How to deal with NPLs. A Global Approach to Recovery / Workouts. Esteban Buljevich International Finance Corporation Pastoriza Eviner Cangueiro Ruiz Buljevich Abogados I. How to deal with Non-Performing Loans II. A Global Approach to Recovery / Work-outs How to deal with Non-Performing Loans (NPLs) Non-Performing Loans Substandard, doubtful and loss loans represent the so-called NPLs. standard loans full payment is expected watch loans substandard loans concern as to payment chances payment is in doubt doubtful loans payment is improbable loss loans payment virtually uncollectible Non-Performing Loans When has a loan gone bad? Majority consent on the following conditions: • principal or interest has been due and unpaid for 90 days or more; and • interest payments equal to 90 day interest or more have been capitalized, refinanced or rolled over. The Basel Committee on Banking Supervision has set a standard definition for “past due loans” specifying that more than 90 days have passed since the last payment Causes of NPLs • Credit relaxation and insufficient regulation. • Holders of trouble or bad loans spread the NPL’s risk by making bad-loan provisions or taking out credit insurance. • Sudden economic changes that lead to loss of confidence and ultimately a financial crisis. • Rising interests rates. • Borrower friendly regulations and overoptimistic creditworthiness during booming economies. assessment of Both endogenous (such as the parties and their circumstances) and exogenous (such as economic, social, political, legal and fiscal circumstances) causes affect the ability of a borrower to comply with its obligations. Why do financial institutions have to deal with NPLs? • NPLs tend to generate economic, financial and fiscal costs to financial institutions, especially when left unresolved. • NPLs are inefficient, costly and risky. • NPLs deteriorate the financial institutions’ financial statements, which may lead to institutions’ failures. • Provisions or write offs must be made in the financial instutions’ balance sheets to cover for potential losses, affecting its profitability. Why do financial institutions have to deal with NPLs? • NPLs not only affect the solvency and liquidity of the holder but also the whole market’s. • Large, unresolved NPL portfolios result in catastrophic micro and macroeconomic effects. • Costly recovery and enforcement procedures. A financial system contaminated with NPLs is a system where consumers and inverstors are suspicious and lacking in confidence. Credit Risk Management In any financial institution, the NPLs problem is closely related to the issue of credit risk management. Upstream Risk Relates to Capital. Expected losses must be covered Downstream Risk Relates to the mitigation of capital loss. Requires effective regulatory framework in order to implement successful procedures for dealing with distressed assets. Smart Solutions for NPL Resolution NPL resolution starts here • NPL containment oriented credit approval policies. • Sharp Monitoring systems • Keen decision making skills amongst their working groups and qualified personnel in specialized tasks . • Provisioning • Well thought NPL resolution strategy Obstacles to Efficient NPL Management in Developing Countries’ Banks and Financial Institutions • Cultural issues negatively affecting management and working habits • Lack of problem solving skills • Weak IT systems affecting monitoring and data collection processes • Lack of information and experience on efficient resolution methods NPLs Resolution Methods Two approaches to NPLs Resolution: Portfolio Asset by Asset True Sale Workouts Synthetic Transactions True Sale Foreclosure / Winding – Up Processes Securitization NPLs Resolution Methods Portfolio Approach – True Sale and Synthetic Transactions • Nowadays, the most common instruments for NPL resolution are true sales, synthetic transactions and joint ventures. • The decision to opt for either a true sale or a synthetic transaction depends on, among other things, whether the bank’s prefers the NPL portfolio to remain on its balance sheet or not. NPLs Resolution Methods Portfolio Approach – True Sale • True Sale erases NPL portfolio from the financial institution’s balance sheet since the whole loan is transferred to the purchaser, unlike the synthetic transactions by which only the credit riskm is transferred. •The servicing of the loan may be assumed by the purchaser, by the financial institution, or by another company. •The difference between the purchase price and the