Category Archives: Historical Financial Events

Non-Performing Loans – an EU perspective


The bread and butter of a traditional bank is the provision of loans. Although banks have reduced their dependency on this main source of income by branching out into other fields of the financial services world, the creation of loans is still a very important economic service. These loans are granted to households, business and to other banks, can be short or long term in nature, having a fixed, flexible or no interest rate and will be subject to different assurances such as collateral.

What is common between all loans is that they all carry a risk – the most basic of which is the risk that the loans become bad-debts or non-performing because the person or entity that took the loan can no longer service it. Non-performing loans will always be a problem for all banks since no model can ever cover all the risk involved and from time to time some borrowers will inevitably be faced with situations that were thought unlikely to happen.

From a regulatory point of view, a loan becomes a non-performing loan once more than 90 days elapse without the borrower paying the agreed instalments. Sometimes the banks can manage to agree new terms with such borrowers but at other times the bank would simply have to write off the loans and try to collect on the collateral and guarantees it would have secured before granting the loan. Banks also have the option of selling off the loans, but this will be at a discount and is dependent on finding someone to take on that debt.

What is the cost of non-performing loans?

It should be kept in mind that the cost of non-performing loans is a direct burden on the bank but an indirect burden on potential borrowers. As a bank is faced with more and more non-performing loans it would inevitably have to tighten credit and thus lend out less money. It must do this since its profits will start getting eaten away by the cost of managing the non-performing loans. Although loans are an asset for a bank they also come at a cost. The cost is not just the opportunity cost of using the same money for a different venture, but also the regulatory cost of keeping the loan on its books.

Therefore, as the number of non-performing loans rises the greater economy will suffer as loans become more expensive and less available. The expense could be in the form of higher interest rates, higher requirements for collateral and more stringent terms for the borrowers. As these factors come into play it would automatically become more difficult to obtain credit from a bank and thus some people and entities will be rejected for a loan. As credit becomes more difficult to obtain businesses will invest less and private individuals will take on less projects. So the effect on the whole economy is multiplied since less work is generated.

How do EU countries compare on Non-Performing Loans?

The below chart depicts the amount of non-performing loans as a percentage of total loans for the EU countries as at March 2016:

As expected the countries with the biggest economic problems have the highest percentage of non-performing loans. Countries like Cyprus which experienced a banking sector crises in 2012/13 and the so called PIIGS (Portugal, Ireland, Italy, Greece & Spain).

If we focus on the worst two countries (Greece and Cyprus) we can see that almost half the loans that have been issued are not being serviced. This of course is a very worrying situation for these two countries which is very difficult to get out of. These two countries are quite apart from the rest of the pack with the next worst country having a percentage of around 20%, which is still worrying. Ireland has started to improve as an economy but the percentage of non-performing loans is still quite high at around 15%. Having said that, the figure has gone down from the 20% registered in September 2015. Malta is sitting around mid-table, however it is worrying to see that over a period of 6 months the figure went up from 3.7% to 6.8%.

The below figure shows the same rates 6 months earlier as at September 2015:


The Bottom Line

Non-Performing loans are an indicator of economic health. The higher the percentage of such loans to total loans the more difficult and more expensive it is to obtain loans. This has a ripple effect on the economy as less investment and private consumption is registered. This is why the regulators place great emphasis on the measurement and management of these loans. Supervisors monitor the overall level of non-performing loans across euro area banks. They also check whether individual banks adequately manage the riskiness of their loans and if they have appropriate strategies, governance structures and processes in place. This is part of the common supervisory review and evaluation process (SREP) that is carried out for each significant bank every year. Furthermore, the European Central Bank regularly carries out coordinated exercises to review the asset quality of the banks it directly supervises.


Brexit – Making Britain Great Again



The more I read into the arguments put forward by the leave campaign who are rejoicing over the “win” that they have just accomplished the more I compare them to the businessman running for the US presidency. Trump’s motto “lets make America great again” seems to have been copied by the leave campaigners who have a motto “lets make Britain great again”. What a role model to choose!

They propose to do so by having more control over their laws and to decide better on how to spend their money. This sort of “centre of world” and “us versus them” mentality seems to be coming from the disillusion of the older generation of the Brits who still dream of the glory days of the British Empire. In actual fact no state is ever totally independent nowadays since they all depend on one another to one extent or another. The more trading partners a state has, the more its economy will grow and the more its people will prosper. Whether the UK admits it or not it needs to trade with Europe as much as Europe needs to trade with the UK.

