Bad bank model gains ground in Greece

Greek banks will have to isolate their troubled assets from the rest to help build the trust of investors and depositors, put an end to doubts and make a fresh start. The top executives of two large banks said last week they intend to do this in the next few months, while a national asset management company may assume the troubled assets of existing bad banks. These are steps in the right direction for banks to provide credit to the economy and avoid a short-lived creditless recovery. In both cases, the management pricing and servicing of troubled loans will be important.

We stressed last week the need for local banks to get rid of their portfolios of troubled loans so as to make a fresh start and provide credit to creditworthy households and private companies in the future. The “bad bank” model, first introduced in the 1980s, provides a structural solution to the problem in a country where direct sales of bank loan portfolios to distressed funds are viewed negatively by the public and the political elite whose ability to mess things up should not be underestimated.

Although direct sales of loans to funds specializing in distressed investments could take place, it would likely be tiny compared to the stock of nonperforming loans (NPLs), which exceeds 65 billion euros at present. By creating a bad bank either as an external institution that is legally and operationally separate from the original bank or an internal entity responsible for winding down ring-fenced portfolios of troubled assets, Greek banks can do more to regain the trust of investors and depositors.

Two top bankers at Piraeus and National told Reuters on Thursday their banks intend to segregate weak assets from the rest. So, it looks as if Greece will proceed with a two-tier scheme. First, there will likely be a “national” bad bank, which will assume the troubled assets of all existing bad banks, such as the bad ATEbank, the bad Hellenic Postbank bank and smaller ones. Second, all or some of the four systemic banks will likely set up their own bad banks and try to convince investors, including foreign distressed funds, to become shareholders in the bad banks joining future share capital increases.

Developed countries have put in place major national bad bank programs with different structure, scope and shareholding composition in the last few years and before. Ireland set up a government fund, the National Asset Management Agency (NAMA), in which participating institutions such as AIB, Bank of Ireland and Irish Nationwide transferred assets comprising land and development loans. NAMA acquired the assets at a heavy discount of about 60 percent below book value and paid for them with Irish government bonds carrying a floating rate coupon. Each participating institution was required to manage the transferred loans within separate units. The state injected tens of billions into NAMA to make it operational, raising the country’s public debt-to-GDP ratio.

In the US, the structure of the national bad bank program was quite different. Individual special purpose vehicles (SPVs) were created, namely investment funds (PPIFs), which invested in real estate-backed securities originally issued prior to 2009 (legacy securities). The PPIFs invested on behalf of the US Treasury and private investors and were managed by private sector asset managers who raised equity capital and got matching equity funds from the Treasury and debt financing from the Federal Reserve via the TALF and Treasury. The program helped restart the market for these legacy securities and freed up capital from the balance sheet of troubled Citigroup, enabling it to extend new credit. Moreover, the price discovery process reduced uncertainty about the state of US banks holding these securities, helping them to raise new private capital.

In Spain, the Asset Management Company for Assets Arising from Bank Restructuring (Sareb) was set up in Q4 of 2012 aimed at reducing uncertainty over the viability of banks recapitalized with state aid. This was in line with the MoU between Spain and the EU in July, 2012 calling for problematic real estate-related assets of banks requiring state funds to be transferred to an asset management company. The maximum life span of Sareb, which is not part of the general government, was set at 15 years.

Certain Spanish banks transferred specific categories of assets to Sareb in December 2012, including foreclosed assets with a net amount above 100,000 euros and loans/credits to real estate developers with a net carrying amount in excess of 250,000 euros calculated at borrower rather than transaction level.

More importantly, the transfer value of the assets was set by taking into account two factors. First, the economic value of the assets. Second, a discount applied to the estimated economic value based on the characteristics inherent to the transfer of the asset to Sareb such as the timing of the divesture of the assets and asset management and administration costs. By adjusting the economic value of the assets, the authorities made sure the prices could not be used to value bank assets that have not been transferred to Sareb.

If the pundits are right, Greece is leaning toward a Sareb-type asset management company for its “national” bad bank for all assets of existing bad banks. The management of these bad loans will be extremely important since it is possible some influential borrowers may seek special treatment, bankers warn. Placing foreign experts in some key positions in the asset management company may be one of the safeguards, they say.

Also, the transfer value of troubled assets from the systemic banks to their bad banks should be established with transparency and ensure a satisfactory return of capital for the project to help attract private investors in bad banks. That way, the Greek bad bank project will likely be successful.