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Arcil NPA Seminar - Mumbai 2007
Asset Reconstruction Company (India) Ltd.
Mumbai, February 1th, 2007
NPA Seminar – 2007Excellent Management of Non Performing Assets
Clemens FroweinHLP entwicklungspartner
Arcil NPA Seminar - Mumbai 2007
Evaluation ofNon Performing Assets
Arcil NPA Seminar - Mumbai 2007
Managing Risk in Loan Origination
Managing NPA from a Banks perspective: Evaluation
� Background: NPA in Germany has become a huge story
� The economic value approach relevant for NPA
� Significant relation between credit cost and stage of impairment
� Behind every distressed debt is a crisis
� The challenging task: Finding the path back to Valu e
� Timing is crucial in dealing with NPA
Arcil NPA Seminar - Mumbai 2007
The German NPA case
Insolvency case: Germany� Low equity capital ratio and high outside
capital ratio in small- and mid-capcompanies
� Inflexible legal framework
� Increase in insolvencies in late 1990s
� High saving ratio of consumer
� Value-decrease in the real estatemarket
� Tax privileged and driven real estateinvestments in East Germany, financedby Banks
� Lack of economic growth leadsespecially in East Germany to recession
� Value-decrease of real estate market
� Mortgage loans: from performing tonon-performing
Germany‘s reunification
Dramatic changes in economic framework
In Germany, NPA has become a very important issue f or the banking industry.
Managing NPA from a Banks perspective: Evaluation
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
The German NPA market (2006)
Ernst & Young Mercer Oliver Wyman
€ 300 billion of NPA
€ 125 billion of NPA
€ 35 billion of SPL
€ 160 billion of bad loans
The German NPA case
Managing NPA from a Banks perspective: Evaluation
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Established and dynamic NPA market
� No concrete estimation about market volume possible
� Economic recession ���� Key reason for increase in NPA risks
� NPAs ���� advantages for seller and buyer
� Servicing ���� success key
� Attractive secondary market
� New business field for ARC
…and even more, NPA is becoming a real success story
The German NPA case
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
The four C´of good Credit
- Character
- Capacity
- Covenants
- Collateral
Credit Risk Evaluation
The four C´of bad Credit
- Complacency
- Carelessness
- Communication
- Contingencies
Adage: Every debt is paid, if not by the borrower, by the lender . (But how does a lender pay for borrower defaults?)
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Starting with the Discounted Cashflow (DCF)
Even if the loan is valued in terms of collateral value, the price of the collateral, if it is fair, will reflect the future earnings that will be generated by the collateral assets.
Therefore, the economic value of a loan will decline should there be a change in terms (say, an interest waiver) that reduces expected cash flow, or should the borrower’s credit rating decline so that default probability increases and the risk of loss becomes greater. In other words, the current question of the “economic value of a loan” is the same as the future question of “whether the profits earned on the loan will exceed the expected losses.” To put this yet a different way, loans that do not earn sufficient returns to cover future credit costs result in a decline in economic value.
Market Price of Loans = Future Cash Flow
Economic Value of Loans =
Discounted Present Value of Future Cash Flow(generated by the loan minus the expected loss (credit cost))
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
The Basic Concept of DCF
1. Forecasting future cash flow
2. Calculating default rate and survival rate
Principal and interest
payments in survival
cases
Amount collected from
disposal of collateral
at bankruptcy
Calculating expectation
Year 1 Year 2 Year 3 Year 4 Year 5
Year 1 Year 2 Year 3 Year 4 Year N
Impairment3. Calculating a discounted present value
Book value Economic
value
DCF method for Loan..• uses the original lending interest
rate as the discount rate and there are no changes in value due to subsequent fluctuations in market interest rate.
• looks only at the portion of economic value that has declined to levels below book value and requires the appropriate provisioning against this
• Basically attempts to cover all expected losses throughout the life of the loan.
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Closer look at Credit Quality and Economic Value
Value
Creditquality
Book value
Impairment
Economic value of loans
Generalprovision
SpecificProvisi-
ons
“Normal” borrowers Borrowers that “need attention”
“need special attention”
“in dangerof bankruptcy
“Bankrupt”;“effectively bankrupt”
Specific Provisions
+Partial
write-offs
The appropriate starting point for dealing with NPL is provisions against the impaired economic value.
