How Italy Seeks to Lure Buyers to Banks' Bad Debt: Q&A

  • Accord with EU could unlock frozen market for bad debt
  • Voluntary program in U.S. post-crisis spurred few disposals

After months of discussions, Italy and the European Commission reached an accord last week on a plan to ease the burden of bad loans on Italian lenders without breaching European rules.

Concern over the swelling bad debt spurred a rout in banking stocks before the deal, and shares have since fallen further on doubts it will fix the problem.

Here are some frequently asked questions about Italy’s program. The answers are based on disclosures from the government, as well as conversations with analysts and investors.

How will the bad-loan program work?

Put simply, banks will be able to bundle their bad loans into securities for sale, while purchasing a state guarantee for the least-risky portions to make the debt more appealing to investors.

The mechanics involve setting up a special purpose vehicle that will acquire the nonperforming loans, create the securities and sell them on to investors. The bonds will be sliced into pieces with varying degrees of risk. The less risky ones -- known as the senior tranches -- will carry the state guarantee, providing an investment-grade rating.

The government set no limit on how much debt it will back, so long as rating companies have determined that the securities, once guaranteed, will be considered investment grade.

Italian loans to borrowers considered insolvent reached 201 billion euros ($219 billion) in November, while a broader measure of nonperforming debt, which includes loans that are unlikely to be repaid in full, climbed to 360 billion euros, according to the Bank of Italy. Most of the bad loans are to companies, from industrial outfits to builders to services firms.

How much will the state guarantee cost?

The cost, to be paid by the vehicle through an annual fee to the government, will vary depending on the risks taken on by the state and the maturity of the notes. The price will be based on the market cost of providing credit insurance to other Italian issuers with a level of risk similar to the debt being guaranteed. The cost of the state guarantee will grow over time.

A servicing company will be hired to collect on the bad loans -- with its fees paid by the cash flows from the underlying assets.

Can banks sell only the best-quality NPLs?

No. The government set up a mechanism to prevent banks from disposing of only their best-quality bad loans -- those eligible for a state guarantee -- which would decrease their total bad debt but worsen its quality. To obtain a guarantee on their senior tranches, banks have to sell at least half of the riskier junior tranches -- enough to allow them to move the loans off their balance sheets.

Will the senior tranches be eligible as collateral at the ECB?

The government is in talks with the European Central Bank over the matter.

What are the potential benefits?

The accord could unlock the market for bad loans, which has been frozen for months while potential buyers and sellers awaited the outcome of the talks.

While the junior bonds in such cases are typically bought by private-equity funds specializing in distressed debt, the securities with a state guarantee could be purchased by a wider range of investors, including financial institutions and investment firms.

For the banks, disposing of bad debts could help clean up their balance sheets, lower their funding costs, free up staff and spur lending. That might in turn provide a jolt to Italy’s economy. It could also kick-start a long-anticipated round of consolidation among smaller lenders.

Will banks risk additional losses from disposal?

Yes. If the loans are sold for less than the value recorded in banks’ accounts, the lenders will have to recognize those losses. Italian banks, on average, have set aside money to cover less than half of the face value of their bad loans.

What are other potential stumbling blocks?

Because the program is voluntary, banks can choose not to participate if they decide it’s too expensive, they don’t want to book further losses on the assets or they lack the capabilities to meet all the requirements.

Is this a state-backed bad bank?

No. A state-backed bad bank implies the creation of a national structure in which lenders segregate their nonperforming loans to clean up their balance-sheets. Under such a program, the government can mitigate the losses banks face from disposing of their bad debts at prices below the values recorded in their accounts. The EU bans state aid that doesn’t meet legal requirements, such as restructuring lenders that receive assistance.

How have other countries done it?

Ireland and Spain both set up bad banks to clean up balance sheets of their failed and struggling banks. In both cases, transfers were mandatory and deep haircuts were applied. Ireland paid an average of 43 cents for each dollar of assets its bad bank took over. Spain’s bad bank paid 47 cents. 

Both countries had to inject capital into banks which suffered major losses due to the transfers. Ireland ended up spending 64 billion euros for the rescues, forcing it to seek help from its European partners. Spain borrowed about 50 billion euros from the EU for its rescue. 

Both countries required or enticed private investors to be majority shareholders in the bad banks to keep the institutions’ borrowing out of their national debt totals. The deep discounts on the loans during the transfer were required for the participation of outside investors. 

The Spanish bad bank has suffered almost 1 billion euros of losses in the last three years, despite the discounts, as prices dipped below the transfer rates. It has managed to sell only 14 percent of its portfolio so far. Its Irish counterpart has recorded over 1 billion euros of profit thanks to a recovering real-estate market and cheap funding costs. It has disposed of about 70 percent of its portfolio in four years.

Who else tried voluntary participation by banks?

The U.S. tried a voluntary bad bank scheme in 2009, called the public private investment program, or PPIP. The U.S. Treasury promised to put up $100 billion in capital and lend the partnerships another $800 billion, with a target to buy $1 trillion of soured mortgages and mortgage-backed securities. 

Only $7.5 billion of capital was taken up at the end by nine partnerships formed, with an equal amount of capital coming from the private sector. The partnerships ended up buying $30 billion of bad loans and securities from U.S. banks, far short of the original goal as banks balked at selling at the deep discounts that the private partners were demanding to risk their own money alongside the government’s.

(Corrects story published Feb. 2 to add conditions for state aid.)
Before it's here, it's on the Bloomberg Terminal.