Non-performing loans have been one of the hottest topics in the private debt space ever since the 2008 financial crisis led to an unprecedented movement of bad debts off bank balance sheets. While the market has calmed in the years since, recent developments may see a resurgence in the NPL sector over the next few years.
When regulators began cracking down on bank balance sheets in the wake of the financial crisis, new capital requirements meant that for many banks it was simply no longer feasible to try to manage their own books of underperforming credit. Across Europe and North America, banks needed to clean up their balance sheets, which led to a vast wave of NPL disposals into the hands of investors. Portfolios worth hundreds of millions of dollars would change hands on a regular basis, and NPL investors had many opportunities to choose from.
“What we saw during the financial crisis were many years where more than £100 billion ($125 billion; €116 billion) of NPLs were being sold each year as every single bank was delivering, and a whole industry really sprung up around that,” says Richard Roberts, head of origination and corporate development for NPL investor and asset servicer Arrow Global.
However, he adds that today the industry is very much at the back end of the mass bank disposals of NPLs seen in the wake of the crisis, with even banks in some of the worst affected countries such as Ireland, Portugal and Italy now seeing NPLs make up only a small part of their loan books. However, more recent events including the long-term consequences of the covid-19 outbreak in 2020 and this year’s US regional banking crisis could mean that a new wave of NPLs are about to hit the market.
Pete Troisi, president and partner at US-based specialist NPL investor Balbec Capital, says the huge stimulus packages from governments during the covid-19 crisis caused many loan delinquencies to be delayed and consequently fewer NPLs to build up on bank balance sheets.
“During 2020-21, there were moratoriums on foreclosures, people were staying at home and not spending money and paying down debts,” he says. “But now stimulus funds have been spent and, with student loans in the US set to resume payment this month and credit card debts at record highs, it is anticipated that there will be an uptick in bankruptcies and non-performing loans in the near term.”
As a result, delinquencies are expected to trend up rapidly in a V-shaped curve as debtors face increased pressures from the end of covid measures as well as inflation and much higher interest rates. Though Troisi does not expect the surge to be anything like what was seen in 2008, it is likely to present a significant opportunity set for NPL investors in the coming years.
“The US residential mortgage market is huge at around $12 trillion. Even if delinquencies only increased by 30 basis points, that’s still a huge increase in the opportunity set for us as a buyer of NPLs,” he says.
However, it may take some time before the effects of current macroeconomic headwinds fully feed through into the market, says Jeffrey Thuringer, partner and head of business investments at NPL specialist Hyland Hill Investment Partners.
“The NPL sales market takes time to develop, and we currently see that development underway,” says Thuringer. “The illiquid credit markets can be slow to fully reflect changes in economic conditions; they tend to be less responsive to rising interest rates, as debt can be either fixed or subject to interest rate hedges. Indeed, during the last cycle, CMBS defaults did not peak at 10.34 percent until 2012.”
Thuringer also mentions that there has not been a high inflation, high interest rate cycle since the 1970s, meaning very few investment professionals operating in the market today have experience of working in this kind of environment, which is leading to further market uncertainty.
However, while it is expected the market will see a resurgence in NPLs, very different conditions to those in the wake of the GFC mean that experienced, specialist investors are likely to dominate and there will be fewer new entrants.
In addition to its own investments, Arrow Global also services NPL books for other investors and says this gives it the scale and links into the market needed to be able to make profitable NPL investments.
“We’re consistently seeing between 60-80 percent of our deals being sourced off market. Often these already sit on our platform, so we’re familiar with the asset and we also don’t have the expense of an agent in the middle,” explains Arrow’s Roberts.
By keeping costs low, Arrow is able to acquire smaller, tail-end portfolios without the need for leverage to enhance returns, which many of the larger NPL investors will not touch.
Balbec’s Troisi emphasises the importance of having a large network and in-house capability to be able to make profitable NPL investments in this market, saying: “You can’t be a tourist in NPLs. You have to have the infrastructure, the servicing capability, and the counterparty relationships to be able to acquire and properly manage these portfolios. There are a lot of barriers to entry.”
While today’s market may have become more challenging, a slew of new opportunities born of shifting economic conditions should keep experienced NPL investors busy in the coming years as well as fulfilling a vital role in helping banks to access much needed liquidity.
A cycle that could last 18 months
One of the most significant developments seen so far is the regional banking crisis in the US, which began when Silicon Valley Bank unexpectedly collapsed in March
Since then, several other regional banks in the US have collapsed or come under pressure and stoked fears that regional banks in Europe might face similar problems. As a result, regional banks are seeing increased attention from regulators and may be forced to generate liquidity though selling off underperforming loan books, which could present a big opportunity for NPL investors.
“Regional banks can and are experiencing stress from the reallocation of deposits out of the banking system to higher yielding instruments, which can also limit their strategic and tactical flexibility,” says Thuringer. “When combined with loan quality and collateral valuation concerns, it can certainly provide an additional catalyst for loan sales.”
Troisi agrees: “The regional bank crisis is a huge deal; it would have been hard to imagine that at the start of 2023 we would have multiple bank failures, but that’s where we are. We’re still in the early stages of regional bank deleveraging and we would expect this cycle to continue for around 18 months with a lot of opportunities to pick up portfolios.”