For German banks, bad loans are an unwelcome reminder of the ill-advised property lending boom that followed the country's reunification in 1990. For debt investors, however, they could be one of the year's big opportunities.
The first bonds backed by expected recoveries on these loans are on the way, analysts say. And as investors grow increasingly tolerant of risk and struggle to meet yield targets, these bonds should offer higher yields than those backed by low-risk mortgages.
German law will probably present hurdles for these deals. For example, the country's strict rules on the transfer of personal client information could hinder efforts to sell bad debts. Nonetheless, banks are expected to push forward in a bid to reduce the burden on their balance sheets.
The Dusseldorf management consultancy Droege & Comp estimates that German banks are sitting on as much as 300 billion euros ($384 billion) of bad loans.
Krishna Prasad, the head of European structured-finance research at Lehman Brothers in London, said there is "tremendous appetite" for asset-backed securities in general "and for assets that offer a good spread in particular."
He argued that with a sound structure to protect investors, "there would certainly be strong demand for these deals," since they should offer better returns than similarly rated securities backed by performing loans.
German banks have traditionally been slow to deal with bad debts, often preferring to restructure and extend a loan than to foreclose. But lately they have started to dump some of these bad loans, which according to analysts at Dresdner Kleinwort Wasserstein accounted for as much as 10% of some banks' loans late last year.
Bank shareholders want to avoid further losses, and new global accounting standards promise to make the retention of bad debt far more onerous. Under the Basel II accord, which goes into effect in 2007, banks will have to hold more money in reserve to cover nonperforming loans - money that could otherwise be used more profitably for new loans.
That is where distressed-loan investors come in. For those with the right expertise, buying loan pools and setting up special firms dedicated to reclaiming money from problem borrowers can yield annual returns of more than 20%.
Ultimately, analysts say, some of these investors will refinance their purchases by issuing bonds backed by the money they plan to recover.
"Recently there has been reasonable NPL trading activity in the German banking sector, and many of the buyers are setting up special servicing platforms and looking to acquire further NPL portfolios," said Ronan Fox, a director and the co-head of European commercial mortgage-backed securities ratings at Standard & Poor's Corp.
"We think a number of these transactions will ultimately have ABS exit routes. There will be no deluge of issuance in the short term, but we would expect to see the first NPL securitizations out of Germany some time around the summer."
Securitization has been used before to help battered banking systems in Japan, South Korea, and the United States recover from banking crises.
In Europe, however, the only deals backed by nonperformers have come from Italy, where securitization has helped banks ditch more than $41 billion of bad loans before the government revoked tax breaks encouraging such deals.
Though a few deals have disappointed, the bulk of the market has performed reasonably well. In 2004, for instance, 11 tranches of these deals had their credit ratings upgraded by one of the three major credit agencies, and only four were downgraded.
Italian NPL deals can offer a premium in the region of 20 basis points over similarly rated bonds backed by performing loans, Mr. Prasad said. Some of these bonds are relatively old and illiquid. German deals might be able to attract investors with smaller premiums.
Of course, some are skeptical of Germany's prospects, arguing that securitization is just one of several ways for banks to clean up their balance sheets, and noting that France's banking crisis in the 1990s produced no securitizations.
Others, however, say that though German banks have plenty of bad debt, they are not forced to sell, and selling at a discount means painfully realizing losses. That means securitizations of nonperformers are likely to occur gradually.