ultimate recovery price constitutes the purchaser’s profit. NPLs Resolution Methods Portfolio Approach – Synthetic Transactions • Only the credit risks are transferred while the loans remain on the bank’s or financial institution’s balance sheet. • There are no asset transfer issues (i.e. loan transfer consents) nor their associated costs. • Risk involved in derivative transactions is greater than the risk of a true sale transaction. • Regulatory issues to consider NPLs Resolution Methods Portfolio Approach – Securitization of NPLs • One of the newest methods of dealing with pools of NPLs is through securitization, either by way of a true sale or a synthetic transaction. • Requires the development of a secondary market for distressed loan portfolios. • Provides immediate liquidity to the originator who sells the NPLs or transfers their credit risk. • Positive impact on the economy as a whole. NPLs Resolution Methods Portfolio Approach – Securitization of NPLs • Better ratings for the originator through the mitigation and transfer of risks. • accelerates NPL resolution process. • Reduces the originators’ operational costs. • Provides for a wide range of investment opportunities through “tranching” and a greater number of investors. NPLs Resolution Methods Portfolio Approach – Securitization of NPLs On the downside: • Returns may not be enough to cover the standard costs of securitization and problems relating to information may rise. • Lack of adequate legal framework may be an obstacle. • Credit risk attached to dealing with NPLs. • Secondary market is not fully developed yet. Some Examples of NPL Securitizations • Korea Asset Management Corportion - KAMCO. • Huarong Transaction in 2003. • International and Commercial Bank of China Transaction in 2004. • Bluebonnet Finance Transaction. Structure of a common NPL Securitization Deal True Sale of NPLs by the originator Servicer in charge of collecting receivables SPV or Issuer buys or receives in trust the NPLs (along with a collateral and/or enforcement rights) from originator and issues the securities Transfer of NPL credit risk through Synthetic Transactions Investors acquire securities issued by the SPV or Issuer NPL Resolution Joint ventures and other resolution structures • Strategic Alliances, Joint Ventures, Partnerships and Outsourced Management Programs. •Most common specialized structure is the joint venture. Common Joint Venture Structure Investors (loan financing or equity investment) SPV (i.e Asset Management Company) SPV + Company A Joint Venture Company A to acquire NPLs or interests in them from originator Originator (holder of NPLs) SPV + Company B Joint Venture to create a servicing company to manage and resolve NPLs bought by the Joint Venture Company A Advantages of Joint Venture Structures • Tailor made solutions for NPL resolution. • Specialized knowledge and know-how on NPL management and/or recovery and/or winding up processes. • Transparency and reputation of the entities involved provide for markets’ trust. • Local and International institutional support. What Lies Ahead • The number of NPLs is likely to increase due to credit deterioration, thus creating new opportunities for investors. • Structures finance is currently viewed as a risky matter, raising concern and mistrust. • Nevertheless, an exponential increase in NPLs may generate profitable business opportunities in both short and medium terms. A Global Approach to Recovery / Work-outs Financial Distress and Recovery Level of Distress Low/ Moderate Refinancing (Out-of-Court) High Refinancing/Restructuring (Out-of- Court or Prepack) Very High Judicial Restructuring/Settlement/Long-term Standstill Maximum Judicial or Voluntary Liquidation or Settlement The Traditional Approach Borrower´s Viability and Collateral Analysis Matrix Viability as a Going- Concern vs. Collateral / Liquidation Analysis The Traditional Approach Traditional Matrix + Long-Term Work-out (+V / -C) False Alarm / Refinancing / Restructuring (+V / +C) Delayed Liquidation (-V / -C) Liquidation (-V / +C) - + Adequacy of Collateral +V : Positive Viability -V : Negative Viability +C : Positive Collateral Coverage -C : Negative Collateral Coverage The New Global Approach New Restated Matrix Character and Good/Bad Faith + Negotiate a Long-Term Work-out or an Orderly Liquidation—Long Standstill may occur (Good Faith Character) Negotiate a Refinancing or Restructuring (Fair Burden Sharing Issues???) (Good Faith Character) Litigate (Threaten) to Settle for Cash or Liquidation—Long