Non-Performing Loans in the Post-COVID World

What have we learned from non-performing real estate loans after the 2008 crisis?  We at Imperial Fund analysed the differences between the COVID-19 pandemic and the 2008 crisis from a global credit risk management perspective.

As a result of the COVID-19 pandemic, the economy suddenly stopped, and this is likely to lead to high levels of non-performing loans (NPL). Within a bank’s mortgage loan portfolio, the following categories can be distinguished according to their payment status: Performing Loans (PLs): loans on the day of payment of principal and interest. Non-Performing Loans (NPLs): are loans denominated as “past due loans” (The payment of principal and interest have delays of 90 days or more). Interest of at least 90 days has been capitalized, refinanced, or delayed by mutual agreement.

High NPLs are a common feature of banking crises and they tend to be studied around such events. Most bank crises lead to high NPLs. During crises, NPLs usually follow an inverse U-shaped pattern. They begin at modest levels, increase rapidly at the onset of the crisis, and peak a few years later, before stabilizing and declining. Anticipating future NPL levels is key to formulating NPL resolution strategies.

Countries can facilitate the resolution of high NPLs using a combination of policy measures, such as:

• Asset quality reviews to identify loans that are underperforming and need restructuring.
• Separation of good and bad assets from banks. This makes good banks’ financial conditions more transparent, stabilizes their market access, and allows them to focus on extending new loans. Defective banks, often structured as asset management companies, proceed to extract value from defective assets.
• Recapitalization of ‘good banks’, to ensure their lending capacity.

The NPL reduction results after the 2008 Crisis are worrying because two thirds of the countries that experienced high NPLs were unable to resolve them within seven years of the crisis. Surprisingly, this also implies that while advanced economies tend to have lower NPLs after the crisis, they also take longer on average to resolve.

Experts stress that NPL resolution is critical to economic recovery. High and unresolved NPLs are associated with deeper recessions and slower recoveries.

COVID-19 versus 2008 crisis

In favor we have that the COVID-19 pandemic is not a crisis induced by the credit boom as it happened in 2008. If the economic recession turns out to be temporary, many NPLs after COVID-19 can be related to viable illiquid companies, instead of unfeasible zombie companies. Multinational banks have entered the COVID-19 pandemic with (on average) higher capital ratios compared to the 2008 crisis. These large banks have accounting standards that allow for faster recognition of NPL and, therefore, a resolution, thanks to its forward-looking nature.

Given the importance of NPL reduction for economic recovery, and the historical difficulties of many countries in implementing effective NPL-related interventions, the design of effective NPL resolution policies for the post-COVID-19 world is a key question of forward-looking financial policy for the world today.

The real significant difference between the 2008-9 crisis and COVID-19 is that in 2008-9, the real estate sector was composed with many “bad mortgages” and both government-sponsored enterprises, Fannie Mae and Freddie Mac, began foreclosure and auctions on these properties. Due to an overabundance of these properties, the supply exceeded demand and prices went down. Given the significant impact of this, Fannie Mae and Freddie Mac are not foreclosing on properties during COVID-19. Instead, people will be given up to 12-month forbearance and mortgages that were for example 30 years, will be 30 years + 3 months. Given this scenario, the overall real estate market has an optimistic outlook.