Building Efficient Debt Resolution Systems

Building Efficient

Debt Resolution Systems

Asset Management Companies

Past & Present

Vienna, February 14, 2012

Ruth L. Neyens, Consultant,

The World Bank

and

Public Asset Management Companies



Entity established for the purpose of managing and

resolving non-performing loans/assets

• Restructuring

• Rapid disposition through sales to private AMC’s



Requires

up-front loss recognition

by banks ,

therefore accompanied by program of

bank

Advantages of Public AMC’s



Allows bank management to focus on core

business and returning bank to profitability



Provides more focused loan recovery

management

Public AMC Challenges



Complex institutions with public/private dimensions that require

strong governance and transparency



Lengthy process to establish



Subject to intense political pressures



Difficult to establish correct transfer pricing of assets



Difficult to recruit and maintain qualified staff



Indemnification



Costly to run and require adequate up front funding



Success highly dependent upon market for sales of distressed

A Long History of Use of Public AMC in Financial Crises

US – Resolution Trust Company – 1989

Sweden – Securum – early 1992

Mexico – FOBAPROA

–

1995

Indonesia – IBRA – 1998

Korea – KAMCO – 1998

Malaysia – Danaharta – 1998

Lessons Learned



No clear evidence that

public

AMC’s deliver better results

than a bank-led decentralized efforts



Private AMC’s deliver better results



More suited for rapid asset disposition than restructuring



Successful AMC’s had clear, limited mandates and tended to

focus on real estate assets



AMC’s require strong governance and enhanced transparency



must be

politically and financially independent



market discipline

must be maintained



there must be a plan to

jump-start credit flows

in the financial

Ireland:

National Asset Management Agency (NAMA)

Established and funded by the Irish Government,

December 2009

―Facts – Irish Financial Institutions

The losses already exist in the loan books of financial institutions due to poor lending practices and declines

in asset values—what NAMA does is that it forces the upfront recognition of those losses by the banks.

CLARITY

The banks would have to be recapitalised in any event to deal with these losses.

INEVITABILITY

NAMA does provide liquidity to the banking system

.

ACCESSIBILITY

It is up to the banking system to use that liquidity provided by NAMA to lend to the real economy on a risk

adjusted basis.

CONSEQUENCE

Excerpt from NAMA presentation of

September 2010

:

Irish government intervention began with its wide-ranging guarantee for bank liabilities—

Euro 440 billion

on 30 September 2008. By

December 2008

, the government concluded that

recapitalisation

of certain

banks was inevitable in order to deal with loan losses.

NAMA Timetable from April 2009 – March 2010

Bill published in

the form of a

consultation

paper

30 July 2009

Bill

introduced to

Dail

16 Sep 2009

Committee

and Final

Stages

Oct/Nov 2009

NAMA

established

and Board

appointed

Dec 2009

EU

approval

of

NAMA

Feb 2010

Transfer of largest

borrowers’

exposures across

all institutions

March 2010

Irish Experience: NAMA – Basics & Assumptions of Business Plan

• In the wake of its financial sector crisis, in 2009 the Irish Government established the National Asset Management Agency (NAMA) to remove troubled assets from bank balance sheets.

• NAMA paid banks for assets with bonds that it issued under a government guarantee equivalent to 95% of bond face value. The bonds, issued specifically to fund distressed asset purchases, are not listed or traded. AMC debt collection proceeds pay-off the bond holders, bonds pay interest and are repo-eligible at the European Central Bank (ECB).

• NAMA’s business plan anticipated that it would acquire EUR 81bn of loans at a average discount of approx. 30% to nominal value. NAMA planned to break even within 10 years, based on the assumption that the property market in Ireland would appreciate by 10% over the period. If, however, it ultimately loses money, a compensating tax surcharge will be assessed on the participating institutions.

• NAMA estimated that 40% of the loans to be acquired would be cash-flow generating, typically paying an average spread of 2% over Euribor, producing sufficient interest income to cover interest expense on debt. Bond principal repayment would be covered by principal repaid by borrowers and from asset recovery proceeds.

