In 2016 the gross book value (GBV) of NPLs on Italian banks’ balance sheets exceeded Euro 200 billion. Interest from foreign specialized investors has increased considerably in recent months. During 2016 we have seen an increase in the number of transactions but it is also true that this market has so far not expressed all its potential. Driven by the aim of helping Italian banks clean up their balance sheets, the Italian Government has put in place several initiatives both to facilitate the disposal of the NPLs and to reduce their occurrence going forward. These initiatives fall into four categories: (A) the introduction of a State guarantee scheme (known in Italy as “GACS”) whereby the Italian Treasury guarantees senior tranches of ABS backed by Italian NPLs; (B) the improvement of Italian bankruptcy and enforcement proceedings, (C) the introduction of new forms of security interests, and (D) opening up the market to direct lending by alternative investment funds (AIM). The idea is to make the Italian lending market more creditor friendly overall which in turn should encourage the further funding of the real economy.

The “GACS” and Atlante
The “GACS” (“Garanzia Cartolarizzazione Sofferenze” or “Non-Performing Loan Securitisation Guarantee”), is a time-limited tool in the hands of the Italian banks in that it expires in October 2017 (i.e. 16 months from enactment) unless extended by the Italian government for a further 18 months. Any such extension would be subject to the approval of the European Commission. Under this scheme the Italian Treasury guarantees senior tranches of Notes issued by Italian special purpose vehicles (SPVs) that are backed by NPLs originated by Italian banks and financial institutions. The GACS would cover interest and principal payments provided that the securitisation meets certain eligibility requirements. Those requirements can be summarised as follows:

• Price: the NPL pools must be sold to the SPV for a purchase price no higher than their stated net book value in the financial accounts of the seller.
• Tranching: the SPV must issue at least two tranches of Notes (senior and junior). There is no limit on the number of permitted mezzanine tranches.
• Rating: the senior Notes must be rated investment grade (i.e. Baa3/BBB-/BBB-/BBBL) by at least one ECB-approved external credit assessment institution (ECAI) being DBRS, Fitch Ratings, Moody’s and Standard & Poor’s. Any second rating agency used (which would also have to rate the Notes as investment grade) may be a rating agency in the approved ESMA list (Regulation 1060/2009).
• Independent servicing: The loan servicer must be a third party with respect to the originator bank and its group. Any substitution of the NPL Servicer must not impair the rating of the senior Notes.
• Full subordination of the junior Notes: no interest or principal on the junior Notes can be paid until full redemption of the senior Notes (and the mezzanine Notes, if any).
• Derecognition: the majority of the junior Notes must be sold to third party investors and in any event the seller must achieve de-recognition of the NPLs.

In order to avoid re-characterisation as unlawful state aid, the GACS guarantee is remunerated at market levels according to a formula which takes into account the pricing for credit default swaps on a basket of investment grade Italian reference entities.

In addition to the GACS, some Italian banks have come together to create an Italian NPL platform called Fondo Atlante, an Italian closed-end alternative investment fund invested in by Italian banks, banking foundations and insurance companies and managed by an independent asset manager (Quaestio Capital Management) with the twin purpose of supporting the ongoing capital increase of under-capitalised banks on the one hand and the purchase of mezzanine and junior tranches of NPLs securitisation transactions on the other. Atlante’s first investment was the subscription of Euro 1.5 billion of equity in the share capital increase of Banca Popolare di Vicenza (equal to a shareholding of 99.3% of the bank). Atlante is now expected to be involved in the rescue plan and recapitalization of Monte dei Paschi di Siena (MPS), the third largest bank in Italy and the oldest in the world. In this respect MPS is working on a securitisation of a large portion of its stock of NPLs (the GBV of the securitised portfolio is estimated to be in the region of Euro 27 billion), which, according to the information circulated so far, would involve the sale of NPLs to a SPV funded by three or four tranches of Notes in which the most senior tranche is expected to benefit from the GACS, a mezzanine tranche is to be subscribed by Atlante and the most junior tranche is to be given to the existing shareholders of MPS through a de-merger scheme. It is expected the NPL securitisation will be accompanied by a share capital increase of up to Euro 5 billion.

The time factor
The key factor which is slowing down the full growth of an Italian NPL market is the large gap between bid and offer which Italian banks experience in attempting to dispose of NPLs. The reason for the gap is mostly due to the extremely lengthy timing for debt recovery in Italy. The enforcement of a mortgage may take more than 6 years and must be carried out through court proceedings. A reduction in the time of recovery would no doubt assist in reducing the bid-offer gap by enabling an investor with high expectation of return to bid a higher price. Research by the Bank of Italy shows that with a target internal rate of return (IRR) of 20% a reduction of recovery times from 4 to 3 years could increase the purchase price of NPLs by more than 4 per cent. of GBV.1

