The golden era of "extend and pretend" is officially over.

Due to the post financial crisis implementation of Basel III regulations, which require banks to increase their Tier 1 capital ratios, the International Monetary Fund estimates that European banks will reduce their balance sheets by as much as EUR 2.5 trillion by the end of 2014. European banks are estimated to hold EUR 1.5 trillion of secured and unsecured nonperforming loans (NPLs) on their balance sheets. NPLs carry a high risk weight and therefore negatively impact a bank's Tier 1 capital ratio. As part of their deleveraging programmes, European banks will be forced to sell NPLs. Already, over EUR 7.5 billion of performing and nonperforming commercial real estate loan sales were completed by European banks in the first three quarters of 2012, according to a study by global real estate advisor CBRE.

With an internal rate of return (IRR) of 1525% per annum, NPLs, either as a single loan or as a loan portfolio, can provide an attractive investment opportunity for funds, family trusts, university endowments and foundations, strategic investors, and distressed asset investors. The United Kingdom, Ireland and Spain have thus far attracted the majority of investment in European NPLs. Buyers view these jurisdictions as having a familiar and stable legal regime which reduces the country risk component of their investment. However, with a decreasing inventory of appealing loans/assets and an increasing degree of market saturation leading to pricing pressure in these countries, savvy yieldseeking NPL investors are increasingly looking to Central and Eastern Europe (CEE) and South Eastern Europe (SEE).

CEE/SEE LOAN BOOKS

CEE and SEE were significantly affected by the financial crisis, most particularly in the real estate lending sector. The explosive growth of the region following 1990 gave rise to real estate development and property value increases that were entirely disproportionate to underlying economic growth, purchasing power, and employment. Expansionist lenders exuberantly supported speculative real estate projects while encouraged borrowers over leveraged, often in multiple currencies. Following the financial crisis, lenders were reluctant to write down their loan portfolios and thus emerged the notion of "extend and pretend". For years, subperforming loans have been restructured, reamortised and rolled over (often windowdressed by the accruing premium default interest rates to appear even more revenue generating than performing loans). However, with two high profile banks recently reporting Q3/2012 NPL ratios of 27 percent and 37.4 percent, respectively, in their CEE and SEE regional loan books, it is clear that "extend and pretend" is no longer a viable business or regulatory model.

Both the International Finance Corporation and the European Bank for Reconstruction and Development have long been active in the NPL market, financing numerous acquisitions of NPLs, either bilaterally or through joint ventures with NPL servicers, in Russia and Turkey. Now, the two supranationals are specifically focused on NPL sales and acquisitions in CEE and SEE, having recognised both their investment value and the fact that bank balance sheet liquidity is essential to a functioning market economy. Target countries include large markets like Bulgaria with an estimated NPL ratio of 15 percent (a large portion of which is tied to Greece) and Romania with an estimated NPL ratio of 16 percent, as opposed to an estimated 10 percent NPL ratio in Spain, as well as small but strategic markets like Slovenia (the first former Yugoslav nation to join the EU and the first former Communist nation to adopt the Euro), which as of July 2012 had an estimated EUR 6.4 billion of NPLs, up 55 percent on the same period in 2011.

COMMERCIAL AND LEGAL FRAMEWORK

The key commercial elements of a successful NPL sale are bidder credibility and financing, a well organised sale process, and realistic price expectations on the part of both seller and buyer. In CEE and SEE, bidder credibility and the availability of financing have increased in 2012, with a steady influx of established NPL investors (including from the US and the UK) and with lenders (and vendors) offering attractive senior debt acquisition financing over a 35 year period. However, the sale process remains weak and opaque, resulting in several highly publicised aborted NPL sales in 2012, and the gap between bid and ask prices remains wide and oftentimes unbridgeable. The latter issue, of course, is due to the fact that banks face competing mandates to increase capital ratios while simultaneously fire selling assets.

From a legal and regulatory perspective, however, there exists a relatively strong and supportive framework in CEE and SEE for the sale and acquisition of NPLs. This significantly mitigates the perceived country risk of CEE and SEE investment. In such economically mature jurisdictions as Poland and the Czech Republic, where NPLs have been traded for over a decade, the local legal regimes facilitate the transfer of NPLs by exempting such transactions from certain burdensome data secrecy, banking license, consent of debtor, and other similar requirements. In Poland, NPLs are typically acquired through a securitisation fund investment vehicle, which further enjoys certain tax benefits. Even such less economically mature jurisdictions as Hungary and Romania, which still impose upon NPL transactions strict regulations as to data secrecy, banking license, consent of debtor, and other similar requirements, offer legal and regulatory advantages in the form of ease of enforcement of creditor rights and remedies. Any creditor who has spent years trying to enforce a residential mortgage in Spain or Italy will certainly welcome the contrast.

FACE IT AND PLACE IT

NPL investment in CEE and SEE as a region is still nascent. It is hoped that as CEE and SEE markets gain more experience, the sale process will improve, and that as banks recapitalise, they will have more flexibility on pricing. It also is hoped that legal regimes across the region will harmonise to facilitate such investment. Nevertheless, one development has already occurred: In CEE and SEE, we have seen the end of the era of "extend and pretend" and the commencement of an era of "face it and place it".

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