Unveiling the Italian Debt Game Changer: Brace Yourself Investors!

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The world is awash in debt. If loans from individuals, businesses and governments are added, the total reaches about $300 trillion, according to the credit rating agency Standard & Poors. Debt has fueled the success of modern financial economies. When the taps are turned off, as happened during the 2008 financial crisis, the system grinds to a halt.

But schemes that finance loans are not always successful. Business ideas fail, jobs are lost and payments are not made. When that happens, the debts become what are called non-performing loans (NPL). This is now a specialized asset class that has grown in importance over the last decade.

Nowhere is non-performing loans more advanced as an asset class than in Italy. A private sector ecosystem has evolved with government support to clean up bad debts.

Some €300 billion in bad loans 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 to the limit and bankrupt banks like Monte dei Paschi Needing bailouts, the country had to solve its problem of non-performing loans. Private equity investors, mostly US companies such as KRR, Apollo and Fortress, rose to the challenge.

These groups have invested in bad loans, often through government-guaranteed securitizations, and have created companies to service debts and seek recoveries. Removing bad loans from banks was a priority for regulators who wanted to free up capital for new loans and keep the economy supplied with credit. The theory is that putting them in the hands of specialists should make training and recoveries more efficient.

However, existing agreements have not turned out to be gold mines for participants. Recoveries have been harder than expected and collections have not lived up to expectations. Legal systems frozen during the pandemic did not help.

The actions of Italian debt collector DoValue, owned by Fortress, illustrate the situation. These are down 60 percent in five years and are now trading at record lows. Shares of Europe’s largest debt collector, Sweden’s Intrum, have performed similarly.

The lack of new debt supply is another problem. The expected wave of new bad loans during the pandemic did not materialize. Payment holidays and government stimulus allowed borrowers to avoid defaulting on their payments. Only 1 percent of total loans became non-performing loans in the second half of last year, according to the Bank of Italy.

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

Bad debts could be increasing. Around the world, pressure on borrowers is increasing. Companies are feeling the pressure. In the UK, company insolvencies increased by 60 percent last year compared to 2021. Insolvencies in Italy and Spain are also increasing. Europe’s debt collectors and investors could be on the verge of a wave of new bad loans.

However, there is another potential obstacle. New proposals from the Italian government of Giorgia Meloni, which recently shocked the markets with a tax on extraordinary profits on bank profits, threaten to disrupt the bad loan process and scare away private investors. Under the proposed legislation, some borrowers could have the option to repay loans at a discounted rate. Basically, they could repay the debt at the same price it was sold for to third-party investors plus a small additional premium. This would mean that they could get rid of their status as bad borrowers.

Given that bad loan transactions typically occur at around one-fifth of a loan’s face value, the change would spell bad news for owners of existing portfolios hoping to benefit from successful debt recoveries. Future agreements on bad loans could be in doubt.

Italian bonds: Meloni moment

Italy’s own debt is a constant source of concern for Europe and a reliable source of high returns for government bond investors.

The country’s debt burden continues to rise and reached €2.9 trillion in July, according to the Bank of Italy. It is now equivalent to 144 percent of gross domestic product. Compare that to Germany, where public debt is only 68 percent of GDP.

Meanwhile, the economy is slowing. Second-quarter GDP decreased 0.4 percent from 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. Additionally, the new government wants to implement tax cuts. With little money available, the fear is that Italy will end up with a larger deficit than expected.

Italy will issue an additional €300 billion in new medium- and long-term securities this year. italian bonds, known as BTP, are the most common. They also find themselves in the middle of an unexpectedly charming period.

The yield on the benchmark 10-year bond remains at 4.3 percent, just 165 basis points above the German equivalent. That spread has narrowed by almost a fifth since the beginning of the year. Fears about Italy’s debt overhang drove it up to 500 basis points during the sovereign debt crisis.

Support from the European Central Bank, which indicated it would protect weaker countries facing widening spreads, has helped. So have local buyers of Italian debt, particularly 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 an ill-advised “mini-budget” sent yields soaring last year. New bond issuance this year will be the second largest on record, but yields have begun to retreat from highs of more than 5 percent recorded over the summer.