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Unprofitable Loans become a critical Problem
Bookvalue
Credit quality
Economic value of loans
Impairment
Value“Normal”
Rate
Cause of impairment
Return ratio
Credit cost rate
“need attention” “need special attention”
“Normal” borrowers Borrowers that “need attention”
Borrowers that “need special attention” Credit
qualityNote: Return ratio – lending interest rate – funding rate – the rate of expense
By continuing to make unprofitable loans in order to support borrower companies, the bank saps its own strength.
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Phases of Loan Value Loss
Note: 1. Refer to Morsman (1982), etc.
Stage 1
Stage 2
Stage 3
Stage 4
Stage 5
Virtual periodof workout
The loan officer recognizes deteriorationof credibility, and degrades to Watch List.
Asset value
Time
The bank begins measures towards thebusiness improvement of the borrower
Since workout does not work, the bank considers the shift toliquidation procedures.
The borrower lapses intoliabilities exceeding assets andloss occurs
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Effects of DCF – for resolution / dealing with NPLsImprovement in transparency and governanceEconomic value will increase the transparency of bank accounting and provide investors, creditors, and depositors with information for their decision making. This evaluation method will give banks more discipline & provide them with incentives to pursue more economically rational behavior.
Improvement in earning power of banksSince banks would become more conscious of economic value, they make further efforts to ensure economic value of loans. Such transformation of lending business model to include loan management and NPL disposal would strengthen bank profitability and contribute to the restoration of sound banking.
Faster business rehabilitationAccounting systems that recognize the impairment of the economic value of a loan will require banks to quickly identify rebuilding strategies and take appropriate measures in a timely manner. Early, fast implementation of rebuilding strategies will limit the loss of a borrower’s business resources.
Reallocation of credit risk through secondary marke t for loan assetsWith accounting systems that recognize impairment of economic value through enhanced incentives to deal with NPLs in a timely manner, the secondary market for loan assets expands. Such a market reallocates credit risk rationally, and as a result, efficient risk taking in the whole economy might ensue.
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Issues to be addressed (for Evaluation with DCF)
Improvements to Internal Management AccountingInternal profit evaluations and management accounting shall reflect the economic value of loans. Once changes in the economic value of loans are reflected in the internal performance assessment of lending and screening departments, these departments would have incentive to be conscious of economic value.
Emphasis on Borrower Cash Flow in Loan ScreeningBanks should place more emphasis on cash flow as they screen potential loans, which includes the introduction of screening methods that appropriately evaluate the business value of a proposal.
Lending Framework that responds to Risk ChangesOne method of ensuring an early response to declines in creditworthiness that is used is to attach covenants to the loan contract. Should financial conditions of a borrower deteriorate, the covenants dictate that the loan contract be reviewed to take account of the change in credit quality.
Organizational Framework that permits early ActionIn collaboration with the borrower to make fundamental changes before there is a significant loss in the economic value of the loan. Cutting problem credits off from the credit generation and screening departments (business line) at an early stage.
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Credit Risk Evaluation: Focusing Borrowers Perspect ive
Evaluate a borrower’s ability and willingness to re pay
Three Questions to address:
� What risks are inherent in the operations of the bu siness?
� What have managers done or failed to do in mitigati ng those risks?
� How can a lender structure and control its own risk s?
