he Italian government’s proposal to give some non-performing borrowers a new option for returning to performing status would create significant uncertainty for banks, servicers, and investors in non-performing loan (NPL) securitisations if implemented in its current form, Fitch Ratings says. It is unclear how many borrowers would use the envisaged mechanism, but it could weigh on banks’ ability to dispose of NPLs.
Under proposed legislation, households and SMEs with loans classified as unlikely to pay (UTP) or non-performing between 2015 and 2021 and transferred to a third party before end-2022 could choose to pay a discounted payment obligation (DPO), calculated as the loan transfer price plus a premium. The transfer price would reflect that paid by the third party for the entire portfolio. The premium would be 20% if recovery proceedings had not begun, or 40% otherwise. Once complete, borrowers would no longer be registered as non-performing on Italy’s Central Credit Register, improving access to new financing.
It is unclear how many borrowers would have the financial resources to clear their defaulted positions. Nevertheless, a retroactive measure could increase the operational burden on servicers, trigger substantial revisions of existing business plans by servicers and purchasers, and affect the profitability of existing investments in NPLs.
Operational implications for servicers would include an unforeseen influx of DPOs and renegotiating contracts with NPL investors and creditors as recovery expectations on those portfolios change. The impact on earnings, and cash flow leverage, would depend on what proportion of a servicer’s income relied on success fees, which are usually higher for secured, corporate and UTP exposures, than for unsecured, retail and NPL exposures. Fitch expects a larger impact on debt purchasers because the new law could lead to lower estimated remaining collections, possibly resulting in portfolio write-downs and lower EBITDA generation.
Legally mandating the DPO price could distort the economic rationale underpinning existing NPL transfers by enabling borrowers to return to performing status at a low cost – for example where claims typically attract low purchase prices on portfolio sale, such as small unsecured NPLs or NPLs secured by bespoke commercial real estate.
In the longer term servicers who purchase or co-invest in NPL portfolios with institutional investors could reconsider their Italian market presence as the predictability of work-out strategies could be jeopardised. This could trigger further consolidation. We will monitor the evolution of the proposal, including implications for the 16 Fitch-rated servicers active in the Italian NPL market (this includes credit and servicer ratings) and Fitch-rated Italian banks whose business models include significant NPL purchases.
Fitch has not rated post-eurozone crisis Italian NPL securitisations, but we believe the proposal could increase cash flow uncertainty in existing deals. In the near term, as borrowers exercise DPO optionality, transactions may benefit from larger cash flows, notwithstanding lower loan-level recoveries. In the longer term, credit profiles of NPL-backed bonds will broadly reflect how their advance rate compares to the collateral portfolio’s purchase price and how widely such optionality is taken up in the portfolio. Junior investors could be most exposed if this reduced recoveries from the best loans while leaving the worst ones unchanged.
Fitch’s NPL rating criteria does not directly rely on servicers’ business plans, but the proposed legislation could change how we assess future NPL securitisations. If it took effect, we would revise our recovery rate assumptions to account for a higher percentage of DPOs. Recovery timing could ultimately be reduced to reflect easing burdens on tribunals.
For Italian banks, reduced NPL portfolio liquidity and higher disposal costs could make it more difficult to reduce NPL ratios on balance sheets though disposals. A well-functioning NPL market has been instrumental to balance sheet clean-ups since 2017. NPL stocks are low, but we expect a moderate increase in new NPL inflows over the next 24 months and assume banks will keep flows and stocks under control, including through disposals.
A functioning NPL market informs our assessment of the Italian operating environment for banks (currently scored bbb) by allowing the sector to operate with asset quality levels closer to European averages. Disruptions could impair the banks’ business, risk profile, asset quality and capitalisation assessments if NPL ratios and the resulting capital encumbrance started increasing beyond our expectations.