So ultimately the British will need to negotiate trade agreements that will most likely be as similar as possible to the current agreements in place. The main difference will be that it will cost the UK a lot of money to renegotiate everything. It seems like all of the world understood this concept except the older generation of the Brits who are still disillusioned by the British Empire mentality. Time will tell if it was a good move or not, what is clear is that the students and young generation who will have to deal with it all definitely did not agree that it would be better to be out.

The Financial Sector and Passporting Rights

The financial sector would definitely be one of the hardest hit sectors as a result of the Brexit. We saw this clearly with prices of the banking stocks around the world taking such a big hit on Friday 24th, the day the results were announced. London is a very important financial hub that is a gateway for many non-EU countries. A big advantage that the EU offers in the financial services sector is the right to passport a license. What this means is that an entity that is regulated in the UK can very easily acquire Passporting rights to operate in the other EU jurisdictions without needing to acquire full licensing in each member state. So for example, if Morgan Stanley has a fund licensed in the UK it can easily and cheaply get permission to promote and sell it in the other jurisdictions with the blessing of each jurisdictions’ regulator.

Since the UK has just voted to leave the EU the passporting right no longer applies to UK regulated entities and products. Thus sticking to our example, Morgan Stanley would have to go to another member state and get its product fully licensed there and then can passport it to the other states. What this means – London just became much less attractive to use as a hub and other jurisdictions will benefit from this.

The people who voted to leave the EU, who were mainly the older generation and people from the North might be thinking, we don’t care about the bankers and high earners working in London. Serves them right to lose their jobs after all we have done to bail them out in the crisis. This of course is the one of the most idiotic arguments one can make and again we see a likeness of the mentality of the leave campaign to Donald Trump. In simple terms: banking sector does bad = whole economy does bad = fall in purchasing power. Who will pay for this all? The tax payer as usual. So the hard working Brits (who either voted to leave the EU or who applied a little logic and voted to stay in) will pay the price for it all.

Who will gain most from Brexit?

First we have the politicians who have used the Brexit to their advantage. People like Nigel Farage and Boris Johnson who I am sure made a bucket load of money from all this and have gained more support that will see them advance in their political career. Then we have the consultancy firms who will be in high demand by both the private sector and the government entities themselves to see how the Brexit will actually affect them. Finally we have China. With a weaker union and a smaller EU block China gains in the long term by attracting more trade towards its jurisdiction and away from Europe. So congratulations to the Brits who voted to exit Europe – you have just made the politicians, lawyers, accountants, other consultants and the Chinese very happy indeed.

The Bottom Line

Ultimately billions of pounds will be spent in relation to the transition to the free “independent” UK. So most of the gains that the Brits thought they would save by not being an EU member would still be spent on new negotiations and added costs of trading. Animosity is clearly present within “great” Britain with speculation that Northern Ireland and Scotland might seek independence in order to remain in the EU. We even have petitioning for London to be declared a separate state and also remind in the EU. I will close the post on a light note however. In one of the interviews with Nigel Farage after the Brexit result in which he admitted that he had twisted words about NHS funding he also stated that Britain should consider more trade with the Commonwealth. Please check out this humorous clip in relation to the notion of the Commonwealth and “great” Britain:

The Fed Increased its Base Rate – Should You Care?

The Federal Reserve Building
The Federal Reserve Building

In this week’s post I will be focusing on the increase in interest rates that has just been announced by the US Federal reserve which is the central bank of the USA. The Fed increased its base rate from the current 0%-0.25% range to a 0.25%-0.50% range. For 7 years we had witnessed a near 0% base rate making money cheap to borrow. The post will aim to focus on how this affects Malta and the broader Euroland countries. I will first be focusing on the effects of an interest rate rise in general and then move on to focus more on how we as Maltese and other countries that use the Euro as their main currency will be affected. Should we care about what the US is doing?

First, some basic economics to help you understand better the rational for manipulating interest rates. Having low interest rates is expected to lead to cheap money that would in turn cause consumption and private sector investment to go up which would lead to a higher gross domestic product. In simpler terms this means that if households and business can borrow at cheaper rates they would be more inclined to do so. When they have access to the cheaper funds they will spend more, for example on new housing or on building a new factory. In turn this will generate more income for other economic participants and everyone is better off.