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Reasons for Distressed Debt
Liquidity crisis
Decrease in sales
Endangered equity
Uncompetitive cost base
Strategic reorientation
Drop in prices
Negative earnings
Safeguard rating
Earnings lower than target
73,9%
69,6%
65,2%
60,9%
56,5%
43,5%
43,5%
13,0%
8,7%
Reasons for distressed debt from banks‘ perspective (% of banks)1)
1) RB Study on German Banks, 2006
Banks identify liquidity crisis, sales decreases an d endangered equity as the most common reasons for distressed debt
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
The dynamics from the corporate perspective
Sco
pe
for
Act
ion
Small
Large
Nee
d f
or
Act
ion
Large
Small
Urgency
Time
STRATEGIC
CRISIS
EARNINGS
CRISIS
LIQUIDITY
CRISIS
INSOLVENCY
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Structural change, e.g. due to� Globalization� Integration� Technology leaps� Shareholder value orientation
Cyclical problems� Drop in demand� Change in the dynamics of
competition� Sales channel switch
Unpredictable changes to themarket/competitive framework� Drop in public-sector demand � Ban on certain products
� Management problems– Ignoring the signs of crisis– Wrong HR policy
� Focus on sales rather than profit
� Growth trap
� Increasing complexity of the product portfolio and customer focus
� Insufficient transparency for corporate control
External causes of crisis Internal causes of crisis
Causes of Corporate Strategic Crisis
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Financials Operations Strategy
Revenue and cost� Revenue, cost and profits by
products, markets, customers� Benchmarking by cost type
(material, person., overhead)� Main causes of losses/risks
Cash flow� Monthly develop. /forecast� Accounts receivable� Inventory� Investment/divestment
Capital structure� Excessive debt/loss of equity� Hidden risks in balance sheet� Need for „fresh money“
Structure� Departments (structure/heads)� Hierarchical levels� Regional coverage� Holding structure
(subsidiaries)
Key processes� Decision-making/ reporting� Value chain (in/outsourcing)� Sales/marketing efficiency� Purchasing efficiency� Production efficiency� Logistics efficiency
Management/ personnel� Qualification� Motivation
Product portfolio� Product mix� Complexity� Innovation� Pricing model
Market and customers� Market segment development� Trends & key success factors� Market access and distribution� Customer and order structure
Competitive position� Existing and potential
competition profiles� Relative positioning (market
share, success factors)
1 2 3
Analysis of the Crisis: Put Your Focus on…
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Mastering Crisis: Most difficult & demanding mgt. t asks
• Problems are so different and situations so complex, there can be no universal remedies for corporate crisis.
• Knowing the strategic and operative causes is key to success and the basis for effective counter-action.
• Major decisions must be made under extreme time pressure.
• A corporate crisis is always a crisis of trust. Therefore, management must show the utmost personal commitment, integrity, stringency , and impeccable behavior.
• Management must be self-critical and open-minded : in the final analysis, most corporate crises are down the management mistakes.
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Liquidity
�Reduce investments to absolute minimum(only essential repairs/replacements)
�Reduce inventories- Lower safety stocks- Dispose of slow movers- Increase quality in delivery
�Reduce accounts receivable- Intensify claim management- Speed up settlement- Push for faster payment terms or
advance payments
�Sell fixed assets- Real estate- Machinery- Holdings
Profitability
�Sales up- Increase prices where possible- Focus sales efforts on customers- Speed up new product launches
�Reduce procurement costs- Lower material/service standard- Negotiate with suppliers- Change suppliers
�Reduce personnel costs- Layoffs/part-time employment- Reduce/waive salary- Stop employment- Reduce overtime
�Reduce overhead costs- Cut travel budgets- Reduce perks- Negotiate interest relief
Regain Value
Regain Corporate Value: Critical Balance for Renewa l
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
� Redefine the product mix
� Reduce complexity costs- Eliminate unprofitable
products- Reduce no. of product
variants- Introduce a modular system
� Identify extra sales and earnings potential- Focus on quality of
customer handling- Enter complementary
markets
� Choose unusual market entry or exit strategy
� Focus on the profitable elements of the value chain
� Develop a business model that creates value
� Optimize business units/ jettison non-core business segments
Product portfolio Target markets Business model
Turning around: The Path back to Value
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Implementation
� Quick wins- Costs down/sales up- Raise cash
� Project organization- Establish strong leadership
and clear responsibilities
� Change management- Regain confidence of
stakeholders and transformmanagement/employees
� Activity management- Monitor progress of action
plans and results in business plan
� Financials- Revenue and cost- Cash flow- Capital structure
� Operations- Structure- Key processes- Management/personnel
� Strategy- Product portfolio- Markets/customers- Competitive position
� Restructuring concept- Financial- Operational- Strategic
� Top-down improvement targets
� Integrated business plan- Base case- Restructuring targets
� Further detailing the restructuring concept
� Bottom-up planning of remedies
Firms „fact book“ Restructuring conecpt Detailed restructuring plan
Phase 1: 4-8 weeks Phase 2: 6-24 months
Turning around: Speed is Key for all Parties
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Successful restructuring projects are fast, require management commitment and affect the entire company
SUCCESSFULRESTRUCTURING
1.
