The ADB’s role in encouraging and facilitating Asset Reconstruction Companies
Dr. William WillmsPrincipal Investment Officer, Asian Development Bank6 November 2004
Introduction
ADB: Participating at early stage
Public Sector: Advising policy and framework dialogue, coordination and relationship management with Governments
Private Sector: Debt and Equity funding at early, riskier, stage
ADB and India
Public Sector: TA on the SAFREASI Act and Secured Transactions
Private Sector: Equity funding for ARCs, potentially Security Receipt investor
NPL market drivers and the ADB
INVESTMENT BANKS: Principal business needs risk sharing
Require leverage to lower equity cost, WACC
Seek diverse partners to better share risks
ASIAN NPL MARKETS: Early-stage DevelopmentEarly stage: Fewer players, higher costs
Later stage: More standardization like other markets
ADB: Valuable Early-stage ParticipantPublic Sector: Provide political value as multilateral
Private Sector: Offer Debt and Equity funding at riskier early stage
Section 1: ADB’s Role in NPL Resolution Projects outside India
Overview
MAIN: Senior, limited-recourse debt
Partial Credit & Political Risk Guarantees
Equity Participation at Early Stage
General “Comfort” as Multilateral Partner
ADB Loan for NPL Portfolio Purchase
Portfolio Acquisition Loan
Senior, limited recourse Maximum of 25% of total transaction cost (funding) or US$ 75
million (whichever is less)
Full credit, market asset and legal due diligence
Market-based spread
Underwriting Fee of 1% - 1.5%
US$, Euro or, depending on the country, local currency
Example: Outright Sale
OriginatingBank
Portfolio
Purchase Price
Servicer
Servicing
SPV
Fee
Investor
100% Debt
ADB and Securitization
ADB Partial Credit Guarantee (PCG)
timely payment of interest and ultimate payment of principal
up to 100% of one tranche
2 shadow ratings by acceptable rating agency
Liquidity Facility
Political Risk Guarantee
Example: Conventional CLOs
CharitableTrust
Outright sale of
PortfolioOriginatingBank
Portfolio
SPV
OriginatingBank
Investors
Investors
Senior Tranche• rated bonds• 1st priority security over Portfolio• 5 years (callable after 3)• Coupon Bearing• Liquidity Facility from OECD Bank
Mezzanine Tranche• unrated bonds• 2nd priority security over Portfolio• 7 years• Coupon Bearing
Junior Tranche• bond/loan/preference shares• subordinated• 10 years• zero coupon (cash sweep)
100% equity
• Guarantee• Loss bearing
Liquidity Facility
Market Value
Critical Issues: The Servicer
More than for any other asset class, the Servicer is critical for an NPL deal. There will not be any cash flow from the assets without a Servicer.
Two kinds of Servicer:Special ServicerSeller (Bank)
Recovery Strategies:Legal ProceedingsDPOs (Discount Pay-Offs) or out-of-court settlementsREO company, a third party that will go to auction if prices become too low with the purpose of selling the property on the open market afterwardsMarketing & Sale Programmes Funding Programmes, to provide funding to potential buyers of real estate properties (at auction or outside)
Other Critical Issues: Underlying asset pool (secured vs. unsecured), legal environment, structural enhancements
Section 2: ADB’s Role in NPL Resolution in India
ADB and Indian ARCs
ARC
Trust
LocalInvestor
Originating Bank
Foreign Investor
100%
Sale of NPL
Security Receipts (SRs)In consideration
Cash
SRs
SRs
THANK YOU
Appendix 1:Asia’s NPL Resolution
Problem
New strategies in investment banking
Moving away from “client focus” to principal business
Ramping up proprietary business
shrinking investment banking fees
growing proprietary trading
expanding distressed debt investment business
example: Goldman Sachs’s business model in Japan
Growing advisory business in area of distressed assets
continuous conflicts of interest to be managed
Equity Solution for Asian NPLs?
NO. Equity is not sufficient.
Magnitude of NPL problem in Asia
Country limits and single deal exposures for investors
Increasing sophistication from sellers (e.g. PRC AMCs): more complex bid/offer spread
Kong Kong/China$480
Philippines$15
Taiw an$65
South Korea$105
Indonesia$60
Thailand$50
Malaysia $40
60 50
105
1528 45
215
14
0
50
100
150
200
250
Indonesia Thailand South Korea Philippines
$ in
billio
ns
Distressed Debt Stock Market
Total Asia ex-Japan Distressed Debt Distressed Debt to Stock Markets
$ in
bil
lion
s
Source: Ernst & Young; BloombergSource: Ernst & Young; Bloomberg
- Approximately US$815 billion of Asia ex-Japan NPLs
- Value of distressed debt is greater than some local stock markets
ADB’s Involvement: EARLY STAGE
EARLY STAGE: CATALYTIC
– “Common Funder”
– Strong benchmarks and transparent NPL market
– “Best market practices”
– Catalyzing debt funding from international and domestic banks
t
FeesNumber of Players
NPL Resolution Market
Market Development
(a)
ADB
(b)
ADB’s Market
Outside ADB Scope:• South Korea• Japan• Taipei,China
Tiny Starting Growing
Thailand Philippines PRC India
Appendix 2: ADB Due Diligence
Introduction
NPLs can be classified into two categories:
Secured NPLs have a security – a mortgage security or personal guarantee – of good quality. In most cases, mortgage loans with a first-rank lien or loans with a corporate guarantee fall under this category. The recovery process will largely depend on legal proceedings, while the extent of the recovery will depend on the real estate market.