For this reason it was clear to the Italian Government that the GACS alone was not sufficient to foster the sale of NPLs by Italian banks. As a result, a wider set of legislative measures was undertaken in order to speed up the enforcement proceedings. In May 2016, the “Italian Bank Decree” introduced several significant improvements to Italian enforcement procedures aimed at reducing the length of the proceedings and simplifying the auction process for the sale of the mortgaged real estate assets. Such measures include: (i) the creation of a data-base of foreclosure and insolvency proceedings including the documents and the relevant information concerning the proceedings initiated against a debtor; (ii) the simplification and reduction of the number of grounds available to debtors to oppose enforcement procedures; (iii) the reduction of the timeframe for the sale of the foreclosed assets and a swifter distribution of proceeds to creditors; and (iv) the digitalization of the procedures including the creation of a database accessible to the public in order to further publicise forced asset sales. The above changes were intended to provide two benefits: (i) shorter enforcement proceedings and, yet more importantly for the banking system, (ii) fewer proceedings since debtors will be less inclined to rely on an excessive long time before eviction.

Innovations in secured lending
In addition to improving enforcement proceedings, the Italian Bank Decree introduced two new forms of security interest: (i) the non-possessory pledge (“pegno non possessorio”), a new security interest over movable assets similar, in certain respects, to a common law floating charge, and (ii) the so called “patto marciano”. Under the non-possessory pledge, business entities are allowed to grant a pledge over present and future non-registered moveable assets in order to secure present or future financial indebtedness while keeping possession of the pledged assets. The non-possessory pledge overcomes the limitations in and lack of flexibility associated with other security rights available under Italian law for moveable assets (which require the transfer of possession of the pledged assets to the pledgee) and allows the pledgor to use and dispose of the pledged assets (in the event of disposal, the security interest automatically extends to the sale proceeds). The patto marciano is a security right over real estate pursuant to which a financing (including an existing facility agreement) can be secured by way of right to transfer such real estate to the lender upon the default of the borrower without court proceedings – a significant innovation. The rationale for this new security interest is clear: to move enforcement proceedings outside the courts, thereby reducing their workload.

The servicing business
Shorter and more efficient enforcement procedures are a key factor in attracting investors in NPLs, but it will take time before the positive effect of changes in law will be felt and reflected in cash flow models and rating agency criteria. A complex legal framework, such as in Italy, makes the role of the special servicer even more crucial. The number of operators in this market is increasing reflecting specialization according to the specific features of the NPLs to be serviced. It is becoming more frequent in the management of Italian NPLs to see the “clustering” of servicing activities whereby servicer operations are divided among various servicers according to different criteria (e.g. secured vs unsecured; small ticket vs large ticket; or based on efficiency). The potential of the loan servicing business has already attracted the interest of private equity funds that have invested in Italian servicing companies in recent years. A further boost to this business is afforded by the increasing tendency of Italian banks to outsource a portion of their debt recovery activities to external servicers in order to manage their NPLs more efficiently and be in a better position when it is time for disposal (on account of having higher quality data and debt recovery records).

Future opportunities
Future opportunities within the Italian NPL market fall broadly into two categories: (i) purchase of large and granular loan pools originated in the retail business and (ii) investments in small commercial loan pools and single name commercial loans to corporates(including project finance).

The latter is a more recent development in the Italian market and is attracting investors with a specific interest and specialist knowledge of how to value the underlying real estate or business. Italian insolvency legislation has been much improved in recent years to better reflect the recovery strategies of distressed debt investors. This should increase future scope for distressed debt trading and investments in Italian NPLs driven by loan-to-own strategies. In April 2016 new legislation (Law No. 49/2016) has finally sanctioned direct lending to Italian borrowers by Italian and EU AIFs. This opening up of the market not only involves lending but also the purchase of receivables (which, if made on a professional basis and for consideration, might otherwise amount to the provision of financial services in Italy). According to the new law, EU AIFs will be entitled to lend directly to Italian borrowers (other than consumers) and to purchase bank debt without the need for a securitisation structure, provided that Bank of Italy procedures are followed. Briefly, 60 days’ notice to the Bank of Italy is required during which period the Bank of Italy will verify that certain regulatory requirements are met (for example, that the AIF is a closed-end fund with an operational structure similar to the structure of an Italian AIF and is subject to the rules concerning risk diversification and limitation (including as to financial leverage maxima) equivalent to the rules applicable to Italian AIFs. Further regulatory provisions must be issued by Bank of Italy in order for such new AIF direct lending provisions to be fully implemented in Italy. It is expected that by end of 2016 the legal and regulatory framework will be completed and at that time more opportunities will be available for specialized investors but also for Italian banks since there will be the conditions for the development of real secondary distressed debt trading. Ultimately, all the above measures were introduced for the benefit of the Italian banking system and wider Italian economy.

Footnote

1. Quanto valgono i crediti deteriorati?, in Bank of Italy, Note di stabilità finanziaria e vigilanza, No. 3, 29 April 2016, 8.