On the other hand, if too much money is present in the economy this will lead to a general increase in prices, or inflation. Thus, in order to avoid having too much inflation the central banks can increase interest rates in order to reduce spending and private investment – in technical words they would be tightening. It must be kept in mind that in the real world things are not as simple as I have just described since there are undoubtedly a lot of variables being affected at once. The following video is great to help understand better how the Fed manipulates interest rates:

Who Wins When Interest Rates Go Up?

  1. Banks

The obvious winners as a result of increased interest rates are of course the banks. For a traditional bank that is mainly concerned with taking deposits and making loans their bread-and-butter is their Net Interest Margin (NIM). This is simply the difference between how much the bank is earning from the interest rates on its loans and how much it is paying in interest rates on its deposits. So if interest rates go up the banks can start increasing the interest rates they charge on their loans and this will lead to increased income for the bank.

  1. Insurance Companies

Insurance companies typically invest their money in fixed income assets such as bonds from the higher quality end of the market. As any fixed income investors knows the yields on bonds has been low for quite a while now and hence the income insurance companies can earn on their investment will increase as interest rates go up. Of course there exists the other side to this argument that as interest rates go up the prices of bonds will go down and thus insurance companies would suffer in terms of the value of their capital. Although this is true, one must keep in mind that insurance business is long term business. So if the insurance company has bought bonds with the intention of holding them until maturity, the price drop experienced before maturity does not really affect them. Such companies would use a combination of strategies such as keeping a portion of the portfolio in short dated bonds which would be less affected by interest rates rising.

  1. The US Dollar

In simple terms since the interest rate one could earn from a US dollar investment is now going to be higher than the interest one could earn from a Euro denominated investment, the demand for the USD would increase. This would lead to a higher USD value and lower EUR. Things get a bit tricky however when you consider that the increase in the interest rate has been anticipated for months now and the USD has already appreciated quite a bit now. So one could argue, is the increase in the interest rate already priced into the USD?  

Who Loses When Interest Rates Go Up?

  1. Oil

Since the price of Oil is quoted in USD and the USD has gone up in value versus other currencies it has just become more expensive to buy oil. The oil industry itself is already suffering from a situation of over-supply, so an increase in the price of oil just because the USD got more expensive could be lead to lower demand which would in turn hurt the oil companies.

  1. Gold

Gold also stands to lose value with an increased USD value, like many other precious metals gold is quoted in USD. Just like with oil, the cost to buy gold would have just gone up simply because the USD went up. This could in turn lead to a fall in the price of gold to counter the increased cost of acquiring it. What makes it even worse is that gold does not earn any interest and in fact it cost money the longer you hold gold since insurance costs and storage costs have to be considered.

  1. Home Buyers

With increased interest rates new home buyers will face higher home loan rates and thus will be able to borrow less or will have to pay more for the same level of borrowing. Even existing home owners who have variable rate home loans will have to start paying more in interest, thus increasing their monthly loan payment and thus decreasing their disposable income.

  1. Issuers of USD debt that operate outside the US

Many countries and companies which do not use the USD as their base currency also issue many bonds denominated in USD. With an interest rate increase this means that if they want to borrow new funds in USD they would also have to offer higher rates since the base rate on which all other rates are built has gone up. Furthermore, their outstanding debt has just become more expensive to service. Although the majority of bonds are issued with a fixed interest rate, since the USD would have appreciate against the currency the issuer uses as its base currency it would cost them more to pay the same amount of USD in the form of interest payments and eventually capital repayment.


How are You affected as a person living in Malta/Europe?

One may argue that the above is all well and good, but it does not affect him/her since we are situated in Malta and our interest rates are determined by the European Central Bank (ECB) and not the Fed. Although this last point is true that our interest rates are determined by the ECB which does not plan to raise interest rates anytime soon, this does not mean that we are immune to what is happening abroad.