Unsecured NPLs do not benefit from a good security. In most cases, mortgage loans with a second- or third-rank lien, unsecured corporate loans, consumer loans or overdrawn bank accounts fall under this category. The recovery process will largely depend on the efficiency of the servicer.
The presence and the quality of a security for NPLs will obviously affect the expected level of recoveries for the creditor.
NPL debtors are either private individuals or corporate legal entities (corporations in most cases). The debtors’ legal characteristics will affect the legal proceedings and their durations.
General Principles
The Asset Side:the characteristics of the NPL portfolio (secured vs. unsecured NPLs…)the efficiency and the recovery strategies of the Servicerthe eventual support mechanisms (Liquidity Facility/Guarantee in the case of payment shortfall on the NPLs)
The Liabilities Side:The waterfall of payments on the different classes of notes (subordination capital and/or interest)The eventual support mechanisms (collateral in the case of payment shortfalls on the notes)
Modeling Process
INPUTS on: -
assets (recovery, timing)
- support
mechanisms
Modeling of Cash FlowsGenerated by NPL Portfolio
Cash Flow Model
OUTPUTS:Expected
Repayment Profile of ADB Debt
Modeling Assets’ Cash Flows
Assets’ Cash Flows: Secured or Unsecured
Secured NPLs – Loan-by-Loan analysisTiming
Type of legal proceedings (insolvency/bankruptcy or foreclosure)Phase of the legal proceedings and number of auctions according to the underlying real estate property.Court timing recovery according to the legal phase.Servicer’s strategy (legal proceedings or out-of-court settlements, or other strategies ….)
AmountMortgage security amountLoan/claim Outstanding Amount (Gross Book Value) at the expected recovery date (legal interest or late payment interest)Forced Sale Value (minus legal fees) at the expected recovery date. The Forced Sale Value of the property is derived from the last Market Value and projections for the real estate market (according to the kind of property – residential, commercial, industrial – and the geographic situation)
Several scenarios regarding timing (courts, Servicer’s efficiency/strategy) and real estate markets (cycles, volatility)
Appendix 3:Other Potential NPL Structures
(1) Joint Venture Management
OriginatingBank
Outright sale of
Portfolio
Market Value
ADB Loans• secured by Portfolio• 5/7 to 10 years
50% In-Kind
Equity Funding
50% Cash
JV Agreement
SPV
OriginatingBank
JV Partner
Portfolio
Compared to Holding the Portfolio, this solution provides:• Leverages the expertise & resources of two JV Partners• Lower upfront proceeds• Medium up-front write-down• Financing risk• Maximum work-out upside / downside• No deconsolidation
Debt Funding
(2) Joint Venture with Pooling
Bank A
Outright sale of Portfolio A
Market Value
Junior Loan A• subordinated security over Portfolio A• 7 to 10 years
25% Funding
25% Funding
SPV
Bank A Bank B
Bank B
Outright sale of Portfolio
B
Market Value
Senior Loan• 1st priority security over Portfolios A & B• 5 to 7 years
Junior Loan B• subordinated security over Portfolio B• 7 to 10 years
Bank B
25%Funding
25%Funding
Joint Management Agreement
Portfolio
(3) Synthetic Sale
OriginatingBank SPV
Investor
1/3 : Financial close
1/3 : 1st year
1/3 : 2nd year
Market Value
Servicing Contract
- Base Fee
- Incentive Fee
Senior Debt
Equity
Premium only
OriginatingBank
(4) Synthetic CLO with CDS
CharitableTrust
100% equity Senior Tranche
• rated bonds• 1st priority security over Collateral • 5 years (callable after 3)• Coupon Bearing
Mezzanine Tranche• unrated bonds• 2nd priority security over Collateral • 7 years• Coupon Bearing
No Credit Event:Zero
Credit Event:Deliver Asset
reference price
Portfolio
SPV
Investors
Investors
CREDIT DEFAULT SWAP:
Funding
Funding
Guarantee
(5) Hybrid CLO with Equity
Portfolio
45% ofequity of
SPV 1
SecuredLoan
7.5% ofequity of
SPV 1
100% ofequity of
SPV 2
CharitableTrust
Senior Tranche• rated bonds• 1st priority security over Loan Receivables• 5 years (callable after 3)• Coupon bearing• Liquidity Facility from OECD Bank
Mezzanine Tranche• rated bonds• 1st priority over 0% RW Assets • 2nd priority security over Loan Receivables• 7 year• Coupon bearing
Junior Tranche•bond/loan/preference shares•subordinated•10 years•zero coupon (cash sweep)
OriginatingBank
Portfolio
OriginatingBank
47.5% ofequity of
SPV 1
Investors
Investors
OriginatingBank
SPV 2SPV 1
Guarantee