NAMA

NAMA Investments Ltd

Asset Management

Company

5 Banks

Irish

Institutional

Investors

NAMA Bonds*

51% Equity 49%** Equity

**Veto right over all decisions that are not in accordance with the objectives of NAMA.

Assets

Liabilities

Non Performing Loans – EUR 77bn nominal, EUR 54bn transfer price Debt: EUR 54bn Equity: EUR 100M 49% NAMA, 51% Irish Institutional Investors

*Some NAMA bonds carry a feature whereby the bonds decrease in principal value if collection proceeds are less than original purchase price.

Irish Experience

:

Long Term Economic Value and Unfair Competition

• Banks transferred assets to NAMA not at market price but at long-term economic value (LTEV), the value that an asset can reasonably be expected to attain in a stable financial system when crisis conditions subside. The difference between market price and LTEV was considered a subsidy by the EU Competition Commission, with participating banks benefitting to the detriment of competitors.

• The European Competition Commission, which closely examined the transfer pricing methodology, ruled that NAMA met guidelines governing government support as the terms and conditions of bond payment as well as the future tax to

participating banks to cover future losses provided an adequate burden-sharing mechanism. Transfer prices were capped at LTEV (with the formula defined) and the discount rate applied to loans provided adequate remuneration for the State.

• Purchase price of assets are determined in reference to the estimated Long Term Economic Value (LTEV) of the Loans, i.e. the value that it can reasonably be expected to attain in a stable financial system when current crisis conditions are ameliorated. Valuation methodology for LTEV is approved by EU Commission .

• NAMA pays for the loans it acquires by issuing Senior Debt securities to the value of 95% of the total consideration and

Subordinated Debt securities for the remaining 5%. In the case of the latter, payment of interest and ultimate

redemption is subject to NAMA’s financial performance. All securities are issued in Euro.

NAMA Transfer Pricing

Difference bt. LTEV and market value considered a subsidy by the EU Commission Portfolio Nominal Value EUR 77bn Transfer Price (LTEV)

EUR 54bn Avg 30% discount to nominal value; 15% more than current market value

Market value EUR 47bn 15% less than transfer

price

Purchase Price

The decision to establish government funded AMC

PRO:

The Economist, “Ireland’s Banking Mess; Austerity is not enough to avoid the scrutiny by

the markets”. 19 August 2010.

“Ireland is paying for its decision to set up a toxic-loan repository that forces

banks to clean up their balance sheets vigorously, rather than put off

dealing with problems (as Germany has done) or insure dodgy loans and just

hope they improve (as Britain has). In the long run,

Ireland’s response is

the better one

, but in the short term it puts pressure on the borrowing

because the government has to keep

injecting capital

into broken banks”.

CON:

Martin Wolf, the Financial Times, 30 November 2010

“So what, against this background, needs to be done by individual countries

and the euro zone? Not what was done in Ireland…the Irish banking systems

is worse than too big to fail; it is too big to save. The first duty of the

state is to save itself, not to

load its taxpayers with obligations to rescue

careless lenders.

”

Irish Experience: Lessons Learned

• Delayed timetable for NAMA’s creation and asset transfer – Speed is of the essence

 Nearly one year to establish NAMA + the government planned to take several years to transfer distressed assets to the agency (in the end this had to be accelerated, as requested by the ECB and the IMF). Asian AMCs also learned that speed was of the essence in supporting troubled financial institutions.

• Discounts applied to assets absorbed by NAMA were too generous

 NAMA estimated the Long Term Economic Value (LTEV) of eligible assets to be EUE 54bn, a 30% discount to their book value, and a 15% uplift on their current market value. It is estimated that property prices have fallen by 50% since early 2007 across all sectors and regions in Ireland and did not recover. The discount applied was not sufficient.

• Narrow definition of eligible assets did not provide enough relief to the banks

 With essentially only commercial property assets qualifying for NAMA, the banks were burdened with residential lending portfolios on their books – assets that came under severe strain as tough fiscal cuts increased unemployment.

 Additional assets should have been eligible

• The absence of liquid funding proved to be as harmful as a weak capital structure

 Ireland’s guarantee on retail deposits stopped bank runs, but corporate clients continued to withdrawn billions.

• Irish reluctance to force private bondholders to share in losses

 Ireland reached a situation of “too big to save” - if bank liabilities had been restructured earlier and private creditors had absorbed part of the hit, the banking system could have recovered more quickly.