MANAGEMENT COMMITMENTThe most important success factor in restructuring –implementation has room for improvement
2.
HOLISTIC CONCEPT – Strategic, Operational and FinancialVery important (P&L, balance sheet, cashflow, strategy, systems) – implementation has improvement potential
3.
QUICK IMPLEMENTATION – Speed is of essenceRated as very important; but low rate of early warning systems implementation
Turning around: Critical Success Factors
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
To identify a loan as distressed debt, most respond ents rely on their internal early warning systems
Identifying Distressed Debt
Internal early warning systemCredit risk criteria pursuant to Basel IIGeneral default in paymentInconsistent payment behaviorOther
73,9%
52,2%
Mechanisms to identify credit as distressed debt ( % of banks) 1)
1) RB Study on German Banks, 2006
26,1%
8,7%
34,8%
� In identifying a loan as distressed debt, 73,9% of respondents rely on internal early warning systems
� Credit risk criteria pursuant to Basel II are applied in 52,2% of cases
� General default in payment and inconsistent payment behavior are more rarely used as indicators
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
Conclusion:
� Each bank has its unique situation in a loan - recog nize it and reduce uncertainty and stress
� NPL Managers job - view the NPL portfolio like a fun d manager, maximizing the value from the portfolio
� Leaving it to specialists – create NPL management co mpetencies
� Acting decisively , on a commercial basis
� Improved risk management & early warning mechanisms (e.g. early symptoms approach “ common cold or terminal i llness”)
� Relationship management is key – communicate!
Managing NPA from a Banks perspective: Evaluation
Arcil NPA Seminar - Mumbai 2007
NPA Strategy
Arcil NPA Seminar - Mumbai 2007
NPA Strategy - Overview
� Learning from Germany: NPA creates opportunities
� The strategic aim is a win-win situation
� NPA strategy is the path between workout and sell
� Start your transaction strategy by defining what yo u want
� Follow a well defined transaction process
� The different NPA strategies are dealing with stres s management
� Case Study: Berlin Hyp has defined NPA as core-busi ness
Managing NPA from a Banks perspective: Strategy
Arcil NPA Seminar - Mumbai 2007
� Accelerating NPA resolution process and resolution in a tim ebound manner is critical� Activity carried out by banks (work-out group)
and / or
� Through specialized agencies (servicing)
� Role of banks and specialized agencies differ across themarkets depending on level of sophistication of financialmarkets and size of NPA problem
The objective is to achieve the NPA clean-up and th ereby unlock and recycle the capital blocked in NPAs
NPA resolution a strategic imperative for banks
Managing NPA from a Banks perspective: Strategy
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Advantages for banks
Impact of NPAs
� NPAs ���� non core business� High risk potential� Capital locked in unproductive
assets�Impact: (Realizable value of
NPAs * cost of capital p.a.)� Impact on rating � Increase in administration
expenses� Reduced liquidity
Consequence of sale
� Focus on core business� Risk-reduction� Release of capital and improved
liquidity for business growth � Improved market valuation� Aid fresh capital raising� Better rating� Decrease in administration
expenses
Impact on the banks: NPA exit - a “win win situation ”
Managing NPA from a Banks perspective: Strategy
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Selling vs. work-out
Pros - Selling� Cut-off with NPA engagement� Positive balance sheet-effect� Cost effective (especially staff
costs)
Cons - Selling� Loss of possible profitable
foreclosure proceeds� Reputation risks
Impact on the banks: NPA exit - a “win win situation ”
Pros – Work-out� Possible profitable foreclosure
proceeds
� Business relation
� Progressive portfolio management
Cons – Work-out� Work-out is not the core
business
� Increase of staff and administrative costs
� A new start for investors
Managing NPA from a Banks perspective: Strategy
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Investors� Returns commensurate with
risks� Attractive secondary market� Strategic purchase possible� Attractive financing
conditions
Competencies
� NPA ���� core business� Quick decisions� New start� Economies of scale� Rich experience in work-
outs / liquidations� Highly motivated staff
Impact on the banks: NPA exit - a “win win situation ”
Investor Side
Managing NPA from a Banks perspective: Strategy
Arcil NPA Seminar - Mumbai 2007
The NPA Transaction: The starting point
Define what you want
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Decision Preparation Phase
Sale Preparation Phase
Quality Assurance Phase
Sale Process Phase
Data Room Phase
Closing& Execution Phase
The Transaction Process
Critical Phases
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Step 1: Definition of goal
� Step 2: Definition of portfolio
� Step 3: Definition of necessary information
� Step 4: Verifying data sources
� Step 5: Discussion and definition of Transaction St rategies
Decision Preparation Phase
Steps to success
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Risk reduction, optimizing the loan portfolio
� Use core capital to participate in the rising marke t
� Reduction of regulatory capital requirements accord ing to Basel I and II
� Quick liquidity
� Focus management and resources on core business � rather than on work out
� Improved rating – better refinancing possibilities� Tell the market (Rating Agencies) “we deal with it”
Step 1: Define your strategic goals!
