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. And something else for Mr. Draghi. Mr. Draghi, will continue attempts to increase inflation, with whatever means necessary, because otherwise, Italy will enter a politically unsustainable situation, where the cost to the budget to serve the debt, will become politically unbearable. Italy, last month, used a Eurostat window to revise the 2013 GDP, increasing it by 59 beur (+3.8%) from drugs and increased prostitution and other illegal activities. This improves also the deficit/GDP from 3% to 2.8% and the 2013 debt from 132% to 127%.

    The bad news, is that this didn't give too much of a benefit, as the 2014 GDP prediction is -0.3% and deficit at 3%.,%20in%20nota%20Def%20pil%202014%20-0,3%25;%20deficit%20al%203%25.%20Niente%20manovra%20correttiva

    So, it only served to gain a bit of time, hoping to regain growth. As you know better than me, with such growth and such low inflation, Italy, to continue serving the debt, must increase surpluses. But let me remind you, that while Italy has lost only 2.5-3% of GDP in total since 2010, in the meantime, it has "lost" 3 PMs (Berlusconi, Monti, Letta).

    Mediobanca, forecasted the italian debt in 2015 to 145%. Rumours about debt restructuring were out this summer from goverment officials in newspapers, without denying officially.

    At the same time, the italian industrialists call for stimulous of consumption. Renzi is in a hard spot. Some say he must think out of the box or he will end being the 4th PM to resign in 4 years.

    Then you see now France, saying "i am going to reduce my deficit at my own rules".

    Auterity is easy when imposed upon the weak one, but when the bitter chalice comes to your own hands, the big boys don't want to drink it...

  4. This is also interesting, 1 day after Hollande basically defied Merkel about the stability pact:

    "Renzi is ready to go to Brussels and clash even with Germany. His explosion of pride: "PD (the Democratic Party) has more votes than the CDU".

    Renzi is too young to accept the faith of Berlusconi and Monti... Imagine if Italy had lost 25% of GDP...

  5. A post of mine was apparently lost.

    Draghi's move is made for the italian banks. Whether the greek ones will see relief or not, isn't the primary goal.

    In August 2014, according to the meeting of Italian bankers, the italian NPL loans reached 170 beur.

    To that, add that 50% of italian debt (a bit less), is held by italian banks. If Italy doesn't return to a good growth quickly, Italy will have to do debt restructuring.

    Prof. Lucrezia Reichlin talked in May about it, openly.

    Ashoka Mody, economics professor in Princeton and former vice director of IMF's european department, in a speech in Bruegel Institute of Brussels, said: "The task for Italy, is enormous and it is not a surprise, that being found in a grasp of a debt of 132%, Italy seeks the solution in flexibility. The problem is, Renzi seeks the solution in the wrong place. For Mody it is a baseless hope. "It is 20 years that Italy doesn't grow. The problem has reaches such a gravity, where a flexiblity of the stability pact, would only give an absolutely frustrating result".

    Mody continues that Italy would certainly benefit from a depreciation of the euro, for which, a coordination between ECB and Fed is needed.

    But the real solution, is debt restructuring: "In 2008 the italian debt was 108%, in 2010 124%, now 136%. Each year is a sort of moving target. Italy needs a calibrated debt restructuring". He argues that this would release funds for investments.

    A big problem for Italy to restructure, is exactly that a restrucrturing may incinerate the italian banks. So, the banks, need to be in good shape, in case restrucruring is required. Draghi, taking on himself bad loans, will help relief italian banks.

    The italian debt is the elephant on the room. Nobody talks, press avoids it, with the hope that "If nobody hears it, everyone will forget it". But there are many indications that the italian goverment is studying it as "plan B" and Draghi will help in that, both with euro depreciation and with "helping" the banks shake off NPLs.

    1. 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.