Standstill is not an option (Bad Faith Character) Litigate (Threaten) to Force a Bloody Restructuring (Fair Burden Sharing), a Cash Settlement or a Collateral Liquidation (Bad Faith Character) + Adequacy of Collateral and Viability The New Global Approach (cont.) Negotiate to Restructure ... assumes good faith character and goodwill in the negotiation process generally, the interest and expectations of the distressed debtor and creditors are mostly aligned: solve the problem as fast as reasonably possible in a sustainable, equitable way assumes a viable, sustainable concern may or may not present fair burden sharing issues A rescheduling or restructuring is the likely outcome a friendly, voluntary liquidation may be an option if there is no viable going concern “...assumes both the ability and willigness to pay by distressed debtor...” The New Global Approach (cont.) Litigate to Settle ... assumes bad faith, gross-negligence, fraud, the lack of willingness to pay or engage or the like assumes that a sufficient standstill period has brought no solution to the distress assumes that creditor has grounds to pursue litigation or foreclosure of collateral benchmark: reasonable grounds to litigate or more than reasonable grounds to litigate “...assumes lack of willigness to pay or engage...take creditors for a ride” The New Global Approach (cont.) Litigate to Settle ... does not require the actual filing of litigation or foreclosure—a meaningful threat of filing of well prepared litigation or foreclosure papers is oftentimes enough main objective is to reverse the logic and show a recalcitrant borrower or sponsor that creditor can indeed litigate or foreclose a cash settlement (either with the sponsor or out of a judgment or foreclosure) or a involuntary bankruptcy or liquidation is the likely outcome The New Global Approach A Short Summary Afford a “performing client” in financial trouble a sufficient standstill period to wait-and-see and undertake a good faith work-out: negotiate to restructure approach If more than two years after the inception of the financial distress have passed, most good faith clients should have restructured or be about to restructure their debts After two years of financial trouble, non-performing clients generally do not improve—on the contrary, they became dead horse clients: litigate to settle approach “...when a client gets used not to paying for a long while, it is tough to find a restructuring solution” The Global Recovery Process— Process—Stages Timeline of Events 1 2 3 4 5 6 7 8 9 10 11 12 13 Restructuring egotiation Dealing with Creditors Post-Closing Formulation of Attacks Matters Soliciting BP / Business Dealing with Initial Acceptance of Valuation Reactions Restructuring Plan Stand-Still Period Operations Consultation with creditors during Financial Distress Restructuring Selection of Professionals Period Creation of Closing Steering Committe Global Recovery Solutions “...creditors should be ready to use multiple creative solutions for overcoming a financial distress...” 1. Debt- for- debt rescheduling 2. Debt- for- equity restructuring; Recapitalization 3. Debt-for-quasi equity instruments 4. Explicit haircuts 5. Payments in kind and synthetic instruments 6. Down payments at par or with a discount/tenders 7. Granting of new collateral Global Recovery Solutions 8. Sale of Assets 9. Interest Rate Relief 10. Spin-off and divestitures 11. Operating Restructuring and Rationalization 12. Leverage New Money Facilities 13. Corporate Governance 14. Settlement or Contributions from Sponsors Key WorkWork-out Principles o Pari-Passu Treatment - Secured vs. unsecured lenders - Short-term vs. Long-term lenders - Trade lenders and multilaterals vs. other creditors - Self-liquidating lenders - Shareholders’ loans o Fair Burden Sharing (According to ranking and seniority, including shareholders)— Approach to Shareholders’ fair sharing of the burden – fair burden sharing and political events – fair burden sharing and systemic crisis – cash contribution – equity dilution – sponsor support “...Principles and pragmatism are equally important for creditors when pursuing distressed work-outs...” Key WorkWork-out Principles o Recovery Expectations according to Status or Seniority (Benchmarking for any out-of-court restructuring) o No Fraudulent Transfers or Discriminatory Preferences or Treatment (Transparency is key) o Pro-Rata Distribution of Payments (Equal access to available cash—the bottom line of any restructuring) - Rules for distribution of cash during