NPA StrategyDecision Preparation Phase
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Step 2: Define your portfolio categories!
NPA Strategy
� Non performing loan� The loan agreement has been terminated or can be te rminated
at any time
� Sub performing loan� The loan / borrower needs to be restructured
� Non core business� This asset class is not in our focus (e.g. involvem ent of foreign
jurisdiction, special assets like Airplanes, Ships, IT/IP)
� What suits potential investors� Industrial / commercial / retail� What are the key collaterals� What about unsecured loans
Decision Preparation Phase
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
NPA Strategy
� Pricing information� What does an investor, a rating agency, a servicer need in order to
offer an acceptable price/rating
� Transferability information� There are reasons (legal/ structural/ transaction costs related) that
make any transfer of assets impossible
� Transfer information� Borrower information and loan documentation� Type of collateral� More you disclose, better the realizations
� “Lemon theory”
Information sharing is key to high profits and succ ess
Step 3: Define necessary information – key to obtain better value
Decision Preparation Phase
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
NPA Strategy
Reduction reasons
Queries regarding Sale object & due diligence
100%
Change ininterest
rate
BidderProfit
Necessaryreductions
TransferQueries
Legalstructure
DueDiligence
Transferquestions
RefinancingQueries
Swap /HedgeCosts
PortfolioValuation
• Value adjustment due to variable refinancing intere st
• Expenses of bidder, risk bonus , profit
• Legal enforceability, insolvency questions• Missing (legal) documents (claims, guarantees etc.)
• Limited access, time etc.
• Limitations, Taxes, Transfer charges• Due obligations, claim for damages
• Timing Questions
ContractsContractQueries
• Quality and effectiveness
Taxes • Fair & predictable
OriginalPrincipal
Pricing bridge: Think about potential adjustment to prices
MaximumBid
Price
MinimumBid
Price
Decision Preparation Phase
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
NPA Strategy
Step 4: Define the data sources and structures
� System� Everything that is in the system can be transferred into a
database
� Binder� Anything with respect to collateral information, or iginal
documents needs to be defined and separated
� Knowledge� Is every information needed written down?
Decision Preparation Phase
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
NPA Strategy
Step 5: Define your potential transaction strategy
Impact on stake holder confidence
Hold & manage(Workouts /
Private Restructurings)
• Bank has 100% risk
• Bank needs significant resources & financial commitment to hold assets
Securitization (ABS)
Joint Venture Asset sale(Bulk / Single Asset,
Negotiated)
•Diversification of risk
•Immediate capitalinjection; Market liquidity
•Lower cost of capitaland greater availability
•Transactions with creditenhancements arerelatively easy
•Work out is still in the bank
•Upside potential
•Recapitalizes bank
•Equity Partnerassumes pro-rata risk
•Immediate capitalinjection
•Highly qualified &incentives assetmanagement
•Positive marketperception
•Upside participation
• Buyer assumes 100% of NPA risk
• Low recovery prices
• No upside participation
Low
Bank Divests100% of NPA Risk
Bank Retains100% of NPA Risk
High Low
High
Decision Preparation Phase
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Sale strategies: Goal - Benefits analysis
Outright Sale
Off
Release
Yes
No
Variable
Yes
Balance Sheet
Regulatory Capital
Outsourcing
Liquidity
UpsidePotential
Risk Transfer
Joint Venture
Depends onthe structure
Depends onthe structure
Partly
Partly
Variable
Partly
SyntheticSale
On
Release
No
Depends onthe structure
Variable
Yes
ABS TrueSale
Off
Release
Yes
Yes
Variable
Yes
HiveDown
Off
Release
Yes
Yes
Variable
Yes
Bar Sub-Participation
Yes
Yes
Yes
Depends onthe structure
Variable
Yes
Third partyWorkoutVehicle
Yes
Yes
Yes
Yes
structure
Yes depending on
structure
Variable
Yes
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Final definition of sale structure
