Stress Tests Spurring $82 Billion Bad Debt Selloff: Euro Credit

Skaters gliding across the ice rink at the five-star Le Meridien Lav hotel are unwitting extras in the final acts of the financial crisis as they practice their turns on the shores of the Adriatic Sea.

Paying as much as 700 euros ($951) a night, they’ve kept the Split, Croatia-based hotel afloat since it was seized by Hypo Alpe-Adria-Bank International AG when the owners failed to manage repayments on about 50 million euros of loans.

The hotel will be sold this year as Europe’s banks seek to offload a record 60 billion euros of bad debts at discounts as high as 95 percent, according to PricewaterhouseCoopers LLP. Sales of assets from Paris office blocks to German-financed chemical tankers are being compelled by the European Central Bank’s pledge to restore trust in the banking sector by scrutinizing lender’s balance sheets.

“Five years ago banks would just wait and hope the assets would recover, but now they are being pushed by the ECB and asset quality tests,” said Alexandra Jung, a partner and co-head of European investments at Oak Hill Advisors LP, a New York-based debt investor with more than $20 billion under management. “As a result, we are seeing a material growth in distressed sales.”

Hotel Sale

Hypo Alpe, which received 4.8 billion euros of state aid since it was nationalized in 2009, will set up a bad bank to wind down or sell 18 billion euros of problem assets that include delinquent property loans in the former-Yugoslavia, and seized loan collateral, such as shopping malls and luxury yachts. Nikola Donig, a spokesman for the bank, said he is optimistic the Le Meridien Lav hotel will be sold this year.

Lenders will offload 300 billion euros of distressed loans through 2018, more than double the approximately 125 billion euros they have sold since 2010, according to PwC.

In Britain, Royal Bank of Scotland Group Plc set up a 38 billion-pound ($62 billion) internal unit for toxic assets in November and plans to sell or run down 55 percent to 70 percent within the next two years. London-based Lloyds Banking Group Plc is also disposing of non-essential assets, raising 257 million pounds from selling souring Irish retail mortgages in December and about 1 billion euros for the sale of real estate loans in the previous month.

Chemical Tankers

Switzerland’s UBS AG, which sold $500 million of distressed debt last month, and Commerzbank AG, are also among lenders offloading bad assets. Germany’s second biggest bank, sold 14 chemical tankers to a fund managed by Oaktree Capital Management LP last month, eliminating 280 million euros in bad shipping loans from its books, according to the bank.

Banks are getting from five to 40 cents on the euro for their bad loans, according to PwC. Spain’s Banco de Sabadell SA said on Dec. 13 it sold 632 million euros of distressed debt for 41.2 million euros, or seven percent of face value, while Lloyds has sold commercial property loans for about 25 cents on the euro.

“There are still a lot of distressed loans that will need a similar magnitude of discount to those sold by Lloyds at 25 percent of face value for them to work for investors,” said Sachin Rupani, London-based principal at Meyer Bergman, which has raised around $500 million from institutions for a fund investing in European retail properties, including those in distress.

Bargain Hunters

The prospect of picking up deeply-discounted assets has drawn bargain hunters from the U.S., where banks acted faster after the financial crisis to cut their balance sheets and offload problem assets. Blackstone Group LP, the world’s largest private-equity firm, Apollo Global Management LLC and KKR & Co. are among firms vying for distressed assets in Europe.

“There are fewer distressed debt opportunities remaining in the U.S., but in Europe we are probably only 25 percent through the cycle and the number of assets coming to the market will only increase,” said Rob Harper, head of Europe for Blackstone’s global real estate debt unit.

New York-based Blackstone invested or committed $3.3 billion for distressed European mortgages and properties in 2013, while Apollo raised $5.4 billion to buy mainly nonperforming loans in Europe, according to a Nov. 7 earnings statement.

Appetite for non-performing debt is also growing among pension funds and insurers seeking higher returns amid near-zero interest rates, according to Graham Martin, global head of portfolio solutions at KPMG LLC in London.

Extra Incentive

Although slower to act than their U.S. counterparts, European Union banks have shed more than $1.1 trillion of assets since the end of 2011, according to the European Banking Authority. Lenders in the region could reduce assets by a further 2.6 trillion euros, according to estimates from Alberto Gallo, head of European macro credit research at RBS in London.

Europe’s financial companies are moving closer to complying with tougher global capital rules known as Basel III as regulators push lenders to shore up their balance sheets. The ECB’s assumption of bank supervision and its probe of lender’s health adds extra incentive to speed up disposals, said Galia Velimukhametova, who manages $750 million of European distressed debt investments for GLG Partners Inc., including the company’s European Distressed Fund.

The ECB is undertaking a three-stage probe into the balance sheets of lenders across the 18-nation euro area as a precursor to its assumption of financial supervision duties in November. The bank wants to identify asset portfolios requiring deeper scrutiny, and then carry out a review of asset quality before holding stress tests simulating the effect of a range of adverse scenarios.

“We’ve moved to a world where banks are more focused on returns and where capital is expensive and in short supply,” said Richard Thompson, a partner at PwC in London. “These factors encourage banks to restructure and downscale.”

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