NAMA to date

Classification Number Nominal Value (EURm) Accounting Value (EUR m) Performing 2,872 24% 15,050 21% 7,586 29% Non-Performing 8,911 76% 56,138 79% 18,838 71% Total 11,783 100% 71,188 100% 26,424 100%

Source: NAMA Quarterly Accounts (Jan 2012)

Assets Transferred

Funding & Payment

Through outstanding

bonds,

NAMA’s

payments to

participating

institutions

represent an

injection of close

to

EUR30bn

of

liquidity into the

Irish Banking

system.

Increase in

Banks’ Capital

Need

Banks’

Deleveraging

Approach

Slowdown in

Credit Extension

Economic

Deceleration /

Unemployment

Lower Financial

Revenues/

Higher NPLs

Emerging Europe Context: Closed Cycle

Cycle

IFIs/Governments may need to

intervene to cover this gap and

break the vicious circle:



Acquire distressed assets to

promote capital relief



Take first-loss position to

stimulate private investors

Traditional distressed debt

investors have disappeared or are

focused on developed markets,

resulting in a funding gap for

distressed assets in emerging

markets

Sellers

Buyers

Price Gap

•Higher recovery estimates than investors;

•Redeploy staff to work-outs who resolve assets until economic recovery permits renewed lending, providing new income sources;

•Do not fully price cost of recovery: funding and legal costs, opportunity and staff costs, time value of money;

•Extend and pretend vs true restructuring;

•―Performing‖ NPLs stay on balance sheets

•High IRR competing investments in markets with more transparent legal regimes and judicial systems;

•Ceteris paribus, pricing more attractive for distressed assets in Western Europe;

•Lack of local skills in terms of legal, servicing, restructuring experience;

•Depressed markets for collateral assets;

•Structuring investment prohibitively complex in some environments;

Problem

Essential Elements

•

With the exception of retail and consumer

loans, most loans in Emerging Europe are

collateralized with collateral values not

recently updated. Loans are held on books

at values well over market price of

collateral and loan assets creating a

significant price gap

.

•

Banks

cannot afford the hit to capital

that

a sale at market price would produce.

•

A

partial sale

at a steep discount could

lead to

regulator scrutiny

of the remainder

of the portfolio, requiring additional,

costly, provisioning.

•

Lending has ground to a halt;

NPLs

removed

from balance sheets may

stimulate new lending.

Potential Solution

Essential Features

•

Assets cannot be transferred at market

price without a

debilitating hit to capital

.

•

Alternative pricing/transfer mechanisms

needed that allow selling banks to:



Amortize future losses and impact on

capital over time



Recapitalise banks



Transfer assets above market price

•

The potential future loss on the difference

between Market Price and Transfer Price

may need to be shared with various

options possible.

Bank

Nominal Value:

Book Value:

Transfer price

Market Price

100

70

50

25

NPL Portfolio

NewAMC

NPL Portfolio:

(

)

50

25

25

• Leads to Realized Losses

OR • To the extent that future losses are shared, the investor or guarantor could also potentially lose.

• Immediate Loss to Bank:

[Book Value,70] – [Transfer Price,50] = 20 • Potential Future Loss to Bank,

NewAMC/Govt or Guarantors:

[Transfer price, 50] – [Market price, 25 + Total Expected Recoveries]

Potential Losses

ASSETS

LIABILITIES

First Loss Provider

Transfer Price – Essentials

• Between “lower than book to higher than market” is a significant “gap”

• Transfer price must be pre-defined with rational underlying economic and financial basis

• Independently determined and verified

• Irish LTEV logical starting point or should transfer price be based on total expected recoveries (less cost of funding and recovery)?

• Expected recoveries based on due diligence, underlying asset and collateral values, recovery assumptions, asset resolution strategy, time to recovery, discount to present value

• Pricing mechanism requires acceptance by domestic regulator and possibly EU competition commission depending on jurisdiction; NPL Sellers (Banks):

• Have immediate losses equal to the difference between Book Value and Transfer Price(1).

• Some banks may need additional capital in order to absorb write-downs. However, in general, transfer should reduce risk weighted assets and release capitalallowing for future lending.

Potential Structure

Transfer Price –

Bridging the gap

Bank Nominal Value: Book Value: Transfer price Market Price 100 70 50 25 NPL Portfolio NewAMC NPL Portfolio: (Acquired at Transfer Price) 50 Assets Transfer Price (50) Cash (25) Senior Debt -Cash payment Sub-Debt / Gtees flexible instruments RECAPITALISATION 25 25 Funding Gap (25) ASSETS LIABILITIES (1)

Payment:

• NewAMC pays Transfer Price either equivalent to LTEV or Market Price plus the value of Total Expected Recoveries (less costs) (2).

