Nonperforming Loan Market Activity Reaches 20-year High

The total global market for nonperforming loans (NPLs) is in the midst of its hottest of period of transaction activity in the last 20 years — and the market shows little signs of cooling, according to the Ernst & Young 2006 Global Nonperforming Loan Report released today. With almost three dozen major NPL sales over the last 24 months by German lenders and the expected escalation in NPL sales activity in China over the next year, worldwide transaction activity is expected to quicken signaling that the NPL market has evolved from a series of regional market opportunities to a full-fledged, mature global marketplace.

Born out of the collapse and subsequent government-backed rescue of the U.S. Savings and Loan industry in the late 1980s, the burgeoning investment market for packages of NPLs has now almost completely circled the globe with major NPL sales in Asia and Europe over the last few years. At its peak, the NPL market totaled US$4 trillion, or roughly one and a half times the entire proposed U.S. fiscal budget for 2007.

The global market began to develop when NPLs ballooned dramatically throughout Asia following the region’s 1997 financial crisis. Today, NPLs are traded in more than a dozen global markets, including Japan, Germany, China and India.

“The development of this global multi-trillion dollar market has resulted in a huge learning curve for banks, regulators and investors alike,” said Jack Rodman, a real estate partner in Ernst & Young Hua Ming in China, and a primary author of the report.

“A combination of poor lending practices, inadequate regulation and failures to reform banking systems has created huge losses for banks over the last 20 years, with a worldwide recovery average of about 33 cents on the dollar,” said Rodman. “To make matters worse, the economic impact of NPLs has created staggering losses for many regions and caused their economies to languish for as long as ten years.”

The recovery statistics have caused many observers concern about the possibility of large scale loan foreclosures in the U.S. following several years of robust lending activity, particularly in the highly cyclical real estate market.

Of those regions that have historically grappled with NPL issues, many have managed to reduce their legacy NPLs (loans made before 1997). Japan, Taiwan and Korea have all successfully addressed major NPL problems in the last few years. “As these regions have established mature NPL markets, they have put their banks on stronger footing,” said Rodman. The report cautions that regulators need to be on guard for signs of overreaching by banks to avoid further NPL problems such as those currently experienced by Indonesia, where NPL levels rose in 2005, or India, which is expected to become a major market for NPL investors in the next few years.

Even China is poised to allow foreign investor’s access to its banking industry. Despite a slow start, the NPL disposition process has accelerated in the last 12 months. However, China’s NPL problems appear far from over considering China’s large numbers of legacy (pre-1997) loans still to resolve and an estimated total NPL exposure of US$900 billion — substantially more than any other region in the report. “China’s overheated property markets are certain to produce fresh NPLs in coming years,” said Rodman.

By far the largest NPL market in Europe is Germany where, despite any public acknowledgement of an NPL problem by banking regulators, there is an estimated US$300 billion in bad loans in various stages of resolution and 32 separate transactions reported since late 2003. This level of activity makes Germany the most active NPL market in the world.

“Investor interest is particularly strong in Germany right now due to positive factors like transparency, a good mix of NPL products and a growing appetite among investors for NPLs backed by real estate,” said Chris Seyfarth, a Transaction Real Estate partner at Ernst & Young LLP who works closely with the real estate professionals at Ernst & Young AG in Germany. “But the growing investor appetite is creating a seller’s market. We expect the transaction frenzy to continue, but the days of mega auctions are mostly behind us. Smaller deals are more likely to come to market, allowing more and smaller foreign and local investors to participate.”

Globally, a robust market is maturing for NPLs in which the health of the banks and the quality of their NPL offerings has improved, and the market is attracting a greater array of investors. The convergence of regulatory, accounting and reporting standards and best practices have brought even greater transparency to the disposition and management of NPLs and have positioned the market to flourish in the coming years.

“For the first time in the 20-year history of this Cinderella market, nonperforming loans in regions as diverse as the United States, China, Japan and Germany will be measured and evaluated equally, using relatively comparable reporting standards,” said Rodman. “These developments, in turn, breed confidence and greater investor interest. Accordingly, we expect that capital flows to distressed assets will reach record levels over the next few years,” said Rodman.