standstill period - Common interest rate vs. Contractual rates - Cash tenders “...Key work-out principles should be applied on a caseby-case basis—flexibility is key for a successful workout strategy...” Key WorkWork-out Philosophies The New Global Approach towards work-outs ... o Always take a rigorous and aggressive approach towards any work-out - within the boundaries of creditors´ legal rights, - taking into account creditor’s role as a good corporate citizen, - with a view to protecting a going-concern and maximizing recovery, - without hesitating to pursue legal remedies or foreclosure, if need be, and - always avoiding lender´ liability or institutional or reputation risk issues, including with the government Key WorkWork-out Philosophies The New Global Approach towards work-outs ... • Never take a passive or indifferent role in a distress and always strive to support clients and relationships unless fraud or bad faith were present • If possible, do not sell exposures and actively pursued reschedulings and restructurings in a RUSH regardless of provisions or write-off/down positions—TIME WORKS IN YOUR FAVOR • Always take a long-term view on recovery Restructuring Mottos o Break the mold (no more business as usual)—change the tone of the relationship (but in moderate, discrete increments) o Assess the character and business ethics of your borrower before determining how to deal with a problem loan o If good faith is present, support your client but never forget that your main mission is recovery o Never compromise with fraud, bad faith or gross negligence—if it has happened once, it might and will happen again...litigation or foreclosure of collateral (or threaten thereof) may the only viable option “...non-performing clients should forget about VIP treatment...” Restructuring Mottos o Always lead, never follow o Be aggressive and determined—always take quick and decisive actions o Never show an indication of weakness, concern or anxiety o Reinforce the authority of the team “...Look like a bureaucrat, behave like a banker—let them underestimate you...” Restructuring Mottos o Never threaten if you are not ready and capable of enforcing the threat; credibility is key o Always behave in a professional, serious, moderate and responsible manner o Be firm and consistent but always avoid a vindictive behavior, an arrogant conduct, extortion pressures or other unacceptable conducts o Always focus on factual issues and not on people; disregard human-factor issues and base your decisions on facts “Don’t love them, don’t hate them, just focus on recovery...” Restructuring Mottos o Be reasonable in determining what you will require a borrower to do—don’t ask your borrower to deliver something beyond its capabilities o Always seek real consideration; not mere promises o Base your recovery expectations and strategy on an assessment of your status, ranking, remedies and available recovery options o If there is good faith, strive to pursue a going concern solution o Once a recovery strategy is developed, follow it on a consistent basis but consider your fall-back position (plan B) “...Reverse the logic, you need to be a problem and nuisance for your borrower; it should not work the other way around...” Restructuring Mottos o Always seek sustainable debt reduction and recapitalization o Always encourage a distressed borrower to distribute available, excess cash to creditors o When possible, seek capital infusion or credit enhancements from sponsors, other constituents or cash from sale of non-essential assets o Never grant a waiver without improving your position, if possible (and as long as you don't violate pari-passu principles) o Never permit collateral deterioration and always seek further collateral (again, respecting pari-passu principles) “...Cash, Collateral and Character are the three Cs of restructurings...” Restructuring Mottos o Recovery means pursuing all available options—always pursue all obligors simultaneously, including guarantors o Use your loss provisions and write-offs as your best friends / you have nothing or little to lose—they can lose their company o REVERSE THE LOGIC: distressed debtors need to feel that they have a big problem, not you—once again, look like an orthodox bureaucrat o Never settle for less than what you would eventually obtain in a liquidation or foreclosure of collateral “Success in any recovery effort requires a creative, patient, persistent, firm and sophisticated attitude...”
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