Assets Reconstruction Companies - Dealing with NPLs

Introduction

During the 1990s, the problem of non-performing loans (NPA) with banks became particularly acute in countries like Japan where the NPA were estimated to be $ 1 Trillion, and with securitization technology with structuring options finding increased acceptability, bankers world-over have been looking at financial restructuring options through securitization.

It was not until late 1999 that securitization of non-performing loans became a reality. On 25th November 1999, Morgan Stanley Dean Witter (MSDW) launched and priced a JPY 21.0 billion issue of floating rate structured notes for an SPV called International Credit Recovery - Japan One Ltd. This was the first time a capital markets solution had been applied to the problem of non-and-sub-performing loans. The MSDW deal was backed by non-performing loans backed on Japanese real estate, a total of 700 real estate assets of various types located throughout Japan. MSDW had been buying these loans over time.

What is an NPA?

“A Non-Performing Asset means an asset or account of a borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or guidelines relating to asset classifications issued by the Central Bank.”

Current Scenario

The non performing assets (NPAs) of the banks i.e. loans given to companies remaining unpaid, were building up in the absence of any stringent provisions and at last count had ballooned to whopping Rs 84,000 crore plus for all banks put together. Incidentally, this figure pertains to the NPAs the banks have acknowledged. But audit and consulting firms like Ernst & Young estimate the actual NPAs could easily be between Rs 1,15,000 and Rs 1,40,000 crore. 

What is an Asset Reconstruction Company?

Asset reconstruction means acquisition by any securitization company or reconstruction company, of any right or interest of any bank or financial institution in any financial assistance, for the purpose of realization of such financial assistance. The company, which undertakes such assets declared as Non-performing by the Lending Institution, is referred to as Asset Reconstruction Company.

The bottom-line is that the companies are really debt collectors, given sweeping powers, which were so far exercised by debt recovery tribunals and civil courts and were not available to the debt recovery department of the lenders themselves.

How does it actually happen: The real miracle that securitization does to non-performing loans is not to turn bad into good. Most non-performing loans securitizations have been supported by substantial over-collateralization or subordinated interests retained by the originating banks. Most of the securitizations, for example, are credit-enhanced by a substantial extent of subordinated notes, which are retained by the originator.

One of the way in which the securitization of NPA happens is that the core NPAs of banks over a certain size are taken over in exchange of NPA swap bonds representing the realizable value of the assets transferred. It is envisaged that the Government will guarantee these bonds. This arrangement will be benefit the banks as they will hold interest-bearing marketable bonds in their balance-sheets instead of making provisions for NPAs which affects the profitability of banks calling for re-capitalization with the taxpayer's money in the case of public sector banks.

Objective:

• To buy out troubled loans from banks and make special efforts at recovering value from the assets, if necessary by special legislation, with special powers for recovery.

• Restructuring of weak banks to divest the bad loan portfolio — essential for a comprehensive restructuring strategy of weak banks.

The debate:

As per one argument, banking is a high-risk industry--commercial banks themselves should bear all the risks arising from their operations and must provide adequate provisions for possible loan losses.  It is hard to justify the use of taxpayers' money for the clean up of NPAs.

Some analysts say that delays in addressing the NPA problem may lead to a financial crisis.  Past experience shows that a crisis could have a devastating impact on the real economy.  The crisis-hit economy would go into recession and banks would be saddled with huge NPAs.  Under this circumstance, the government is in a better position to establish mechanisms to resolve the problem of NPAs of ailing financial institutions.

Securitization Ordinance, 2002: Acting Tough

Under this ordinance promulgated on June 21, if a corporate borrower defaults on its loans for 180 days, banks will be able to issue a notice to the borrower and if money is not paid within the next 60 days banks can take possession of the security offered by the borrower at the time of availing of the loan and sell the same to realize the dues. The ordinance also provides that no court can interfere in the matter and issue stay orders, which could help the defaulting borrowers.

In short, the ordinance takes the judicial system out of the loan recovery process and by stipulating definite number of days for definite action, ensures the whole process of recovery would be quite swift.  The right to take possession of the security was there earlier under the transfer of securities act but only for mortgage securities and not for every type of security. The ordinance enlarges this right and includes all types of securities like mortgage, fixed and floating charge, hypothecation etc. though liens and pledge are not covered.

Problem

For banks in the red, it means a clean balance sheet by passing on the buck. Rather than dealing with the problem of NPAs and getting rid of them, the attempt is only there to transfer these assets to another body, which arose due to the inefficiency and lack of check backs in the system.

