by Dr. Andreas von Keitz, director, and Roman Zeller, managing director, AlixPartners

The German distressed debt market is the biggest and most attractive market of its kind in Europe. The market, estimated at approximately 160 billion to 300 billion ($192.5 billion to $361 billion), is defined mostly by seller-driven real estate loans where a handful of players have made a killing recently. The market is expected to continue to thrive and mature in 2006.

There is a tremendous amount of optimism in the market. Some surveys suggest that the changing landscape for German banks is the reason for this optimism: the loss of local state guarantees of Germany's state-owned Landesbanken, the impending Basel II rules on capital adequacy, and the necessary preparation for potential M&A activities have put the squeeze on non-performing loans, such that they are ending up on NPL servicing platforms and the secondary market. Others, surveys suggest, see this changing landscape as a "restocking of the pond," which will favor even greater opportunities in 2006.

Either way, a lot has happened to date. For instance, in 2003, Dallas-based Lone Star Funds bought a 225 million NPL portfolio from bankrupt Gonthard & Metalbank. A few months later, the first multi-billion euro deal (for 4.3 billion) involved Hypo Real Estate Bank, a spin-off of HVB Group, with Lone Star Funds again as the buyer.

Expected returns of up to 22% pre-tax have drawn in heavyweights like Cerberus Capital Management, Fortress Investment Group and major investment banks like Goldman Sachs, Credit Suisse Group, JPMorgan Chase and Merrill Lynch - all of which have bought huge NPL portfolios in the past. The overall transaction volume jumped to approximately 12 billion face value in 2004.

Investors know that distressed debt investing is cyclical and fairly predictable. Historically, the most fertile periods for distressed debt opportunities follow periods that had a high number of low quality issuances (which includes deals in the triple-C ratings range). Today's default rates are at their lowest in years, and new issuances of low quality bonds (totaling 26 billion in Europe in 2004 and 8 billion for the first quarter 2005 alone) are at a record high.

The tremendous activity continues today. Early in 2005, HypoVereinsbank announced the disposal of an NPL portfolio (consisting mostly of canceled real estate loans) of approximately 15 billion. The disposal of the NPL portfolio will be in small portions. The bank has decided to deal only with those investors who have a strong and successful track record in the German market.

AlixPartners, which has extensive experience with the German distressed debt market, anticipates the future will hold even more challenges and opportunities in market development and distressed debt. Here are four trends we see:

1. We expect further growth in the total NPL volume, but we believe that smaller and more inhomogeneous portfolios will make their way to the market.

Due to the existing market forces in the German banking sector, banks will be continually forced to sell their bad loan portfolios. Given the huge volume and the time needed for German banks to bring their troubled loans down to an acceptable level, we expect stable growth in the sale of NPLs.

The two largest banking groups in Germany - the public sector and cooperative banks - have not yet entered the market. Multiple surveys have estimated that the bad loan portfolio for public banks is about 40% of the total NPL portfolio in Germany. Additionally, the cooperative banking sector has accumulated NPLs of approximately 17%. Huge bad loan volumes are also held by commercial and mortgage banks of about 43% (several of the latter portfolios were traded years earlier).

As a result, we expect the vast majority of the 2005 market volume to come largely from commercial and mortgage banks with an average portfolio size of 700 million to 1 billion. But there are fewer multi-billion dollar debt portfolios to bid. Instead, we anticipate smaller German banks - with smaller portfolios - will make their way to the market. However in the public/savings banking sectors, the existing bad loan portfolios tend to be too small for trading.

We are convinced that the transaction process will likely become more standardized and, consequently, transaction costs will decrease. To make the trade viable, we believe that the actual transaction size for NPL portfolios (actually 400 million to 600 million) will decrease to 100 million of face value. The approximately 480 savings banks in Germany will have to join forces and pool their bad NPL portfolios to make them palatable to investors.