� Impact on balance sheet and tax
� Data gathering and information packaging
� Decide on the sale process (bilateral, auction – wid e or limited)
Sale Preparation Phase
Sale preparation phase
NPA Transaction Process
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Quality review
� Finalize representations and warranties
� Third party discussions
QualityAssurancePhase
Quality assurance phase
NPA Transaction Process
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Organisation of Data Rooms
� Organisation of Q&A Process
� Set up of Confidentiality Agreement and Confidentia l Information Memorandum
� Definition of investors to be invited
� Pre – Invitation discussions with investors
� Draft of Sale and Purchase Agreement
SaleProcessPhase
Sale process phase
NPA Transaction Process
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Advise during Data Room Phase / Q&A Process
� Negotiation and finalisation of SPA and schedules
� Finalisation of bid sheet documents (bid letter, bi d sheet, bid process)
� Internal organisation of transfer
Data room phase
DataRoomPhaseNPA Transaction Process
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Bid comparison
� Signing and closing
� Interim servicing
� Transfer of loan files
� Transfer of assets
� Hello and good bye letter
Closing &ExecutionPhase
Closing & execution phase
NPA Transaction Process
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� To deal with distressed assets / impaired loans / N PAs / SPLs / non core is vital for banks� Management bandwidth � Rating� Regulatory core capital
� There are different options for bank� Straight–forward disposal� Joint venture� Hive down� ABS
One option does not exist: Not solving the question s around loans that should not be in the books
Summery
Managing NPA from a Banks perspective: Strategy
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Managing Stress in the Banks Balance Sheet*
NLP Management in Berlin Hyp;
* Presented by Bernd Morgenschweis at the Arcil NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: The Situation in Berlin Hyp
Income statement (in € million) 2005 2004
Net interest income 222.3 227.0
Personnel costs 36.1 33.8
Other operating expenditure 30.7 37.1
Depreciation on tangible assets 8.2 5.3
Operating expenditure 75.0 76.2
Risk provisioning 91.3 105.1
Operating result 57.7 45.6
Tax 9.0 6.6
Annual surplus36.7 24.8
Key figures
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: The Situation in Berlin HypKey figures
Business development (in € million) 2005 2004
New loan commitments 8,551 2,219
Mortgages 1,475 850
of which: Residential Loans 551 427
Commercial lending 924 423
Public sector business 7,076 1,369
Loan disbursements 8,666 1,982
of which: Mortgages 1,586 584
Public sector loans 7,080 1,398
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: The Situation in Berlin Hyp
� Solutions for EverythingBerlin Hyp offers their customers tailor-made finan cing solutions characterised by
competitive terms high product flexibility
swift decisions reliability and quality
� Guidelines of our Work� Sustaining capacity for change � Seizing opportunities � Maintaining continuity� Increasing competence � Rising to challenges
The profile
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Where Stress comes from
� Bad loans were a major part of balance sheet
� Most of them without interest / profit
� Negative outlook (fall in collaterals in the east o f Germany)
� Position on “risk provisioning” was negative in the discussion with the rating agencies (1.6 bill. € as 12/05)
� The “Bad Loan Team” needs more and more staff –operational expenses are growing
� NPA Market in Germany was booming – so there was a c hance to reduce the risk portfolio faster than expected a t acceptable prices
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Where Stress comes from
Global Aspects:
� Abolition of the German Mortgage Act (modification of legal basics) – Market and regulatory forces
Refinancing advantages (Monopoly to issue mortgage bonds)dropped out – consequence: We are in stiff competition with a lot of other Ger man banks !
