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Banks need to decide today what to do with their NPLs

The crisis we are experiencing presents a major dilemma for banks. Many of their borrowers are facing difficulties in paying their loans on time. These borrowers are asking banks for forbearance on current due payments. Given the government 90 days forbearance programs, banks routinely grant such requests. Absent the government programs, such forbearance will lead to reclassification of a loan as a Non-Performing-Loan (NPL), thereby requiring an increase in the reserve set aside for potential losses. Indeed, the trend in the upcoming NPLs is clearly shown through the data coming out of the CMBS market. Moreover, even during the government programs, JPMorgan’s most recent financial reports show a massive increase in reserves.

Without government forbearance programs, banks need to decide what to do today.

If banks believes, as many do, that even with government help we are heading into a recession that can last at least a year, banks will need to act now. In the coming months, there will be a surge in the number of NPLs. Many banks will want to sell them. And with high supply the discount on these loans will increase.

Indeed, an important lesson from the 2008 crisis, the longer a bank waited the deeper was the discount on the loans sold.

Currently, there are more buyers looking for NPLs than sellers. To take advantage of this higher demand banks need to sell now some of their potential NPLs. Depending on the type of business—such as hospitality, retail, or multifamily—and the strength of the client’s balance sheet, it is possible to estimate the likelihood of a recovery or the soundness of a foreclosure. Selling now the loans with the higher likelihood to fail, will hedge the risk of the banks against the deeper discount expected in the future.

However, although selling the NPLs in the near future is inevitable, banks prefer to postpone this action because of potential reputation effects vis-s-vis clients, peers, and investors. Waiting and selling loans, even at deep discounts, together with many other banks does not carry the same reputation risk.

But banks need to be creative. Instead of accepting deep discounts to avoid the reputation risk, they can conduct a confidential competitive sale process. The selling bank can run an anonymous auction among the potential buyers, and reveal its identity subject to signing NDA only to the winning buyer. This process can be done even for banks who wish to sell only part of an NPL, due to a commitment to the borrower not to sell the whole loan.