Cleaning Up Toxic Loans Was Meant to Be a Great Investment. Then Coronavirus Hit.

Key part of cleanup operation from sovereign-debt crisis is stalling just as a new, likely

bigger wave of soured loans looms

By Patricia Kowsmann

Copyright 2020 Dow Jones & Company, Inc. All Rights Reserved.

With Europe still reeling from last decade's debt crisis, Banca Popolare di Bari SCpA, a cooperative

bank in southern Italy, was under pressure from regulators to clean up a big pile of bad loans that

were weighing on its results.

So in 2017, the bank tapped a government plan to package the nonperforming loans, or NPLs,

and sell securities backed by them to investors.

Other lenders followed, creating a thriving NPL securitization market. U.S. funds Davidson

Kempner Capital Management LP, SPF Investment Management LP and Waterfall Asset

Management LLC bought in.

Now the coronavirus pandemic is hitting that market hard. While investors have bet little in dollar

amounts, the shake-up is hurting Italian banks' efforts to continue cleaning up. And it is raising

questions about how they will deal with a new, and likely bigger, wave of nonperforming loans

coming up. NPLs still account for 7% of Italy's total loans, one of the highest levels in Europe.

Of about 230 billion ($255 billion) in NPLs sold in Italy since 2015, almost a third have been

through securitizations, according to Ernst & Young.

The main problem with the market is that unlike mortgage-backed securities, whose payouts

depend on homeowners' continuing to pay their loans, payouts on the NPL securities rely on debt

collectors' being able to recover payments, often from borrowers who haven't met obligations for

several years.

Since the coronavirus outbreak in Italy, loan recovery has been hard. Debt collectors have

struggled to reach borrowers to negotiate even partial payments on unpaid loans. With a full

lockdown since March that is just now relaxing, face-to-face meetings have become impossible.

Courts, where many cases end up, have been shut. And any attempts to sell property used as

collateral for the loans are difficult with the real-estate market frozen.

Even when those restart, loan recovery will be tough as Italy is entering a deep recession.

"Securitized nonperforming loans are one of the asset classes most exposed to the coronavirus

crisis," said Mara Turbica Manrique, a senior credit officer at Moody's Investors Service, which in

late April downgraded two deals, including Banca Popolare's, and put 11 others under review

because collections have been significantly slower than anticipated.

A report by DBRS Morningstar, which also rates Banca Popolare notes, shows that for the six

months ended April 30, collections from the bank's NPLs totaled 2.5 million, sharply lower than

the 8.5 million expected in the business plan. Collections to date are almost 30% lower than

originally expected.

If collections in Italy keep falling, income might not be enough to pay investors. In that case, the

already financially stretched Italian government, which has guaranteed the senior securities in most

deals to make them attractive, would be called on to foot a chunk of the bill. But junior investors

could lose their investments.

In a typical deal, a bank transfers a portfolio of NPLs to a special-purpose vehicle, which then

issues senior notes and riskier ones. Because the senior notes are guaranteed by the government,

the bank usually keeps them.

In its 2017 deal, Banca Popolare put together 320 million loans to some 1,500 borrowers whose

debt had turned sour. About 80% of the credit was to companies, the rest to individuals. Many

loans were backed by properties concentrated in a region east of Rome and another further south.

The bank then created a special vehicle that bought the loans at a 68% discount and issued an 81

million senior note, a 10 million mezzanine note and a 13 million junior note.

The bank bought the senior note, protected by the state guarantee. Davidson Kempner bought

the other notes, which pay a combined interest rate of 16%. The interest payment relies on a debt

collector's being able to recover enough from the borrowers.

In late April, Moody's downgraded the deal because collections have been significantly slower than

anticipated.

Davidson Kempner was paid interest on the notes as scheduled, but if collections don't pick up,

that might stop. This applies to other NPL deals.

"It is very clear all the performance levels of the NPLs are affected," said Paula Lichtensztein, a

credit analyst at Scope Ratings. The agency estimates a reduction of as much as 70% in Italian

NPL securitizations this year.

A spokesman for Davidson Kempner declined to comment. The hedge fund is among the 10

largest NPL buyers since 2015, according to Deloitte. It also owns Prelios, the debt-collection

company used in the Banca Popolare securitization deal, meaning its overall return also includes

fees paid to Prelios by the special vehicle.

Despite its cleanup efforts, Banca Popolare is currently being rescued by the government.

Source: Wall Street Journal, 2nd June, 2020

Required:

(a) Assume you are an investor of a CDO (or an ABS as Hull refers to it) in the above mentioned

NPL securitisation market. Why are they considered risky instruments as suggested in the

article?

(5 marks)

(b) As a creator of a the above CDO what are your risks?