When Will the Wave of Non-performing Loan Deals Hit?

Everybody should watch The Big Short

In the Academy Award-winning Hollywood movie “The Big Short,” the eccentric physi-cist and hedge fund manager Dr. Michael Burry (Christian Bale) is one of the first inves-tors to discover the negative outlook of U.S. banks’ mortgage portfolios.

He is convinced that the ratio of non-performing loans will skyrocket in 2007. He builds up significant short positions and bets against mortgage-backed securities. Very few understand, and even fewer share his stance. When the market eventually does col-lapse, he earns a 489% profit, closes his investment fund, and leaves his offices wearing the same worn-out Bermuda shorts and flip-flops he has been wearing in the office the entire time.

The signs of an upcoming increase in non-performing loans were obvious, at least for Burry. But what about now?

In the aftermath of COVID-19, banks face another credit downturn. How can lessons learned in the 2008 crisis be adapted and utilized now?

Is this different?

The COVID-19 situation has different characteristics than the 2008 credit crisis.

1) Sector-specific: The COVID-19 situation impacts different sectors in different ways. Travel, leisure, accommodation, and the fashion industry have been hard hit. Other sectors like transportation, logistics, e-commerce, and digital entertainment have been boosted. Only borrowers in the first business sectors are causing headaches for the banks.

2) State support: States are offering fiscal support measures to shore up liquidity and mitigate the economic impact. The level of government intervention is unprecedented worldwide. These measures can delay the effect.

3) Uncertainty: There is a high degree of uncertainty about the long-term economic consequences of the pandemic and lockdowns. It’s difficult to predict precisely which sub-sectors may bounce back and which will suffer long-lasting damage. The pandemic also affected demand. Consumer behavior and people’s preferences shifted.

Loan Moratorium –Hungarian borrowers maxed it out

European banks placed a moratorium on EUR 871 billion worth of loans in 2020: approximately 6% of the European banks’ total loans. Hungarian banks reported that an astonishing 39% of commercial loans and 54% of retail loans by value were under mor-atorium at the end of 2020.

The National Bank of Hungary estimates that 15-20% of the total value of bank loans bears an increased credit risk. The moratorium currently delays non-performance. Once the moratorium ends, banks may face a cliff-edge effect. In Hungary, the suspension is intended to end in August, followed by a gradual return to reality. This rather long moratorium and its further extension cover-up risks of structural, management, and other performance issues of borrowers known as zombie firms. On top of that, bor-rowers may get used to the pleasant conditions and develop a culture of non-payment that harms the overall stability of the lending ecosystem in the long run.

NPLs: Restructure or Sell?

The European Central Bank has estimated that European banks’ non-performing loans could reach an unprecedented total of EUR 1.4 trillion. Bankers currently spend half their time monitoring the performance of existing borrowers. There are two ways to handle vulnerable loans: restructure or sell.

Restructuring: We saw an increase in restructuring deals around yearend 2020. If fiscal supporting measures and liquidity are maintained, the economic prospects of more borrowers might justify restructuring in 2021.

Sale: Non-performing loan levels at Hungarian banks were at a record low of 1.8% as of the end of 2020. This means banks had already started offloading non-performing loans. As a result, the Hungarian banking arena seems to be prepared to absorb at least some of the non-performing loan losses expected for 2021.

Despite of the more intense monitoring and restructuring measures, the banking sector will undoubtedly face a peak in the ratio of non-performing loans when the loan mora-torium expires. We will probably see some further deleveraging later this year or next, whenever the suspension ends and lending gets back to normal.

But what is the new normal in lending? That is a topic for a separate article.

This article was first published in the Budapest Business Journal print issue of June 4, 2021.