Italian debt: rule changes could put pressure on investors

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The world is awash with debt. Add up the borrowings of individuals, businesses and governments and the total reaches some $300tn, according to credit rating agency Standard & Poors. Debt has powered the success of modern financial economies. When the taps are turned off, as they were during the 2008 financial crisis, the system seizes up.

But the plans that loans fund do not always succeed. Business ideas fail, jobs are lost and repayments are not made. When that happens the debts become what are called non-performing loans (NPL). This is now a specialised asset class that has grown in prominence over the past decade. 

Nowhere are NPLs more advanced as an asset class than in Italy. A private sector ecosystem has evolved with government support to clean up bad debts.

Some €300bn of NPLs were stuck on the balance sheets of Italian banks in 2015. This was almost a quarter of the total in the EU. With government finances already stretched and failing banks such as Monte dei Paschi in need of bailouts, the country had to fix its NPL problem. Private equity investors, largely US firms such as KRR, Apollo and Fortress, accepted the challenge. 

These groups have invested in NPLs, often via government guaranteed securitisations, and set up businesses to service debts and seek recoveries. Extracting the NPLs from banks was a priority for regulators who wanted to free up capital for new lending and keep the economy supplied with credit. The theory is that putting them into the hands of specialists should make workouts and recoveries more efficient.

However, existing deals have not turned out to be goldmines for participants. Recoveries have been harder than expected and collections have fallen short of expectations. Frozen legal systems during the pandemic did not help.

Shares in Italian debt collector DoValue, owned by Fortress, illustrate the situation. These are down 60 per cent in five years and now trade at all-time lows. Shares in Europe’s largest debt collector, Sweden’s Intrum, have performed similarly.

Lack of new debt supply is another problem. The expected wave of new NPLs in the pandemic did not materialise. Payment holidays and government stimulus meant borrowers did not default. Just 1 per cent of total loans became NPLs in the second half of last year, according to the Bank of Italy. 

Debt collectors are broadening their reach to compensate. Both DoValue and Intrum have expanded into Spain.

Bad debts could be on the rise. Around the world, pressure on borrowers is increasing. Businesses are feeling the pinch. In the UK, company insolvencies last year rose by 60 per cent compared with 2021. Insolvencies in Italy and Spain are rising too. Europe’s debt collectors and debt investors could be on the cusp of a wave of new NPLs.

There is, however, one further potential hurdle. New proposals from the Italian government of Giorgia Meloni, which recently shocked markets with a windfall tax on bank profits, threaten to upend the NPL process and scare private investors away. Under proposed legislation, some borrowers could be given an option to repay loans at a discounted price. Essentially, they could repay the debt at the same price it was sold to third party investors plus a small premium on top. This would mean they could shed their status as bad borrowers.

Given that NPL deals are typically done at around a fifth of the face value of a loan, the change would spell bad news for existing portfolio owners who hope to profit from successful debt recoveries. Future NPL deals could be in question.

Italian bonds: Meloni moment

Italy’s own debt is a constant source of worry for Europe and a reliable source of high yields for investors in government bonds.

The country’s debt load is still rising, reaching €2.9tn in July, according to the Bank of Italy. It is now equal to 144 per cent of gross domestic product. Compare that to Germany, where government debt is just 68 per cent of GDP.

Meanwhile, the economy is slowing. Second-quarter GDP decreased 0.4 per cent on the previous three months. The European Commission has cut its 2024 growth forecast for the country. Lower growth means less money in government coffers to pay debt costs. Plus, the new government wants to hand out tax cuts. With little cash to go around, the fear is that Italy will end up with a higher than expected deficit. 

Italy will issue an additional €300bn of new medium and long term securities this year. Italian bonds, known as BTPs, are most common. They are also in the midst of an unexpected charmed period.

The benchmark 10-year bond yield is still 4.3 per cent — only 165 basis points above the German equivalent. That spread has narrowed by almost a fifth since the start of the year. Fears about Italy’s excessive debts pushed it as high as 500bp during the sovereign debt crisis.

Support from the European Central Bank, which indicated it would shield weaker countries facing widening spreads, has helped. So have local buyers for Italian debt, notably individual investors whose cash languishes in low-interest bank accounts.

Italy is not alone. The UK has been able to restore calm to its own debt markets after a ill-judged “mini Budget” sent yields spiking last year. Issuance of new gilts this year will be the second largest on record, yet yields have begun to retreat from highs of more than 5 per cent recorded during the summer.