2. Intelligent business models for handling NPL portfolios are becoming necessary.

Investors are demanding a return on their investment in excess of 20% pre-tax. To achieve this target, efficient servicing platforms for handling the NPL portfolios have to be established. Some ways to make the process more efficient include lowering processing costs, getting higher recovery rates, and quicker amortization periods.

The major distressed debt investors and investment firms all have longstanding experience in other NPL markets, such as Japan and the U.S. In Germany, for example: Dresdner Bank created a special institutional unit in 2002 to get rid of 32 billion of assets; Hudson Advisor handled the NPL portfolios bought from Lone Star; Goldman Sachs is working extensively with GFKL Financial Services; Other players like Allgemeine Hypothekenbank Management, a unit of Aareal Bank, offer credit services to the market; Some use joint ventures between banks, such as Citigroup Global Markets with Eurohypo; and the cooperative banks have had their own workout solution since 1987 in the form of Bankaktiengesellschaft Hamm.

Other business models are in the works and should begin to appear when large (bundled) portfolios from the public banks make their way to the market. The joint venture of WestLB-NordLB-Shinsei Bank and Chris Flowers (of JC Flowers & Co.) will surely be a part of this solution. The mission of this platform is to buy portfolios and/or offer public banks external servicing for their NPL portfolios.

What are the key success factors for running a successful NPL platform? First, don't do the workout with those who worked with the portfolio before. Second, have a strong local presence (e.g., agents, lawyers, etc.). Third, use proven processes and IT support (e.g., power dialer, software for recovery of claims and account receivables). Fourth, have a good mix of quality professionals (e.g., mortgage, investment bankers, entrepreneurs). And lastly, have an incentive system in place consistent with the targets.

Keep in mind, though, it cannot be ruled out that the still-nascent market will at least temporarily dry up after the first strong wave

of deals.

3. Germany is still a tough place for sub-performing loans.

The commercial and mortgage banks dominate the market and hold the majority of distressed (single) assets: sub-performing and single-name loans. Much of the new debt being sold is commercial, which is more complicated to value and restructure than real estate, making it harder to maintain the returns investors expect, ranging from 10% a year for lower-risk portfolios, to over 20% for riskier deals.

Issues arise for any person who acquires a portfolio of German SPL. According to Kreditwesengesetz, the German federal financial supervisory authority, German Bafin demands that the management of sub-performing loans (e.g., loan extension, re-negotiating loan terms and payments) requires involvement of an entity that is licensed as a German credit institution. Distressed debt investors like Cerberus and Lone Star have even acquired small banks to meet this requirement.

For example, Goldman Sachs bought Delmora Bank, the bank of the bankrupt Schmidt Bank, with an NPL/SPL portfolio of about 2 billion. Other banks are for sale, such as (Allgemeine Hypothekenbank Rheinboden, in which Cerberus, Chris Flowers and George Soros have expressed interest to use them as a bad loan bank.

4. Germany isn't the last word in the European debt market.

In addition to the activity in Germany, new markets for bad debt are developing in Eastern Europe and Russia as their banking systems mature. Other European Union countries such as Italy also have big stores of bad loans.

The Czech Republic is setting the pace among post-communist Central European countries as governments and banks there begin to tackle the huge volume of NPLs left over from the first decade of difficult transition to a market economy. Through auctioning big packages of NPLs, the Czech government has created Central Europe's most developed market in distressed assets. The Czech example has already been copied by Slovakia, and now Poland is looking hard at the advantages of an auction program.

In conclusion, Germany's banks are in the midst of shedding a huge number of NPLs - in the magnitude of 160 billion to 300 billion, presenting an enormous opportunity for investors. AlixPartners expects the market will continue to grow, but will become more standardized as models to handle the NPL sales are developed. We think it will be more challenging for investors to achieve significant returns on distressed (single) assets in Germany, and that Germany isn't the only market in Europe for these investors. The former-communist block countries will prove to be ripe for investors not too far down the road.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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