 The market value equivalent for assets will be paid in Cash to Banks (in this example, 25)

 The difference between Market Value and Transfer Price will need to be funded or potentially require recapitalisation (in this example, 25). Final principal amount paid will be tied to total recoveries on the portfolio. If potential future loss is shared, burden is split between shareholders, guarantors, and investors.

• The NewAMC pays for the loans it acquires through:

 Cash - AMC issues Senior Debt securities to investors equivalent to market price (in this example, 25) with proceeds paid to selling banks; and

 Alternative mechansim to bridge the difference between market and transfer price (25, in this example), for example, partial principal g’tee on bonds issued by AMC from

governments or IFIs.

Payment to Selling Bank –

bridging the gap, cont

Potential Structure

NewAMC Funding:

• Senior Debt: To be offered in the market to private investors and IFIs

(3).

 Funding from Senior Debt would be used to pay for the Market Price of the acquired NPL Portfolio, potentially less riskier, or with higher probability of repayment. Interest payments fixed.

• Guarantees: Possibly provided by governments/IFIs on Variable Value Bonds issued by NewAMC as partial payment to asset selling banks. (4). Interest and principal payments linked to NewAMC’s results and

recoveries.

 This funding is for the difference between the Transfer Price and the Market Price, equivalent to Total Expected Recoveries (less costs) or LTEV  Riskier, as the total recoveries are unpredictable. These bonds could have a burden sharing mechanism, with the guarantor/investor and the bank sharing the shortfall on recoveries. This would put some of the burden of future loss on the

guarantor/tax payer vs. 100% to the bank.

 To compensate for its higher risk profile, this type of funding could have an unlimited upside potential based on total recoveries 

while the Senior Debt has a fixed repayment schedule and a fixed principal repayment.

Funding the AMC

–

bridging the gap, cont

Potential Structure

Latvia Public-Private Partnership – Concept

• Latvia considered using an AMC to remove NPLs from a large bank’s balance sheet. A systematically significant bank, removal of NPLs from its balance sheet would support stabilization of the financial sector.

• Investors could have include the Government of Latvia, International Financial Institutions (IFIs), and professional distressed asset investors. A flexible liability structure was considered, with funding shared among the three parties.

• As always, transfer pricing was an issue with the possibility that assets may have been transferred above market levels to address various issues.

Assets

Liabilities

Performing Loans

Senior Debt: 2 to 3 years – 10%

Funding by DA Investors Mezzanine Debt: 5 Years – 40%

DA investors, IFC, EBRD

Non-Performing loans Subordinated Debt – 45% Gov t of Latvia Equity – 5% Govt of Latvia

AMC Structure

Government has full upside after reimbursement of senior and mezzanine

investors on both sub debt and equity Existing short-term debt funding from government converted

to sub-debt, no additional funding

At the time, benefits included:

•Strong signal to restore confidence in the financial system

•Release of part of Government of Latvia’s liquidity tied up in the bank •Possible long-term economic upside for the AMC and taxpayers

Pakistan PPP - Concept

•A public-private limited partnership to acquire

collateralized distressed corporate assets directly from local banks.

•An average hair-cut of 75% on the NPLs purchased is to be applied, a steep discount likely to attract private

investors.

•Banks are required to sell at the established price. •The AMC would restructure credits and/or sell weak manufacturing units (mostly in the textile sector) to strong investors (mostly local groups).

•AMC will be 100% equity financed i.e. no leverage with

expected capitalization of $250 million to $350 million. •Equity investors include Government of Pakistan (GoP) (49%), IFC (20%), local DFI’s/private investors and/or IFI’s (26%), and a technical partner (5%).

•The level of GoP ownership in the AMC is expected to decrease overtime to pave the way for increased private sector ownership and when private sector NPL resolution begins to develop, leading to transfer of assets to other entities.

Assets

Liabilities:

100% equity funding

Non Performing Loans

GoP: 49% IFC: 20% DFI: 20%

Technical Partner: 5%

Funding & Shareholding Structure:

Resolution Trust Company (AMC)