Iain Balkwill, partner at Reed Smith, argues that securitisation is the answer to European NPL woes

The balance sheets of European banks are currently stocked with huge volumes of non-performing loans (NPLs), which have largely festered while the banks have channelled their efforts towards recapitalisation. As recently demonstrated by the European Banking Authority stress tests, balance sheets have largely been strengthened, which has precipitated a marked shift in focus towards deleveraging the banks through the off-loading of NPLs.

To date, the deleveraging process has ranged from single loan sales to the disposal of mega pan-European NPL portfolios. While such disposals have played an integral role in providing a mechanism through which the European banks have been able to de-lever, they have nevertheless proven to be challenging and time-consuming to implement. It is also fair to note that with the exception of a small number of jumbo deals, the size of the majority of NPL portfolio transactions can be considered small relative to the sheer volume of NPLs that banks desperately need to shed.

To capitalise on the NPL opportunity, over recent years Europe has seen a marked increase in the formation and expansion of funds that specialise in the investment of distressed debt (NPL investors). Noting the significant volume of NPLs that are yet to be off-loaded by the European banks, the need for this to take place in a timely manner as well as the continued need for NPL investors to obtain leverage to meet the levels of return demanded by their investors, now would appear an opportune time for European banks to catalyse the deleveraging process by embracing the deployment of securitisation technology as a mechanism to off-load jumbo-size NPL portfolios.

Although there are a myriad of different types of securitisation structure that could be used, a simple structure is likely to involve the establishment of an SPV that would acquire an NPL portfolio partly funded by the issuances of tranched notes (NPL bonds). The remainder of the purchase price will be provided by the NPL investor, which could take the form of either a straight equity contribution, a subordinated loan or the structuring and purchase of a deeply subordinated NPL bond.

In many respects, the European market is neatly poised to embrace this technology and on the face of it, the emergence of NPL bonds would seem to be highly desirable. For an investor in NPLs, it would increase the source and volume of funds available to finance their NPL acquisitions. For the securitisation investors, structures such as this will not only enable them to invest at a level that satisfies their risk and return appetite, but these types of transactions would also give them the volume, yield and variety of paper that their investment portfolios so require.

Despite the clear benefits of NPL bonds and the existence of the capital markets technology required to create such a product, to date there has been limited use of securitisation structures. This could be attributable to the unfavourable regulatory environment that has created a number of challenges and uncertainties for investors and arrangers of securitisations alike. Equally, there could be a simple reluctance to embrace these structures, given the innate complexities of this financial engineering and the stigma attached to securitisation that continues to subsist following the onset of the global financial crisis.

Regardless of these reservations, the tides do, however, seem to be changing and it is becoming increasingly clearer in many quarters that securitisation in some form could have an integral role to play in the European bank deleveraging process. A prime example of this can be found in Italy, where the Italian legislature has devised a state guaranteed securitisation structure to circumvent issues with applying state aid to address the NPL issue. Similarly in Greece and Spain, recent legislation has been introduced that would seem to encourage the application of securitisation technology to off-load NPLs.

The widespread deployment of securitisation is considered by many to be one of the key factors that brought about the global financial crisis. Indeed, for a number of years, any mention of securitisation was regarded as a dirty word and at one point this technology was destined to face certain extinction.

Nine years on though, securitisation is certainly not extinct and is, in fact, experiencing a renaissance - as shown by the European Commission's proposal that simple, standardised and transparent securitisation is one of the building blocks of a European capital markets union. Although only time will tell what role securitisation will have as a financing tool more generally, one thing that is certain is that this technology has the latent potential to play an integral role in off-loading jumbo-sized NPL portfolios from the balance sheets of European banks. For that reason alone, if European banks choose not to at least consider embracing this technology, then they do so at their peril!