Germany’s new secondary credit market act designed to increase acquisition of NPLs

The business landscape in Germany is facing a major challenge: insolvencies and defaults on loans are on the rise. But where there are risks, there are also opportunities. The increase in non-performing loans (NPLs) is opening and creating an exciting playing field for investors. With the new German Secondary Credit Market Act (KrZwMG), the legislature wants to create an efficient market to reduce the high number of NPLs. In this article, the second in a series on NPLs in Germany, we look at current trends, risks and opportunities relating to NPL transactions.

Non-performing loans and corporate insolvencies on the rise

Non-performing loans and insolvencies are increasing, according to the figures and forecasts of the results of the NPL Barometer published in mid-July 2024 by the Bundesvereinigung Kreditankauf und Servicing (BKS) and the Frankfurt School of Finance & Management. In 2023, 14,590 corporate insolvencies occurred, which was an increase of 16.7 % compared to the previous year.

In 2024, the information service provider CRIF forecasts an increase in corporate insolvencies of almost 15% compared to last year. The pandemic and the war in Ukraine are cited as two of the triggers for the increase in insolvencies, which has resulted in increased energy and commodity prices and higher interest rates. Inflationary pressure and falling domestic demand have created a scenario where insolvencies are inevitable.

NPLs have peaked and will continue to grow, leading to an increase in portfolio sales

This increase in insolvencies is also directly related to the NPL market. The number of NPLs is currently slightly below its peak in late 2023. Experts are now expecting an increase in NPLs in line with the rising number of corporate insolvencies. This is also consistent with the results of a European Commission survey on NPL markets, which revealed that around 71% of respondents are expecting slightly higher levels of NPLs in the next two years. The main sectors affected include corporate finance, commercial property and unsecured consumer loans. An increase in portfolio sales is also expected because the current situation also offers opportunities for investors to profit in the NPL sector.

NPL market regulated by the German Secondary Credit Market Act (KrZwMG)

The legislature's adoption of the German Secondary Credit Market Act (KrZwMG) to implement Directive (EU) 2021/2167 (Secondary Credit Market Directive) is in step with market developments given that the KrZwMG now regulates the market for NPLs. The legislature's intention is to respond to the current situation of the constantly growing NPL market and to reduce the number of NPLs and prevent excessive volumes of NPLs. The background to this is the the negative consequences NPLs have on banks. For regulatory reasons, banks must hold more equity. High levels of NPLs on banks' balance sheets ultimately lead to funds being tied up. As a result, fewer loans can be granted overall. The KrZwMG was passed to free up capital and counter the associated negative effects on the economy by encouraging the reduction of NPLs. The law is intended to create a basis for a transparent and comprehensive secondary market on which institutional investors outside the credit banking sector can purchase NPLs from banks. To expedite this, the law regulates special duties relating to conduct, information and notification. For example, sellers of NPLs must provide buyers of NPLs with sufficient information about the NPL so that they have a sound basis on which they can assess business opportunities. The buyer of the NPL, however, must involve a credit service provider in the purchase of receivables under loan agreements with consumers or SMEs. The law also regulates regulated market access for other European credit service providers. This means that authorised credit services institutions will also be able to operate across borders in the future.

Basic structure of an NPL transaction is the same as the sale of a receivable

The basic structure of the NPL transactions is an ordinary sale of receivables where the seller of the receivables transfers the loan receivables to a buyer in return for the agreed purchase price. (It is similar to factoring). The entire credit relationship can be transferred or just individual receivables can be transferred. But why should an NPL be sold or purchased?

Advantage for banks: balance sheet relief and relief with enforcement of claims

Through the sale of NPLs, banks can relieve their balance sheets of problematic assets and improve their balance sheet structure by reducing these risk positions. This leads to less capital being tied up in NPLs and means that more loans can be granted. The fact that the sale of receivables shifts the administrative and credit management costs should also be considered. This can provide relief for the banks' debt enforcement apparatus. The sale also leads to further liquidity since the receivables are at least partially paid. Since the NPL transaction does not require the consent of the debtor, there are no legal hurdles in this respect.

