“In these unprecedented times” has to be one of the most used phrases since the pandemic began—and for good reason. The changes we’ve seen have influenced everything from the smallest of daily activities to the largest of global economies. But even as we start to get back to precedented times, one of the lasting repercussions of the year of quarantine is a huge wave of loan defaults. This has led to an increase in distressed debt and non-performing loans.
Non-performing loans (NPLs) are loans in which the borrower has not made payments on the interest or principal in over ninety days (or another specified period). Once this occurs, it is a key indicator that the loan is much less likely to be repaid, and the loan is marked as non-performing. These loans clog balance sheets as they not only decrease profitability but also keep banks from being able to issue new loans to customers. This leads banks to sell off these NPLs at a large discount to debt buyers.
As such, the influx of distressed debt, which is bought from companies in or near bankruptcy, opens up new opportunities for NPL buyers, traders, especially in the commercial real estate market. As co-founder of the syndicated marketplace Metechi, I have seen a huge uptick in non-performing loans. It is easier than ever to get into the NPL business but, if you’re looking to get in on this NPL wave by purchasing or trading debt, it’s important to understand exactly how the market has shifted due to COVID. Here are some important considerations:
Zombies are slow
If you’re hoping to hop on the NPL train, be patient. NPLs are not generally a fast-acting market. COVID-19 has led to broad economic contraction, which has also been seen in NPLs, but because NPLs are such a slow-moving market, this new debt may take some time to become available. In fact, many of the sales in the US and Europe prior to COVID were still due to the 2008 financial crisis, which demonstrates just how long-lasting debt can be.
Additionally, while banks have seen an increase in criticized and non-performing loans, in 2020, forecasts indicate that things won’t be as dire as originally expected. Some forecasts estimated we would see nearly $1.3 billion of loans fall into the non-conforming category. It seems that we have leveled off right around $900 million.
This softening of the distressed debt increase is due to the zombie effect: firms are being kept alive by government support like the $1.9 trillion stimulus package just passed in the US. These will eventually phased out but even still long grace periods make loans slow to turn bad. As more and more of these firms fail to bounce back, the credit losses will increase, leading to a slower, steady supply of NPLs. In other words, while it may seem like so many businesses in America are struggling right now, many of them have either been saved by the stimulus packages or will simply fail to bounce back over time, rather than just immediately going under.
The CRE dominoes are set
Despite the slow reaction time, things have been set into motion, and the inertia is strong. In a recent report, PwC estimated that around $180 billion in NPLs will trade in 2021 and 2022, with most coming after 2021. As mentioned before, most of the 2021 trades are expected to be legacy debt (older debt), with more recent coming into the fore in 2022 and beyond. In fact, the ECB estimated that we could see as much as $450 billion in NPLs hit banks’ balance sheets before 2022, which means sales could skyrocket in future years. Remember, just because an NPL hits a balance sheet doesn’t mean it’s immediately available for purchase—it takes time for a bank to decide to sell their debt.
In the US, it seems that commercial real estate NPLs will dominate. CRE is one of the hardest-hit sectors, and one least to be resilient post-pandemic—already, offices are planning on staying virtual or semi-virtual even after it becomes safe to return, leading to a collapse of the traditional office-space economy. As unfortunate as it may be for companies, it presents a huge opportunity for CRE debt markets, as the United States CRE sector alone is expected to reach $320 billion in distressed debt in the next five years.
Though these changes may happen on a semi-unpredictable timeline, the pandemic will continue to create significant growth in NPL sales. As much as vaccines and public action may bring the era of COVID-19 to a much-anticipated end, the effects on NPL markets will carry forward for years as banks attempt to recover from the pandemic, just as the effects of the 2008 crisis are still apparent in their balance sheets today.
This means that as an NPL buyer, you can definitely plan on a higher availability of NPLs, but should plan on purchasing debt over a longer period of time. Zombie firms will soon falter, and over the next twenty-four months, there will be a steady supply of loans classified as non-performing. However, they may take some time to hit the market, so if you’re looking for newer debt, you also may need to wait until some of the older debt (like debt from the 2008 crisis) has been purged.
Still, the pandemic has led to a huge opportunity for debt buyers who are patient and observant enough to find investments that are right for them, and the influx of debt and availability of NPL marketplaces make this an excellent time for new buyers to get into the space.