Dennis Buckley, director at Credit Mediation Limited, discusses alternative securitised NPL structures

Estimates from reports compiled by PwC and EY put the current volume of non-performing loans (NPLs) made by banks within the EU at between €1.2trn and €1.5trn, with these levels expected to rise further in the next few years. The market has seen a number of high-profile sales of large NPL portfolios, the most recent being Lloyds' sale of its Irish mortgage portfolio. Such distressed debt sales to hedge funds are one option, but there is an alternative means by which European banks may be able to achieve the sanitisation and deleveraging necessary to restore the health of the continent's financial system.

A (fairly) new approach
Initiatives are under way to try to relieve the pressure on the incumbent European banks, including the proposed establishment of new lenders that will specifically look to buy ABS from troubled banks. However, these institutions will not be set up immediately.

There is an alternative, which can be more readily implemented, in the form of privately placed loan notes. If structured properly, this alternative can be beneficial for the selling banks, investors and the European economy.

Let's take an example. A European bank has a distressed asset-backed loan on its books, which has been written down to next to or even zero. An experienced servicing company arranges for a valuation on the underlying collateral and then agrees a price with the bank to buy the underlying loan at an appropriate discount.

Any proceeds that the bank receives above where it had provided for the loan can be booked as profit, allowing it to move on. The servicer then arranges for the loan - and similar ones it is asked to purchase by other banks - to be packaged up into a privately placed loan note, which can in turn be sold to qualified investors. If structured transparently, this product should appeal to more than just hedge fund investors.

In addition to transparency, it may also be necessary to dispel the myth that 'distressed' investing is always risky and only to be undertaken by hedge fund daredevils. Most traditional ABS investors will happily buy a Punch Taverns or Breeze bond at par, even where they risk facing a time-consuming restructuring or severely diluted return. But when it comes to buying something that has already become distressed - which can be professionally managed and mature at an overall return in excess of 10% - they seem less interested and unappreciative of the mitigation of downside risk resulting from discounted pricing.

Hedge funds tend not to be bothered with such structures because they are relatively small and illiquid. In order to obtain the best outcomes, they may need to be managed over several years.

Regulators appear to be slowly waking up to the advantages that such an approach can provide. While, for now, many institutional investors remain reluctant to accept the challenge of understanding the fundamentals behind securitised NPLs, the market for NPL securitisations can be expected to grow significantly over the next few years.