Advantage for investors: higher expected returns and the possibility of acquiring shares at favourable conditions

The reason for investors to purchase NPL portfolios is that they can do so at a much more favourable price. As a result, they have the prospect of a higher return on their investment, precisely because of the higher risk, and can benefit from the lower prices. They also have the option of acquiring real property for which a lien has been created to secure the respective loans. However, the purchase decision requires careful risk assessment, particularly with regard to the debtor companies' restructuring capability.

Investors can also acquire companies at favourable terms since NPL transactions make it possible to achieve creditor status in an affordable manner. These claims can be converted into company shares prior to an insolvency through a restructuring plan or a restructuring settlement in accordance with German Act on the Stabilisation and Restructuring Framework for Businesses (StaRUG). This is referred to as a debt-to-equity swap. In addition to the possibility of acquiring company shares prior to an insolvency, it is also possible to convert receivables into company shares by means of a debt-to-equity swap once insolvency proceedings have been opened, particularly as part of insolvency plan proceedings.

Increased liability and default risks in recovering NPLs in acquisitions can be minimised by assessing risks when making the decision to sell

There is a considerable risk that the buyer could be exposed to avoidance in insolvency proceedings following the collection of acquired loan receivables. Pursuant to section 130 (1) no. 1 German Insolvency Act (InsO), this may be the case, for example, if an application for insolvency is filed within three months of the loan being collected and the buyer was aware of the illiquidity at the time when the payment was made. This is relevant because, as already discussed, NPLs are closely linked to corporate insolvencies. A 90-day default with payment, as defined in Art. 47a CRR, can already be considered in court as evidence of the borrower's illiquidity. If the seller remains responsible for the collection of the claim or only makes a partial contribution towards this, its knowledge of the debtor's financial situation is also attributed to the buyer. According to case-law of the highest instance, the situation is only different if the seller of the claim is no longer involved in the enforcement of the claim. There is therefore room to manoeuvre here.

If the risk of avoidance in insolvency materialises, the loan amount must be repaid to the insolvency estate and the claim filed with the claims register, unless the claim itself is covered by a security that cannot be avoided. It is therefore of utmost importance that the effectiveness be assessed and that it is ensured that securities cannot be avoided under insolvency law.

A further risk may be that during the course of insolvency proceedings the claims sold are subordinated claims in accordance with section 39 German Insolvency Act (InsO). Such claims are only settled after all other claims have been settled, which often means that there will not be any funds left to settle these claims. In order to minimise this risk, a careful due diligence review is absolutely essential. Although the seller providing a guarantee would be an alternative, it is unlikely that the seller would do so.

In practice, NPL transactions also involve portfolio purchases, which include loans from debtors who are already insolvent. These portfolios consist wholly or partly of insolvency claims, whereby there will also be securities, which make the purchase more attractive as they increase the value of the claims. Therefore, the value of an insolvency claim depends on both the expected insolvency quota and the underlying security. As a general rule, the respective security determines the price of NPL portfolios. When making the decision to purchase, care must be taken. A legal due diligence review should be done to ensure that the securities have been effectively provided. In particular, the insolvency administrator is responsible for the security of insolvency claims since such claims can lead to additional realisation costs.

The playing field for NPLs is open and investors should only acquire NPL portfolios after a careful risk assessment

As shown above, corporate insolvencies are increasing significantly in Germany. In the near future, the NPL market will continue to grow alongside the rising numbers of insolvencies. The new German Secondary Credit Market Act (KrZwMG) is the legislature's response to this development and is intended to make trading in NPLs more attractive by providing relief for banks and giving them more room to manoeuvre when granting loans. It remains to be seen whether the legislature, which imposed a wide range of obligations, has succeeded in doing this. There are certainly exciting opportunities for investors: they can acquire NPLs at favourable terms, achieve higher returns and even acquire company shares through debt-to-equity swaps. Careful risk assessment, however, is crucial to minimise liability and default risks.

For more information on the new German Secondary Credit Market Act and investment opportunities in NPLs, contact your CMS client partner or these CMS experts.