The biggest effect that Malta will have from the increase in the Fed rate is the effect on the currency, specifically the USD/EUR exchange rate. So if the USD has gone up and is expected to go up even further this will have an effect on individuals as well as businesses. Let us take a look at some specific areas where we will be affected:

  • Traveling abroad

The cost to travel to the USA will now be higher. So even though you might still have to pay $1,000 for a few days of accommodation in a New York hotel that $1,000 which used to cost you around €715 in 2011 will now cost you around €915. That is close to a 30% increase in the cost. When you consider the total cost of a holiday in the USA this difference would add up to quite a bit of change. This will be true not just for travelling to the USA of course, but to anywhere that prices in US Dollars as a main currency. So for example going on a cruise that accepts only US Dollars would become more expensive as well.

  • Fuel Costs

As previously discussed, the price of oil is denominated in USD. So any other derivative of oil such as diesel and petrol for motors, fuel for airplanes and so on will also be affected by the price of the USD. Luckily for us we are in a situation where oil prices are very low due to oversupply. Hence, the increase that one would expect in the oil price is being counterweighed by the supply side keeping the price down. But if the supply had to be reduced or the demand would somehow increase the price of oil would in fact go up.

  • Cost of Precious Metals

Like oil, the prices of precious metals is denominated in USD. So the cost to acquire these precious metals will be higher, even if the prices had to remain unchanged.

  • Importing of goods in USD

Besides oil, many other items are bought in USD. Anything we import in USD will now be more expensive than it was just a few years ago. So importers will be negatively affected by the fall in the EUR which came about as a result of increased interest rates in the US. This also affects individuals who are used to buying items online for example.

  • Exporting of Good to the USA

It is not all bad news however, the exporters will benefit, specifically the ones that export to the USA. Since in dollar terms EUR items will cost less, the items that are exported to the US would be considered cheaper and be more competitive versus other US made items. So for example the European car manufacturers will now be able to price their vehicles more competitively against their US counterparties. Unfortunately for Malta we do not export many goods to the US. But we do compete with the US in certain services industries. So the higher USD would mean that it would be cheaper to do business through Malta (and other Euroland countries) rather than through the USA.

The Bottom Line

At the end of the day, how we are going to be affected by the Fed rate cut will take quite a while to be seen. Although there will be an immediate effect, the total effect of the move will take months to come to fruition. It all boils down to expectation and real economic indicators in the end, although the Fed said that it will continue to increase interest rates it also said that this will be gradual and it did not commit to any hard target. Jobless rates in the US are still not at desired levels so if we should have weak economic indicators in 2016 the pace of the internet rate hikes will be very slow or stopped completely. What is certain is that whatever happens in the USA will definitely affect us in Euro-land, and not just on the investments side.


Securitisation and The 2007/09 Financial Crisis


In the words of George Santayana, ‘Those who cannot remember the past are condemned to repeat it.’ For this reason I have decided to dedicate today’s post to the process of securitisation and how it was at the heart of the 2007-09 Great Financial Crisis. What have we learnt and is securitisation still important as a method of risk management?

I will try to keep the post as simple as possible but at times I will have to use some technical words. For the investment enthusiast the content may be a bit heavy at first but the important thing is to understand the overall picture and not the detailed specifics. For the readers with knowledge and experience in finance it is interesting to refresh your memory on the subject. The post will first attempt to introduce the key elements in a simplified manner and then a short clip will be presented at the end.

What is Securitisation?

Securitisation is the process in which certain types of assets are pooled so that they can be repackaged into interest-paying securities. For example, a bank would package together an amount of home loans (known as mortgages), or car loans or credit card loans or any other asset and then sell them off to a Special Purpose Vehicle (SPV). The interest and principal payments from the assets are passed through to the purchasers of the securities. Thus, the SPV then sells securities to investors which are backed by the assets it would have bought, hence the name Asset Backed Securities (ABS).

Securitisation is not a recent invention and has been in existence since the 1970 when home mortgages were pooled by U.S. government-backed agencies. In the 1980s other income-producing assets began to be securitised, and in the years leading to the financial crisis the market had grown quite dramatically.

Why Securitise?

One might wonder, what is the purpose of securitisation and why would banks in particular use it so much? To answer this question we must first recognise that banks are subject to increasingly strict capital requirements. This means that for any asset on a bank’s balance sheet it must keep or reserve a certain amount of capital. In a way, this reserved capital is an expense for the bank since it cannot use the funds for other profitable uses. Furthermore, traditional bank assets such as home loans are not very liquid, meaning they are not easily converted into cash at short notice. Therefore the bigger the loan book of the bank the more tied up capital it needs to keep on reserve and more the restricted it becomes.

