By Erol Riza
The recent calls by EU regulators for greater urgency in resolving non-performing loans (NPLs) in Cyprus, together with efforts by the finance ministry to amend the foreclosure law, may not result in the desired outcome.
There is also pressure on parliament to legislate in favour of a secondary market in NPLs in Cyprus and introduce a securitisation tool for problem loans as an additional support for the banks to manage their large NPL portfolio. These efforts, five years after the financial crisis, raise very serious questions over why Cyprus has not addressed the problem and why the stakeholders are looking for additional tools when such tools may not be necessary. As for setting up a secondary market or introducing securitisation, this is for the birds as they say in the UK.
In Cyprus, the problem of NPLs can be broken into two key areas: the corporate real estate-linked problem loans and the distressed primary dwelling/house owners. The former was the result of a long period of a credit-fuelled property bubble which burst like all such bubbles do when they are financed by excessive borrowing. All the empirical evidence in the world will show that such crashes in property prices are the result of banks extending speculative credit.
As for the primary dwelling non-performing loans the problem is again linked to the very poor quality of lending to households which did not have the ability to repay their loans and were granted credit on the value of their property, the loan-to-value measure which banks used. Both are problematic in Cyprus but they need a different cure for the banking sector to get back on its feet.
The Irish example is a very good guide even though in Cyprus there was no state-supported agency to buy the non-performing loans like National Asset Management Agency (Nama) did in Ireland. Nama bought €74billion of NPLs at a haircut of 57 per cent according to the Central Bank of Ireland.
Property prices in Ireland corrected much over the early years of the crisis in Ireland which subsequently attracted buyers. According to the Central Bank of Ireland, property prices between 2008-2013 fell 55 per cent which were in part due to the bursting of the bubble and unemployment which rose from 4.1 per cent to 15.1 per cent. Nama bought most of the commercial real estate loans of the banks and the Irish government recapitalised the banks. The Irish government also introduced another very focused range of measures such as:
- Prudential Capital Assessment Review
- Mortgage Arrears Resolution Process and Targets
- Internal Guidelines on Sustainable Mortgage Arrears Solutions
- Distressed Credit Operations Review
- Mortgage Arrears Resolution Process
- Credit Service Act
In addition to all these measures pressure was also put on management to focus on reducing NPLs and meeting targets set by the central bank. Thus, a combination of active policy intervention, intensive supervisory focus and robust legal initiatives were all necessary. These were coupled with strong borrower protection. In support of the banking system the Irish authorities did not take any measures that would weaken the ability of banks to realise their collateral.
We can compare and contrast with Cyprus and take the lessons learned by the Irish to see where Cyprus failed and where there is scope to make progress. In Cyprus, despite the inclusion of an Asset Management Company solution in the 2012 MoU with the Troika, no such entity was included in the MoU programme agreed in March 2013. When the opportunity to set one up in July 2013 was considered by the Resolution Authority, the politicians did not wish to hear about splitting banks into good and bad.
Thus, the Cyprus banking system instead of having a single asset management company had three internal bad banks, each working on developing their own teams to manage non-performing loans when they were not fit and trained for such a purpose. There were identical guidelines, as the ones mentioned above, to the Irish measures introduced by the Central Bank of Cyprus but it is arguable how intensive, focused and robust was the supervision and implementation.
One can argue that if the Central Bank of Cyprus had a strong and effective oversight the Co-op Bank would not have been allowed to operate as it did; the Asset Quality Review conducted at the co-op in 2014/15 should have alarmed the authorities given the nature of its loan portfolio. For if the central bank in Cyprus worked like the Irish one, the co-op would have been restructured much earlier and saved the tax payer a lot of money. To make things worse the Parliament in Cyprus weakened the ability of the banks to realise their collateral and this exacerbated the problems of the co-op.
The key lessons which the Central Bank of Ireland states in its most recent report are the following:
- If left to their own devices banks will not resolve their NPLs;
- No single measure will resolve NPLs;
- It takes considerable time to address NPLs and EARLY intervention is critical;
- Most reduction of corporate real estate NPLs was via loans sales, whereas for the primary dwellings/homes it was self-cure and modification
In closing, it is not too difficult to see where Cyprus has gone wrong and what should happen in the coming months to allow the banking system to recover.
In Cyprus banks were left to their own devices to set up, train staff and to introduce all their restructuring efforts based on guidelines of the central bank which took nearly two years.
To make matters worse the banks faced a very hostile parliament which weakened the banks’ ability to realise their collateral. Meanwhile, the political system promoted debt forgiveness instead of debt repayment.
The banks have, with the exception of the co-op bank which has needed state support, an opportunity following their better capital positions and reasonable provisions in terms of NPL coverage, the chance to sell their NPL portfolios of corporate real estate loans. These may be the only loans that could be of interest to an institutional distressed asset buyer from overseas; no such buyers for the size involved exist in Cyprus. This does not require a secondary market in Cyprus as it is done on a bilateral and discreet basis and both Bank of Cyprus and Hellenic Bank must already know who the buyers may be. A secondary market for small amounts makes no sense and I doubt if banks will be willing to post prices of NPL sales on any public platform.
Securitisation of NPLs is difficult in more mature markets and it is doubtful if it will work in a legal framework that is not fit for purpose. Moreover, it is very hard to see how a bank will be able to structure such a financial tool when it is necessary to have a pool of assets which is granular (diversified) and when most of the loans are real estate-linked. The European Central Bank proposed a securitisation tool which is akin to a two-tranche senior and junior bond issue but this will require state guarantee to find a buyer and is unlikely to happen in Cyprus after the co-op problems.
Thus, if the reported story on Bloomberg this past week is correct and the Bank of Cyprus will work with Morgan Stanley and KPMG to sell nearly €5 billion in NPLs this would be very good news and there should not be any obstacle to such a sale. Similarly, the small step in this direction taken by Hellenic Bank in selling some of its NPLs to B2Holding should be followed by sales of a larger NPL portfolio.
As for the primary dwellings, the government should introduce its proposed agency, ESTIA, to buy distressed household non-performing loans from all banks and should outsource the management to non-Cypriot private asset managers who will have a horizon of 15-20 years to recover loans via self-cure and modification. This would include some debt write off, loan repayment term extension and split mortgage or reduced payment. The purchase of these distressed loans should be via the issuance of a 20 year zero coupon bond, if this is approved by the Council of Ministers and the EU authorities. The zero coupon means that there is no impact on debt service during the life of the bond but it increases the stock of debt which is payable at maturity. Effectively, the government will swap the bonds for the NPLs, which it has done with the co-op.
The Irish example is one Cyprus should learn from and the government should not interfere once the co-op is sorted out. The government should take care of the primary dwelling NPLs as this is a social issue, and there should be a cap on the amount of eligibility.
Erol Riza is managing director of SME Markets Limited