Wednesday, October 1, 2014

The Miraculous Conversion of Bad Loans Into Good Loans!

"Mr Draghi, ECB president, will this week unveil details of a plan to buy hundreds of billions of euros’ worth of private-sector assets – the central bank’s latest attempt to save the eurozone from economic stagnation" - Financial Times.

The unveiling of this plan will be most interesting. The ECBs declared intent is to buy only good loans. If banks sell their good loans, their demise is programmed because all they would have left on their books is bad loans. So there is a gap which needs to be bridged.

The logic is as follows: an individual loan may be worth nothing. A package of individual loans may include loans which are worth nothing. But the package will also include loans which are worth 100%. Typically, it takes quite some time to find out which loans will eventually be repaid and which not. Thus, one buys a whole package of loans and assumes that a certain percentage of it will be paid for sure.

Greek banks hold bad, or non-performing, loans of about 70 BEUR. Some of them will no doubt eventually be paid in full. Other may turn out to be a complete loss. No one can tell at this point with certainty what the eventual outcome will be. If anyone can make a good projection, it is the ECB because they have just subjected all those loans to intense examination. Let us assume that 30% of these loans, 21 BEUR, will eventually be repaid in full with great certainty. Let us further assume that another 30% of these loans, another 21 BEUR will be repaid at least in part. And, finally, let us assume that the remaining 40% of these loans, 28 BEUR will never be collected. The challenge is that, upfront, one doesn't know which loan is which. So let us retrieve the recipe of sub-prime and make tranches:

Tranche A: this is the Senior Tranche and we will put 21 BEUR of those loans into it which, today, seem to be of the best quality of the lot.
Tranche B: this is the Junior Tranche and we will put the next 21 BEUR of those loans into it which, today, seem to have a fair chance to be repaid, at least partially.
Tranche C: this is for gamblers; we will call it the Equity Tranche and we will put the remaining 28 BEUR into it.

Tranche A will get a rood rating and therefore the ECB can buy it at par. The return on this tranche ought to be a reasonable market return for good quality loans. The rating for Tranche B is going to be much lower but the ECB apparently also intends to buy a bit of Tranche B. The return on this tranche will be fixed considerably higher because there is considerably more risk. And those who buy the Equity Tranche will have a stasggering return potential or --- a significant loss.

This is all fine and dandy but the Greek banks are not helped if Tranche A - or even Tranche B - is taken off their books. They want to get rid of the entire 70 BEUR. And if the entire 70 BEUR is part of Mr. Draghi's plan, someone will have to take a very significant loss. Otherwise, the losses stay on the books of the Greek banks.

Since no one wants to intentially take a loss, the plan will have to be structured in such a way that it appears that every buyer of any of the tranches has a fair chance to make a return. It will be interesting to see how the potential losses are hidden and/or who will eventually end up with the losses.


  1. All this sounds in some way familiar, like the elements of a new edition of the subprime crisis. Someone has to be found who guarantees (or seems to guarantee) a lot of paper that is to a large degree worthless. Whether this will be the ECB or the European gouvernements who are supposed to take over the risk in a sort of anticipated bailout, in the end it can be expected that the losses will again land with the European taxpayers.

    There is a further element that is similar to the subprime crisis: When the original creditors have passed on the risk to others, they will lose any interest in reducing the risk (e.g. by intervening early on when risks become apparent or by restructuring loans when insolvency can still be avoided).

    It is hard to believe that the ECB proposes this as a solution.

    1. The whole mentality behind asset securitization is that bank-customer relationships don't really matter. Now that is perfectly ok when a large corporation issues a bond. That corporation knows from the start that its lender is anonymous, that there is no 'account manager' of the lender with whom one can maintain a personal relationship of trust and confidence.

      Borrowers really don't 'need' the trust and confidence of a bank in good times. All banks will run after them. But when clouds appear on the sky, most borrowers would like to have a banker they 'can talk to' and who 'understands and helps them with their problems'.

      When the selling of loans became popular in the early 2000s in Germany, many Mittelstand companies got scared. They might one day wake up and find that their lender is no longer the supportive local or regional bank but, instead, some stranger who had other motives than supporting his customer. Rightfully, there was a rush to insert clauses into loan agreements that the loan could not be transferred to a third party without the borrower's consent. That is a clause which I would recommend every borrower to include in loan agreements. If the bank tells me that this is not acceptable, then I would tell the bank that it is not acceptable to me to work with a bank which may not want to remain my bank.

      I remember the mid-1980s when I was workiong for an American money center bank which had a tradition of corporate lending. We were routed through seminars to learn the 'new banking'. To sum it up: traditional lending means putting a loan on the books and leaving it there. That's for the boring bankers who have no creativity. The balance sheet is far too valuable a place to fill it up with loans which stay there. Corporations make their profit by turning their assets all the time. If banks don't do the same, they don't deserve to earn a profit. Thus, we were to think of loans as assets which must be turned. The balance sheet was only a 'temporary parking place' for those assets. We would no longer lend the bank's money but, instead, we would 'originate' those assets and 'distribute' them in the market at market prices. That way, we would free the balance sheet, generate loads of fee income and increase the return on assets phenomenally. Sounded great! To us; the customers were not asked...

      To be sure: asset securitization can be a very valueable instrument for certain purposes. Examples would be: accounts receivable, car loans, other 'mass loans', etc. In short: for financings where the bank-customer relationship is really of no relevance. But where the bank-customer relationship is of relevance and where a third party decides to do away with it. then it can lead to very undesireable results.

    2. What i write

      "In relation to ECB stress tests and Drachi ABS plan:...

      77 b are npl.
      42 b business loans, 25 b mortages and 10 b consumer loans.
      Around 44 b are asset backed securities, which is arount 10-15% of total assets in 4 banks. Classification of those loans is different.
      But Greek banks ---until now--- did not have the right to use ABS as collateral in ECB refinancing operations, short and long term, only they use them as a collateral for short-term repos transactions.
      ECB by minimising eligibility criteria for ABS is giving the opportunity greek banks to use ABS as collateral for refinancing operations for long term, which is the key.
      So greek banks may gain access to longer term funding.

      The ABS market might start growing if hedge funds find investing opportunities.

      German stance is inconceivable, for Drachi's efforts, even 1 or 2 austrian banks, Klaus, have issues to resolve.

  2. "History repeats itself, first as tragedy, second as farce". Let's pool all the money (debt) and share them equally, It's bloody ironic that the quote is from Karl Marx. No wonder people start reading Ayn Rand again.

  3. In Germany FAZ and Die Welt quite often published texts explaining the difficulties of all PIGS countries: Portugal, Italy, Greece, Spain.

    Now, Portugal and Spain seem to be on better ways, but France is shown to be on the down road.

    Every competent analyst knows that the problems of Greece could be paid by the northern countries because the sums are much smaller than in Italy and France.

    The future of the Euro imho will solely depend on the results in Italy and France within the next few years.