The pricing of NPAs is a critical issue. There are two ways in which an NPA can be sold to an Asset Reconstruction Company (ARC) — at book value or according to what the market can bear. While the former is good for the bank, it good also mean huge losses to the ARC. Mostly, no ARC would be willing to take on bad debts on book value unless forced to do so. Book value transfers would only shift the losses from the banks to the ARCs.

• As a book value transfer will result in huge losses to the ARCs, transferring the assets at a discount at realizable market prices will aggravate problems related to fixing a market price. If the Financial institutions are allowed to retire off their debts, and then continue with the same old practice, these problem will not only continue but will take a much more broad dimensions.

Specialists in recovery on loans: This is a wrong premise that the NPAs can be dealt better by ARCs because they specialize in the recovery of loans. Banks should not only be responsible in for giving away loans but would also be responsible in recovery of the same.

This can be only a short-term solution rather than a long-term solution.

What should be done??

ARC can be only be a solution in the short run and should not be the continuing process. NPAs, should only be transferred to the ARCs of the past rather than this continuing it as a future remedy of NPAs as this will encourage banks and financial institution not to take steps in improving their credit assessment and review processes.

• The option of transferring at realistic market prices, though sounds good, but is difficult in India. The key reason of this not happening in India is the risk of being questioned by CAG and other authorities.

• Conciliation and negotiation to settle the realizable value of NPAs would be better in private sector ARCs. Private sector ARCs can be selected by banks on the basis of competitive bidding if more than one ARC is interested, otherwise the bank management should be free to negotiate a suitable value for the assets and terms of the bonds to be issued by the ARCs.

• One possible solution is to set up a quasi-Resolution Trust Corporation (RTC) mechanism.

• There is a need to reduce stamp duty rates and make them uniform all across the states, varying from 7 per cent in some states to even 12 per cent. Further, the stamp duty rate should only be imposed in one stage rather than two stages — firstly while transferring the assets from banks to ARCs and secondly from ARCs to final buyer, else the purpose of ARC would be defeated.

• Securitization is not a solution. What can be possibly done is to bring down the interest rate to the existing 12 or 13 per cent instead of 19 per cent at which the loans were originally given. Hence capital restructuring is necessary.

• Rating of the loan portfolio before it is transferred to the ARCs: The pricing should also be based on the rating of the loan portfolio as it will be an independent judgment of the portfolio.

Long term Solutions:

• Need of adequate funding, government support, policy guidance and necessary actions

• The most important long-term measure in containing the growth of NPAs is radically altering the bankruptcy and recovery laws and procedures.

• A lasting solution to the problem of bank NPAs can be achieved only with proper credit assessment and risk management mechanisms, avoiding adverse selection and not compromising on asset quality. If the assessment of credit risk will be better, the NPAs would go down, the cost of funds will also fall and borrowers may be able to get credit at a cheaper rate. Overall, there will be rise in the value of the assets of the banks and banks might get higher valuation on the stock market, which is not the case at present.

• It is extremely essential to distinguish between the willful and the non-willful defaulters. Both cannot be treated on the same footing.

• Bankruptcy regimes, voluntary mechanisms for settling of debts and strong foreclosure laws. Without these, an effective securitization mechanism is not possible

• NPA linked to the future realization by the company under debt rather than just allowing the banks to retire the debts at certain price to  ARCs, The banks should be made a part in the realization of the NPAs over and above the certain level. This not only will help in getting over the problem of pricing but it will also improve co-operation between the banks and the ARCs in realization of debts.

• NPA of the banks and Fis should be treated differently and not as a same entity.

• Developing secondary market for these securitized instruments will help in making these instruments more liquid

• Reduction in dependence on Banks/ Financial Institution for commercial lending by developing our primary and secondary markets.

Performance measures should be taken for the financial institution retiring off their debts as that will improve their asset portfolio, hence they should be made to improve performance and encouraged to take steps which will help avoid this problem in future to the maximum possible extent.

How to deal with the political interference at the lower level?

This is a systemic problem, which will remain whatever steps we take. This should be addressed at grass root level and it can only be controlled if corruption can be controlled and proper mechanisms are put in place at the lowest levels. Professionalism at the grass-root level is a must to tackle this problem.

Conclusion

Recent securitization activity in several countries, including Japan, Korea and Italy, is getting boost from a strange application: securitization of non-performing loans. The most crucial question in securitization of non-performing loans is: does a bad apple, when sliced, becomes a good apple?

Proper management and speedy disposition of NPAs is one of the most critical tasks of banking reforms today.  The main purpose of active involvement by the government is to remove NPAs from the banking system quickly so that the banks can resume their normal functions.

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Sonit Singh
sonit_in@yahoo.com
MPIB II (Finance)
Symbiosis Institute of International Business