A potential boom of trading nonperforming German loans (NPLs) portfolios is expected going forward, market sources said. Estimates are that German bank balance sheets could hold an estimated 300 billion (US$361 billion) of NPLs - and it's one of the largest European NPL asset pools that can be securitized. If estimates are accurate, the market can expect a plethora of these loans to hit the scene. German courts can also anticipate a surge of loan enforcement proceedings.

The market has not seen activity on the public front to date, primarily because there was little definition of performance criteria in the past. However, the impending changes made in Basel II should more clearly define how German institutions treat nonperforming loans going forward. "Under German accounting, banks currently treat NPLs as a loan for which specific loan losses are allocated," analysts at the Royal Bank of Scotland explained. "This treatment allows for liberal interpretation, which, given the declining economic climate, may have led certain institutions to encourage understatement, although we believe that many banks are already using the Basel II definition of greater than 90 days past due."

"With the German legal system resolving somewhat faster than its Italian counterpart, significant value may be found in the earlier transactions if rating agencies and hence structures provide generous credit enhancement to cover the uncertainties in an untested market," analysts at RBS added.

The primary incentive for Germany to securitize these portfolios is to avoid the lengthy workouts - 10-years in some cases - preventing management from focusing on the performing loan portfolio business of banks, said Standard & Poor's.

S&P said its rating approach remains largely the same - following four distinct phases that have been applied to past structures emerging from Italy, where these types of loans have been securitized over the past six years. The rating agency first considers why the nonperforming loan exists. If the loan is to be sold to a third party, the agency looks at the capabilities of the new servicing platform. It then analyzes the business plans/resolution strategies in an overall market context and places this analysis in the context of the overall transaction structure proposed.

Setting up the servicer platforms for these loans can be a difficult process. With over 300 billion of loans potentially available for securitizing, analysts questioned whether the market would have the breadth of talent to workout this magnitude of NPLs. How the market will function is still up in the air. What's clear is that changes to the German true-sale law, the upcoming removal of Landesbank's state-supported guarantees and Basel II should increase incentives for bank securitization of NPLs.

"There is always a large element of the unknown in assessing nonperforming loan portfolios; not only are there matters that we know that we do not know, there are also unknown unknowns' - factors we have not anticipated," reported analysts at S&P. "This makes the rating analysis of nonperforming real estate loan portfolios both interesting and challenging; it is far from a bland Monte Carl' analysis with haircut proceeds, delayed timing, and considering 99th percentile smoothed cash flows."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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