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Selling bad loans as bonds set to help Europe's banks, but at a cost

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Selling bad loans as bonds set to help Europe's banks, but at a cost

A€150 million bond issuance by a small Italian lender has provided a rehearsalfor a much bigger sale of nonperforming loans by , butif securitization is to help clear the €1 trillion in bad debts stiflingEuropean bank lending then banks will have to brace for losses.

bundled €471 millionof bad loans into a €150 million bond, selling the senior tranche of the dealwith the help of government guarantees newly available for such instruments.The first sale of securitized Italian NPLs since the financial crisis came asMonte dei Paschi, the world's oldest bank, has targeted the sale of bad loansworth €27.7 billion as it fights for survival.

Whilebanks from 30 European countries sold €104 billion in debt in 2015, theEuropean Banking Authority and the International Monetary Fund see convertingthe loans into tradable bonds via securitization as a way of making the marketmore efficient and easing the burden of NPLs left over from the financialcrisis.

Turningbad debt into a bond may have echoes of pre-Lehman recklessness, but this timeinvestors should know what they are getting into. And, at a time of negativeofficial interest rates, some will be keen to acquire the resulting bonds,though the need to study the chances of recovering the dud loans will requiresignificant due diligence, Andrew Dennis, a fund manager at Aberdeen AssetManagement, said.

"Thepeople who are looking at those will be typically people with very high returnhurdles and a strong tolerance for risk," he said in an interview, addingthat demand for Italian securitized NPLs will be boosted by the governmentguarantees introduced for senior tranches by an April law. Buyers could includepension funds, which, though restricted in the amount they could buy, need toprovide a yield over many years, to match payouts they have to make toretirees, Dennis said.

Popolaredi Bari's senior NPL bonds were sold with a coupon of 50 basis points oversix-month EURIBOR, which was at negative 0.2%. Monte dei Paschi aims to convertits loans into €9.2 billion of bonds, with €6 billion in senior guaranteednotes, and another €1.6 billion mezzanine notes underwritten by the Italiangovernment-sponsored Atlante fund, which bore a coupon of EURIBOR plus 600basis points, as well as a junior tranche, Reuters reported in August, citingMediobanca.

Inaddition to government guarantees, Italian efforts to encourage securitizationare being supported by changes to insolvency laws aimed at speeding up the timein which houses and other collateral can be repossessed — a process that candrag on for as much as seven years, according to Moody's. Securitization isparticularly key in Italy because, unlike Spain and Ireland, it missed thechance to set up a bad bank to absorb bad loans before new European bankingregulations on state aid made such a move much more difficult. Under its owndefinitions, Italian NPLs total €360 billion.

Crystallizing losses

Whileoff-loading NPLs cleans up banks' books, often lenders in countries such asItaly, Spain or Ireland would have to take a loss in excess of existingprovisions in order to do so.

"Irrespectiveof whether the NPLs on the banks' balance sheets would be sold through asecuritization or a loan sale, the main issue at the moment is that, in manycases, the sale would crystallize losses for the banks," Moody's analystDavid Bergman said by email.

Montedei Paschi's rescue plan envisages selling off NPLs at only 33% of gross bookvalue, costing €1 billion in additional provisions. Balancing this loss was aplanned €5 billion rights issue, which was running into trouble Oct. 7 due to alack of investor support, according to Reuters. Popolare di Bari's loans weresold at 31%.

Packagingbad loans into bonds makes them easier for investors to buy and sell, but itdoes not make the debts — including mortgages and other loans secured by housesor other collateral, as well as loans to companies and credit card debt — anyeasier to collect. In Italy, the new securitization rules call for theappointment of third-party servicers to collect the money. But obstacles remainhigh, with collection times higher in the south of the country, Dennis said.

Eventually,securitization has the potential to remove a significant portion of NPLs frombanks' balance sheets, but this might take years due to both the difficulty ofbundling the loans and the cost of haircuts, according to both Dennis andSebastiano Pirro, a credit analyst at London hedge fund Algebris Investment,one of the biggest buyers of Italian NPLs.

Further,producing the securities themselves will be a time-consuming process, with theconstituent loans having to be assessed by rating agencies.

Investorsalso require detailed local knowledge to understand how likely loans are to berepaid, Pirro said.

"Thereare a lot of American investors who've said quite clearly in their annualreports that they want to invest in Italy. But they can't buy the loans fromthe banks — they've been in due diligence for three years and they can't closetransactions," Pirro said.

Despitethe challenges, Pirro said, there was demand and that NPL securitization couldhave a significant future.

"Thiscould kick-start. I think the market is going to start being a lot more liquidand is going to start to work much more efficiently," he said.