are talking about price improvements for the senior tranche in the order of 2-3 basis points on the total gross value of the securitised portfolio.
The real knot to be untied so that banks can then sell their non-performing loan portfolios is, in fact, that investors’ valuations should come closer to those on the balance sheets of the credit institutions. The present value of a loan is calculated by applying a predefined discount rate to the future value of that loan, given by definition by the sum of the nominal value that will be repaid, plus all the interest that will be paid until maturity, assuming it is progressively reinvested. But everything depends on deciding the rate at which that future value is to be discounted.
If, for example, it is assumed that a bank has on its balance sheet 100 million nominal of problem loans, the bank calculates the present value of that portfolio by discounting the future recovery value at the original rate of return of the loan, which is therefore on average 4-5%. And even admitting that the bank has already written down those loans and has therefore applied a coverage ratio of 60%, which is the average coverage ratio applied by the system, this means that that portfolio on the balance sheet would be valued at 40 million.
By contrast, specialist investors reason on very different parameters, because they have in turn promised a return to their own investors and the discount rate is based on those expectations. Expectations obviously linked to the risk of investing in the distressed credit market, which can fluctuate even between 12 and 15% without leverage. All this, then, without considering the length of judicial recovery proceedings and any other direct and indirect costs linked to the management and recovery of the credit.
This is to say that specialist investors normally tend to value a mixed portfolio of secured and unsecured NPLs securitised in a junior or mezzanine tranche at a much lower price than the one at which the banks would value it: the 40 million from before would thus easily fall to 15 million, which would rise to 17 if the senior tranche (which one can imagine might be half in terms of the gross value of the portfolio) were given a guarantee worth 100-200 bp. Too little to narrow the famous price gap.
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