Everybody is talking about UTP when it comes to forecast Italian loan market deal flow. Literally everybody. Whether this will materialize or not is not the object of this article. Self-fulfilling expectations is not a topic that should be part of a long-term investment strategy and I have decided to focus on something else today: the growing secondary NPL market. The reason is simple: regardless of how loans are currently classified in Italian banks balance sheets, recent dynamics suggest there could be significant opportunities in buying distressed loans portfolios in the secondary market. Does this seem odd? Yes, it does. But it makes a lot of sense as well when you think about the fundamentals behind this somehow erethic view.
On the supply side, there are in fact several reasons why a secondary market in Italy is almost unavoidable among which is worth mentioning i) servicing capacity; ii) investor’s needs; iii) long weighted average life of Italian distressed portfolios. On the demand side on the other hand, secondary NPL investors are increasingly looking at seasoned portfolios chiefly for three reasons: i) better risk / reward profiles as compared to the primary market; ii) possibility to monetize an operational arbitrage (yes, there are arbitrage opportunities and I will convince you about this); iii) better segmentation.
When it comes to analyze the Italian impaired loans market at systemic level, it is hard not to realize that, beside the obvious financial implications of an Eur 300bn stock of NPLs, there might be operational issues as well. The basic questions to answer are: is there enough capacity to properly service all these loans, related collateral and legal procedures? Are existing old-school servicing platforms scalable? Are banks able to manage such a large stock in house? This perceived asset management bottleneck has been at the basis of recent M&A deals in the loan servicing sector. Also, the volume of activities that have been outsourced by the largest Italian servicers suggests that a significant ramp up is not a straightforward endeavor and that if NPL servicing operations are not supported by state-of-the-art IT, economies of scale in the sector at some point become marginal if not negative (more on this in a later article. I promise: this topic will be very interesting). Anecdotal evidence suggests that most secondary trades, almost never captured by market reports for unclear reasons, have been driven primarily by the need to free up servicing capacity, in case of captive platforms, or as a consequence of “misalignments” between servicers and investors. With large NPL securitizations ongoing, the recent set-up of special vehicle like REV or SGA and increasing AuM across the sector, it is easy to assume that as part of large portfolios work-out, there will be much more focus on portfolio disposal as a tool to amortize large stocks. In fact, I personally believe that the sale of homogeneous sub-pool will become a core servicing activity in the near future.
There is however also a strong anecdotal evidence that NPL investors (primary buyer for lack of better words) are also a key driver for secondary trades. Here the reasons become way more variegated. We have seen investors shifting from one asset class to others selling existing proprietary portfolios in the process. We have also seen investors moving away from Italy and selling their residual exposure. This is really not something new as we have all already seen these dynamics at work in the US, UK and Ireland very recently. What is probably less obvious is that those investors with strong ties with local servicers have realized that there are significant opportunities in capturing market demand for homogeneous loan pools that could be repackaged after a period of tailored servicing activities.
As it is impossible to talk about NPLs in Italy for mainstream media without complaining about the inefficiencies of the local legal system (which by the way are already fully priced in), we also have to mention that Italian NPL portfolios tend to have a longer weighted average life as compared to other jurisdictions. Given the fact that most NPL investors are fund structures with (by definition) a non-infinite maturity, it is hard not to think that there will be technical reasons as well for the development of a healthy secondary loan market. On this topic, we also need be honest about the fact that the longer the WAL, the more P&L could be frontloaded creating another incentive to investors to repackage their exposures at some point in time.
So, this seems obviously logic but are there really investors active in this niche? Yes, there are. The main investment thesis is that, at least so far, secondary trades have represented a more compelling risk /reward opportunity as compared to the primary market. Mostly, the reason why these trades attract interest is the fact that without the massively (at time insanely) large processes typical of the primary market, secondary market players can focalize better their attention on the portfolios they are most interested on knowing that the probabilities of closing those trades are way higher as compared to the primary market. Anecdotal evidence suggests that less competition and more transparency on price expectations has been beneficial for all players involved: buyers have been incentivized to invest more time and efforts in due diligence and sellers have been able to work with pre-selected, reliable counterparties with mutual satisfaction.
There is another less obvious angle for investors though. Operational arbitrage. The thesis is a simple one: if an investor’s servicer has better operations and better information on borrowers as compared to the selling counterparty, there are clear opportunities for short-term profits and long-term value creation. As a firm we invest massively in the secondary market: how is it possible to monetize a loan portfolio that have been in special servicing for years already? What’s the catch? There are many. It’s our policy not to discuss about competition (servicers) so I would limit myself in saying that, generally speaking, investors are reluctant to spend considerable amount of money in gathering in a recurring way updated borrowers’ information. Let me then first point out that by filling info gaps and by gathering updated information on ALL borrowers is a strategy that economically can have significant pay offs if carried out skillfully. To do that in an economic and efficient way is a way more complex matter but there are players that have started to implement highly advanced operational processes delivering significant returns for their clients by providing better quality intelligence on borrowers. Information is however not all: to really extract value an investor needs to make sure its special servicer has better operations, IT and borrower reach than who has serviced the portfolio before. If we go back to the systemic servicing scalability issues described before, it is hard not to assume that some investors will try to find a way to monetize the inefficiencies of the current servicing market. This will likely create additional thrust for a liquid end institutionalized secondary market.
There’s one more thing. Generally speaking, investors (whether focused on large or small portfolios, secured or unsecured, etc) are increasingly demanding more segmentation. Italian banks have already learned this lesson but, under pressure from regulators, are struggling to sell perfectly segmented portfolios. In the secondary market, instead, investors are able to find tailored portfolio where they can deliver better quality underwriting and therefore higher prices.
A well-developed NPL secondary market would also be beneficial at systemic level fostering financial stability and economic growth in the long run. Even for Italian banks engaged in massive deleveraging programs, the development of a liquid, broad based secondary market would enhance liquidity and reduce price volatility. A functioning liquid secondary market will also be beneficial for risk allocation to those players that can better price and manage NPL portfolios reducing that systemic operational risk that I believe is currently piling up and that represent one of the key challenge for the years to come as far as Italian NPLs are concerned.
Now let us all go back and discuss UTP…….