� An over saturated banking market enforces consolida tion in order to stabilise and increase margins
Adequate margins as a result of risk-oriented prici ng methods
Identify the main “risk drivers” and analyse the bad loan cost’s
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Where Stress comes from
� Increasing importance of the capital market and consequent lymore pressure to enhance interest margins and to reduce badloans
Optimise the portfolio structure: push good loans – and:Adjust portfolio by outsourcing or selling non performing l oans
� Pressure due to Basel II regarding the obligation of providi nga risk adjusted equity
Develop and implement a conservative Credit-Risk-Strateg y fornew lending business (stop increase in risk portfolio)Reduce the risk loan portfolio – to cut cost (employees,operating, risk) and save equity-costs
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
The burning issue:
Optimise your Portfolio, reduce the mountain of bad debt and increase
the value of your company !!!
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
Strategic goals defined for NPA Management
� Reduction of loan risks (transfer of risks) leads t o an adjustment of the balance sheet and to more transparency
Market knows – your balance sheet is in good order an d there are no hidden risk positionsPositive influence on the evaluation of rating agen cies
� Gain of liquidity resulting from a lower amount of equity required owing to Basel II
� Increased profits / potential profits due to phase- out of interest-free loans (non profit risk assets)
switch the interest free assets (sell them off) to interest-bearing assets (work with the purchase price – issue new loans)
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
� Focusing the existing work out competence on proble matical cases with profit-yielding
� Cutback of resources needed in the work-out field ( no core business)
Performance and profit determines actionsIt’s important to distinguish between “dead loans” (there is no chance to get the money back) and “distressed lo ans” (there is a positive view on recovery)
Reducing the bad loan portfolio offers the chance t o make the employees in the work out group redundant (cut cost)
Strategic goals defined for NPA Management
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
� No more provisions caused by a declined loan qualit y
Selling - reduces the risk of the insecure exposures- eliminates the possibility of future risk (fall in value of
securities)
� Bull market constantly demands results at higher pr ices
The higher the price for bad loans - the bigger the profit forthe company – at the moment a perfect market in Germ any!
Highly liquid foreign investors dominate the marke t
� Positive external effects of being proactive in pro blem solving
Strategic goals defined for NPA Management
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
Critical Points
� Quality of data / Need for resources
Investors need a lot of information about the loan (in details history of life of the loan, securities, valuation, etc.)
Is the data of high quality or is there further maintenance necessary?
� Question whether the transaction is legally allowed
Sub-performing or non performing loan (banking confidentiality) ?
� Sufficient minimum volume of the identified portfol io in order to be profitable both for the seller and for the buyer
??
??
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
Critical Points
!!
??
� Sufficient shielding / appraisable securities
Crucial!!! If the investor pays only 40% of the loan and you need more – the transaction / the closing is at risk!
� Individual analysis vs analysis of the portfolio
Enough collateral / provision / depreciation in detail or in total ?
Portfolio selection OK or several critical loans ?
� Before doing the “go-to-market” check the values in order to be sure that the buyer won´t cancel the deal
Reputation risk!!!
??
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
Critical Points
� What sort of cash flow is expected
Check the projected loan cash flow – OK in relation to assumed price?
The more cash flow – the higher the price!
Is there upside potential ? => price in!
� Warranties / tax issues?
� No special commercial transaction structure (pool o f securities / syndicated loans / public guarantees)!
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Preparing the dealPreparing the deal
Dealprocess
Dealprocess
ClosingClosingFundamentaldecisionFundamentaldecision
� Confidentiality statement
� Information letter with procedure details
� Opening of the Data room
� In house Portfolio Valuation
� Projecting the Due Diligence
� Investor selection (long list)
� Setup Data room (equipment and security)
� Portfolio-Identification
� Check the in-house effects
� Portfolio-Clustering
� Board decision
� Bid analysis
� Accept the tender (best price)
� In-house decision
� Conclusion of the contract
� Transfer (loans) to the new owner
Process of the deal
Case Study: Strategy of Berlin Hyp
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Fundamental Decision (1/3)
Portfolio-Identification
� Performing/ sub-performing /non-performing ?
� Strategic/ non strategic ?
� Depreciation/ interest arrear /interest-free?
Berlin Hyp Project:
� 200 non performing loans, volume 500 Million €
� Most of them interest-free and cancelled by the bank
� Selected in two deals:• Retail portfolio
(80 customers, loan volume 50 mil. €)
• Mixed portfolio(120 customers, loan volume 450 mil. €) residential and commercial properties
Case Study: Strategy of Berlin Hyp
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Fundamental Decision (2/3)
Case Study: Strategy of Berlin Hyp
Check the in-house effects– Data quality OK or is there
“homework” to do? (scheduling time/man-power/requirements)
– Adequate collaterals/ depreciation? Upside potential?
