Distressed debt investors around the globe will be monitoring their computers this coming Sunday, October 26, 2014. At noon Central European Time (7:00 a.m. in New York and 11:00 a.m. in London), the European Central Bank (ECB) will release the results of its “Comprehensive Assessment” of the financial health of 130 banks in the European Union. Starting Monday of next week, many European banks will be forced to produce and execute comprehensive plans to reshape their balance sheets in response to the ECB findings. We believe significant sales of stressed and distressed loans and other credit instruments will quickly follow as banks struggle to optimize their balance sheets in a more complex European market. The knock-on effects of the Comprehensive Assessment and the banking sector response should create unprecedented opportunities for buyers of distressed loans. In particular, we expect that:

  1. Significantly more distressed assets will come to the European market in the next six to nine months, and distressed asset prices across Europe will respond to the selling pressure;
  2. Some secured loans will be less attractive for banks to hold on their books and will be more likely to be disposed of, as the revaluation of the underlying collateral reveals a substantial coverage deficiency (e.g., loans collateralized by physical assets such as aircrafts, ships and real estate);
  3. Some banks (e.g., Germany’s Landesbanken), despite significant political clout and government guarantees, may score poorly on the Comprehensive Assessment as their loans have been revalued using a more traditional and conservative methodology. These banks need to adjust their loan portfolios by selling higher risk loans;
  4. While a bank’s key capital ratio (or CET1 ratio, as described below) may be improved by issuance of common equity, this is not a cure-all – banks with limited or no access to the capital markets (e.g., Italian cooperative banks owned by customers and employees) will experience strong pressure to sell low quality assets to improve CET1 ratios; and
  5. Even if a bank “passes” the Comprehensive Assessment, fear of rating downgrades or stakeholder pressure could force low-scoring banks to unload risky assets and improve CET1 ratios.

The Comprehensive Assessment is the largest study of its kind in terms of the number of banks reviewed, the systemic significance of the banks chosen for review and the geographical coverage of the exercise.1 The results will be published on the ECB’s website and will be formatted using concise templates – in the aggregate and on a bank-by-bank level – disclosing data collected, tested, analyzed and collated by the ECB and the national banking supervisors. The ECB will highlight a final “score,” or common equity tier 1 (CET1) ratio,2 derived from each of the two components of the Comprehensive Assessment – the Asset Quality Review (AQR) and Stress Test.

ASSET QUALITY REVIEW

The AQR has impressed banks, observers and markets with both its scope and its depth, and has been hailed as the most comprehensive review of asset quality to date.3 Included in the review are all asset classes in a bank’s banking book and trading book, whether in the “hold to maturity,” “available for sale” or “held for trading” portfolio. Certain loan portfolios were selected for indepth review based on risk exposure and the ECB, working with national banking supervisors and independent consultants, has created “apples-toapples” exposure classifications, reviewed the accuracy of asset impairment and provisioning methodologies, and, when necessary, revalued physical collateral (e.g., real estate, aircrafts, ships) using independent sources. Banks with large exposures to illiquid asset classes have also been subject to Level 3 asset fair value exposure review, which requires revaluation of non-derivative Level 3 assets and review of processes used in calculating the fair value of trading book positions and pricing models for Level 3 derivative assets.

STRESS TEST

The AQR phase of the Comprehensive Assessment produced an adjusted CET1 ratio for each bank, which was then subjected to a Stress Test in phase two. Under the Stress Test methodology, the European Banking Authority (EBA) applied a baseline scenario and an adverse scenario to the AQR-adjusted CET1 ratio, taking into account impact on credit risk, market risk, sovereign risk, securitization and cost of funding. The baseline scenario is based on the winter 2014 forecasts of the European Commission, extrapolated to 2016 using a model-based approach. For the adverse scenario, the EBA has assumed much more dire circumstances in the Eurozone and the rest of the world over the next two years.

If a bank’s AQR-adjusted CET1 ratio or baseline scenario-adjusted CET1 ratio is below 8%, or its adverse scenario-adjusted CET1 ratio is below 5.5%,4 the bank is considered to have failed the Comprehensive Assessment, and must develop a capital plan to cover the shortfall and submit the plan to the ECB within two weeks. The capital shortfall must be covered within six to nine months.

KNOCK-ON EFFECTS OF THE COMPREHENSIVE ASSESSMENT

The importance of the Comprehensive Assessment to the market goes beyond the “pass/fail” grade. The results will provide unprecedented transparency to the balance sheet and asset positions of the banks, and bank regulators, rating agencies, bank owners and bank creditors will likely prompt the banks to make specific improvements to their balance sheets, including reduction of previously opaque risk exposures.

European distressed debt investors anticipate that a key component of the banks’ capital plans to improve CET1 ratios would be asset sales designed to reduce riskweighted asset values, including sales of non-performing loan portfolios.5 The effort to engineer improvement of bank balance sheets is projected to generate market activity of genuine interest to distressed investors.

This is a tremendous opportunity for distressed investors on a number of levels, and will likely improve the overall health of the distressed trading market. After an extended period of market inactivity, investors in European distressed debt will soon have a reliable way to assess sellers and predict large scale asset dispositions. They may be rewarded for their patience when banks begin to dispose of distressed assets with renewed urgency. Be prepared.