The following is an article written by Clifford Tjiok, chief commercial officer & management board member, LOANCOS, and Thomas Spulak, executive director, Proceed Portfolio Services. The opinions expressed here are those of the authors and do not represent the official stance of ION Analytics.

German banks are at a crossroads as non-performing loans are increasing.

Last year, NPL volumes rose to EUR 46bn, up from EUR 38bn in 2023, according to data from the European Banking Authority. This year, NPLs are expected to rise to EUR 60bn, according to the NPL barometer of BKS Federal Association for Loan Purchasing and Servicing.

Commercial Real Estate finance appears to be facing most of the challenges, due to valuation decrease, increased defaults on rental payments from lessees, and increased refinancing costs. This situation the banks are finding themselves in could provide opportunities for NPL investors, but they need to understand that banks will first try and exhaust other options before moving to selling their NPLs at discounts.

While the EBA NPL backstop forces banks to gradually increase write-offs depending on whether an NPL is unsecured (reaching 100% or full write-off recognition in year three) or secured by collateral (reaching 25% in year five and 100% in year nine), banks will be considering the following five options:

Option 1 pertains to regular restructuring and workout activity, typically also requiring fresh money/recapitalisation from outside into a distressed transaction. In stressed CRE financing, we are seeing most of the activity here, albeit with core workout capacity having been massively reduced during the low-interest period, and seasoned restructuring battle-horse staff being reduced or phased out into retirement.

Option 2 pertains to effecting a structured workout pre-insolvency using the STARUG legal regime as a consensual solution to avert a company’s default on its ability to repay its debt. In stressed corporate financing, this is the preferred option, next to ESUG cases.

Option 3 pertains to effecting a pre-packaged insolvency following the ESUG legal procedure (similar to US Chapter 11) enabling existing liabilities to be cut off and to come up with a revised capital structure. In distressed financing, this has become somewhat of a standard, which may or may not lead to senior lenders receiving financial instruments having optional upside value at exit. This was already very common from the days of fallen LBO angels and others post the GFC.

Option 4 pertains to doing actual sales of NPLs, directly or through loan trading platforms such as Debitos, which has been mostly active in Southern Europe in recent years. NPL secondary loan market activity has so far been rather subdued. Only EUR 150m of German NPLs, mostly unsecured loans, have traded per annum over the last three years, according to Debitos. Obviously, there is other NPL trading volume outside of this. NPL sales could accelerate when the EBA backstop rules start to bite or when other circumstances of the banks change (e.g. NPL ratio too high or if SRT securitisations are no longer sufficient to free up Risk-weighted Assets (RWA)).

Caveat emptor: NPL investors need to be cognizant that to purchase NPLs in Germany, an NPL special servicer licensed by regulator BaFin needs to be deployed, following the new Secondary Loan Market Law. Plus some other regulatory things that need to be complied with (e.g. regulatory reporting for NPL sellers and buyers using the EBA data template).

Option 5 pertains to holding assets in parking-lot solutions, e.g. after enforcing collateral as senior lender by using a vehicle established exactly for that purpose e.g. REO (Real Estate-owned) assets or other forms of asset or collateral transfers to new asset owners. This is a tool that worked well for real estate assets after foreclosure, post 2005 and for shipping assets around 2010, and is expected to work very well again for assets from upcoming real estate NPLs. Obviously, this time around, the real estate transfer tax topic is always something to be aware of.

A EUR 70bn commercial real estate finance gap has opened, according to a recent report from CBRE. While the number appears big, it is not expected that the market will go under. If we turn the clock back to 2011/2013, there was a big EUR 50bn maturity wall of CMBS financing expected to hit the market. That wave in the end got refinanced by the banks that had come out of the global financial crisis with tighter capitalisation rules, also having offloaded some of the NPL burden into what became a very benign credit market from 2011 onwards, leading straight into the low-interest environment pre-COVID.

We expect the financing gap to close through a) amend and extend type of action plus fresh money to repair holes in the capital structure (see Options 1 to 3), b) loan sales (Option 4), and regular refinancing, e.g. at lower LTV levels or even through the good old sale-and-lease back (only for strong lease cash flows).