However, if the bank had to somehow find a way of getting these slow moving assets off its balance sheet it would not have to keep any capital against them, plus it would have the cash to buy/create more profitable assets like new loans. Keep in mind that banks make commissions form new bank loans from the fees they charge, so the more bank loans they create, the more fees they earn. Therefore, one of the major advantages of selling off existing loans by securitising them is that the bank has more capacity to make new loans and earn new commissions.

Another advantage of using securitisation for a bank is that it can limit its risk exposure to a particular sector. Imagine Bank XYZ Ltd was specialised in construction loans in a particular geographical region. If the construction sector of this region had to slow down for some reason or another, bank XYZ Ltd would lose income and risk having more bad debts or defaults on its existing loans. Therefore, in order to be less dependent on these types of loans bank XYZ Ltd could securitise an amount of these construction loans and sell them off its balance sheet. By doing so  it is transferring the risk attached to these loans to someone else, plus it is getting new money to make new investments with.

How Securitisation Works

The table below helps us to understand better how the securitisation process works in more detail:



In essence the securitisation process involves just two steps:

Step 1 is for the bank to identify the assets (e.g. home loans) it would like to remove from its balance sheet and pools them into what is called a reference portfolio. This portfolio of pooled assets is then sold off to an issuer, such as an SPV which is normally set up by a financial intermediary specifically to purchase these portfolios and transfer the assets off-balance sheet.

Step 2 the issuer finances the purchase of the portfolios of pooled assets by issuing tradable, interest-paying financial products that are sold on to  investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the bank that originally made the loans keeps servicing them in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee.

The reference portfolio is not divided into assets with the exact same characteristics, however such assets form part of several slices, called tranches, each of which has different risk and return parameters associated with it and is sold separately. The more senior tranches would be the less risky ones, however they would also pay the less returns (mainly interest). The senior, least risky tranches would have first call on the underlying assets if something had to go wrong. Therefore, if there had to be a number of defaults in the reference portfolio first the senior tranches have to be paid off and then the least senior ones.

The conventional securitisation structure assumes a three-tier security design—junior, mezzanine, and senior tranches. In such a structure the junior tranche will be the one to suffer the first losses, then the mezzanine and finally the senior tranche. The senior tranches were regarded as very safe and unlikely to suffer any loss of value, and hence where often classified as AAA rated by the credit rating agencies. See more about credit rating agencies in one of my previous post on Bonds vs Bond Funds.

What went wrong?

In theory securitisation is a good thing both for banks and for people seeking loans. Banks, as we have seen, are able to make more money through fees by securitising loans and making new ones. On the other hand the people seeking out loans would find it easier to obtain credit since the banks are more able to lend them the money. So as long as banks are making more loans to individuals or entities that are of good quality and can actually afford the loans the whole economy will be better off.

The problem however is that when banks realise that they do not really have to keep any capital against the loans they make, since they are selling them off to some other entity, they may become more lenient and less interested in the quality of the borrower. This is exactly what happened in the 2007-09 Financial Crisis. As banks created more and more loans the amount of good quality borrowers who needed to take out a loan started to shrink. As a consequence, banks started to relax their screening and monitoring of borrowers. This eventually resulted into a system-wide deterioration of lending and collateral standards.

This means that more and more sub-prime (i.e. more risky) borrowers were finding it easy to obtain cheap money. As long as house prices keep rising and the banks can keep selling off these loans to investors the banks will keep earning more and more commissions. The problems will occur (as the they did in 2007-09) when the housing market no longer keeps rising and when (inevitably) the borrowers who could never afford the loans that they made in the first place will eventually default.

As any home-owner knows, a property can take a few weeks or years to sell off. If many borrowers are defaulting then the banks would have taken over the properties which were set as collateral for the loans. The situation would be that banks would end up with a lot of properties on their balance sheet which they cannot hold and would like to sell off quickly. Since the supply of properties is so high the prices have to fall. In turn, as prices keep falling the housing market gets worse and even more people would end up defaulting. Thus a downward spiral is created which then affected the entire economy.

An easy way to understand better all the above is by seeing the cool visual presentation below:

I hope you enjoyed the trip down memory lane, which is a lot easier to accept now that we have recovered from the lows of 2009!