This article was published in "Structured Credit Investor" on 10 May 2017.

Allied Irish Bank last month sold €400m gross book value of non-performing buy-to-let loans to Goldman Sachs at a 50% discount to their original value. The transaction signals a shift in the seller base for non-performing loans from foreign banks and bad bank NAMA to domestic Irish lenders.

According to Tom McAleese, md at Alvarez and Marsal, between 2011 and 2016 the Irish loan sale market was driven by NAMA and the Irish Banking Resolution Corporation (IBRC) as the primary sellers, as well as foreign banks that were leaving Ireland or downsizing their operations. Irish domestic bank activity was relatively quiet during that period, as they were focused on restructuring their non-core operations, in particular overseas.

"Selling domestic NPLs was primarily avoided in order to minimise capital losses and protect client relationships, where appropriate," McAleese observes.

Indeed, the recent AIB transaction forms part of what Deloitte calls the 'second phase' of deleveraging and NPL resolution in Ireland, with NAMA having completed €10.2bn in CRE sales last year. Most foreign banks have exited their non-core Irish lending, NAMA is nearing the end of its open market loan sales programme and the CRE market is now primarily a secondary market. Activity has declined from its 2014 peak, dropping from €28bn to €13bn in 2016.

Irish bank NPL ratios currently average 13.6%, but the ECB is compelling lenders to reduce these ratios to the EU average of 5% over the next 3-5 years. AIB's NPL ratio stood at at 14.9%, as of end-2016.

The tight ECB timeline explains the necessity of loan sales. As McAleese points out: "NPL reduction can't be done through restructuring and forbearance alone, as cure periods back to performing can take up to three years, which slows down a five-year reduction plan. It has to be done through a combination of loan sales, asset sales, debt settlements, write-offs and debt-for-equity swaps."

The inability of restructuring solutions to deal effectively with the challenge is evident in the build-up of large volumes of forborne loans. According to a recent Moody's report, while the use of restructuring solutions by banks has contributed greatly to resolving mortgage arrears, it also resulted in the build-up of nearly €20bn of forborne loans across the four largest banks at end-2015, or 20% of total mortgage lending in Ireland.

Investors have also been disappointed by the slow pace of asset recovery. The market is well understood in terms of legal framework and processes, but the work-out period for asset recoveries is often longer than expected.

Buy-to-let loans are generally preferred by investors over primary household mortgages. "They are a retail asset class from a regulatory perspective, but have similar features to commercial real estate from an asset management perspective," McAleese observes.

This means that an investor can take possession of the property by appointing a fixed asset receiver to secure the property and the rent, whereas investors would have to resort to a court for mortgages. It fits with the investment philosophy of private equity investors, which typically seek to turn the assets around quickly.

The attractiveness of the Irish market is an additional factor. McAleese points out that private equity investors choose the Irish market given common law legislation, creditor enforcement rights, legal and political certainty and deal track record.

Around €64bn of Irish loans have been sold in the last three years. Securitisation, however, has played a lesser role until now due to the availability of ECB funding.

Although Irish property prices are recovering, there remains an inbuilt legacy of default, with significant numbers of owner-occupiers still carrying negative equity in their properties. The Irish pillar banks have found it easier to sell commercial and buy-to-let loan books, but are now under increasing pressure to bring residential loans to market, following their poor performance in the 2016 EBA stress tests. AIB and Bank of Ireland, for example, were among the weakest of all 51 EU banks included in the stress tests.

In this regard, the pricing of Lone Star's European Residential Loan Securitisation 2017-NPL1 last week could open the floodgates for a wave of Irish NPL RMBS (SCI 6 April). Deal flow has started to pick up - after a downturn in mid-2016, following the Brexit referendum - and several large funds remain with a significant footprint in the market, such as Cerberus and Oaktree, ready to invest.

Structured Finance Information, “Irish NPL wave expected”, 10 May 2017.

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