– Find the balance: loss of interest ���� rise in depreciation
– Check number of employees – reduction in staff feasible?
Berlin Hyp Project:– Fill 350 data fields for 1 customer,
thereof only ∅∅∅∅ 150 OK– Check 200 loans for adequate
collaterals / depreciation (220 new valuations by the surveyor in 2 months)
– 620 hours of external help from a temporary employment agency(e.g.: scanning 22.000 pages loan documents)
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Fundamental Decision (3/3)
Case Study: Strategy of Berlin Hyp
Portfolio Clustering
– Local / international / geographical bundling
– Residential / commercial / retail Loans
– Board decision
– Based on: full report with all the advantages and disadvantages
– Discussion over all the pros and cons
– Final decision
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Preparing the Deal (1/2)
Case Study: Strategy of Berlin Hyp
In house Portfolio Valuation– Result of the portfolio check – what’s the realistic price?– Can we sell the portfolio at this price (reputation risk)?– Why can’t we manage the problem by ourselves (experience)?– What is our economic valuation of the property market in the near future?
Projecting the Due Diligence – Appoint a legal advisor or a consultant for the deal– Prepare all the legal documents and check them carefully (the data in the
system must be the same as in the files !)– Prepare the agreement for sale (with all details)
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Case Study: Strategy of Berlin Hyp
• Investor selection (long list)– Select the potential investors (by yourself or thro ugh an advisor)
• Setup Data Room
Berlin Hyp Project:� 5 identical Data rooms in 5 different buildings equipped with 25 workstations (telephone,
internet, computer)� Catering and security company for every room� 1 virtual Data room by internet arranged (Retail Portfolio)� 1,400 files – filled with the important loan information� 35,000 loose divider copies in the files well-organized � 22,000 loan documents scanned for the internet Portfolio
Preparing the Deal (2/2)
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Confidentiality statement� Prerequisite !!!
� Information letter with procedure details� Telephone list with the people who are responsible
� Opening Data room� Welcoming the auditors� Clear the procedure to update the information base� Check the schedule for the question and answer proc ess
Berlin Hyp Project:� 2,100 Q+A – managed by the loan specialists� Every week a “loan officer call” (ten biggest loans )� Response time: within 72 hours
The Deal Process (2/2)
Case Study: Strategy of Berlin Hyp
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� Bid analysis / Accept the tender (best price)� Which is the company with the highest price?
� In house decision� Check the pros and cons and say: The winner is: …..
� Conclusion of the contract� Finalize the deal with the conclusion of the agreem ent
� Transfer (loans) to the new owner� Send a letter to all customers with brief informati on about the finalised deal
and the transition to the new loan-owner� Order a lorry ( ☺☺☺☺) and transfer the complete files to the owner
Berlin Hyp Project:� closed both deals with “Deutsche Bank London”� a significant decrease in the bad loan portfolio
Case Study: Strategy of Berlin HypThe Closing
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� A fundamental reduction in the bad loan portfolio r esulting in a large profit (purchase price higher than expected)
� A positive attestation by the rating agencyThe internationally renowned rating agency Moody's has awarded the bank's mortgage bonds the good rating A a1. This is evidence of good structure of the assets serving a s collateral and the progress the bank has made in optimising its ri sk profile. Berlin Hyp already has two independent rating resul ts with the top “Triple-A-Rating” for its public mortgage bonds.
• Reduction in staff
Case Study: Strategy of Berlin Hyp
Review on the Goals
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
� NPA Portfolio deals are presently our core business in a booming market
� International investors’ interest in NPA business has continued to grow steadily – on top of that: this brings a lot of fresh money to the German market
� Probably the next step is to restructure these portfolios and sell them back to new customers
� Selling all these critical loans result in an optimal balance sheet. This brings on the one hand positive feedback from the rating agencies and on the other hand room and flexibility for new loans
� Following the positive experience, Berlin Hyp is preparing the next (4th) bad loans Portfolio deal (300 – 500 mil. €)
Case Study: Strategy of Berlin Hyp
The Outlook
Case Study: The Berlin Hyp
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
Thank You
Managing NPA from a Banks perspective: Strategy
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