3. Managing NPA from a Banks perspective: Evaluation
Managing Risk in Loan Origination
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 Value
Timing is crucial in dealing with NPA
Arcil NPA Seminar - Mumbai 2007
4. Managing NPA from a Banks perspective: Evaluation
The German NPA case
In Germany, NPA has become a very important issue for the
banking industry.
Germany‘s reunification Insolvency case: Germany
Tax privileged and driven real estate Low equity capital ratio and high outside
investments in East Germany, financed capital ratio in small- and mid-cap
by Banks companies
Lack of economic growth leads Inflexible legal framework
especially in East Germany to recession
Increase in insolvencies in late 1990s
Value-decrease of real estate market
High saving ratio of consumer
Mortgage loans: from performing to
Value-decrease in the real estate
non-performing
market
Dramatic changes in economic framework
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
5. Managing NPA from a Banks perspective: Evaluation
The German NPA case
The German NPA market (2006)
Ernst & Young Mercer Oliver Wyman
€ 35 billion of SPL
€ 300 billion of NPA
€ 125 billion of NPA
€ 160 billion of bad loans
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
6. Managing NPA from a Banks perspective: Evaluation
The German NPA case
…and even more, NPA is becoming a real success story
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
Arcil NPA Seminar - Mumbai 2007
7. Managing NPA from a Banks perspective: Evaluation
Credit Risk Evaluation
Adage: Every debt is paid, if not by the borrower, by the lender.
(But how does a lender pay for borrower defaults?)
The four C´of good Credit The four C´of bad Credit
- Character - Complacency
- Capacity - Carelessness
- Covenants - Communication
- Collateral - Contingencies
Arcil NPA Seminar - Mumbai 2007
8. Managing NPA from a Banks perspective: Evaluation
Starting with the Discounted Cashflow (DCF)
Market Price of Loans = Future Cash Flow
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.
Economic Value of Loans
=
Discounted Present Value of Future Cash Flow
(generated by the loan minus the expected loss (credit cost))
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.
Arcil NPA Seminar - Mumbai 2007
9. Managing NPA from a Banks perspective: Evaluation
The Basic Concept of DCF
1. Forecasting future cash flow
DCF method for Loan..
• uses the original lending interest
2. Calculating default rate and survival rate rate as the discount rate and
Calculating expectation there are no changes in value
Principal and interest due to subsequent fluctuations
payments in survival
cases
in market interest rate.
Amount collected from
• looks only at the portion of
disposal of collateral economic value that has
at bankruptcy
declined to levels below book
value and requires the
Year 1 Year 2 Year 3 Year 4 Year 5 appropriate provisioning against
this
3. Calculating a discounted present value • Basically attempts to cover all
Impairment
expected losses throughout the
life of the loan.
Book value Economic Year 1 Year 2 Year 3 Year 4 Year N
value
Arcil NPA Seminar - Mumbai 2007
10. Managing NPA from a Banks perspective: Evaluation
Closer look at Credit Quality and Economic Value
Value The appropriate starting point for dealing with NPL
is provisions against the impaired economic value.
Book value
General
provision
Specific Specific
Provisi- Provisions
ons +
Impairment Partial
write-offs
Economic value of loans
Credit
quality
“Normal” borrowers Borrowers that
“need attention” “Bankrupt”;
“need “in danger “effectively
special attention” of bankruptcy bankrupt”
Arcil NPA Seminar - Mumbai 2007
11. Managing NPA from a Banks perspective: Evaluation
Unprofitable Loans become a critical Problem
Rate Credit cost
By continuing to make
rate
unprofitable loans in
order to support
Return
ratio
borrower companies,
the bank saps its own
Cause of strength.
impairment
“Normal” “need attention” “need Credit
Value special attention” quality
Book Impairment
value
Economic value of
loans
“Normal” borrowers Borrowers that “need Borrowers that “need
attention” special attention” Credit
quality
Note: Return ratio – lending interest rate – funding rate – the rate of expense
Arcil NPA Seminar - Mumbai 2007
12. Managing NPA from a Banks perspective: Evaluation
Phases of Loan Value Loss
Asset
value The loan officer recognizes deterioration
of credibility, and degrades to Watch List.
The bank begins measures towards the
Stage 1 business improvement of the borrower
Stage 2
Virtual period
of workout
Stage 3
Since workout does not work,
Stage 4 the bank considers the shift to
liquidation procedures.
The borrower lapses into
Stage 5 liabilities exceeding assets and
loss occurs
Time
Note: 1. Refer to Morsman (1982), etc.
Arcil NPA Seminar - Mumbai 2007
13. Managing NPA from a Banks perspective: Evaluation
Effects of DCF – for resolution / dealing with NPLs
Improvement in transparency and governance
Economic 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 banks
Since 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 rehabilitation
Accounting 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 market for loan assets
With 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.
Arcil NPA Seminar - Mumbai 2007
14. Managing NPA from a Banks perspective: Evaluation
Issues to be addressed (for Evaluation with DCF)
Improvements to Internal Management Accounting
Internal 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 Screening
Banks 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 Changes
One 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 Action
In 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.
Arcil NPA Seminar - Mumbai 2007
15. Managing NPA from a Banks perspective: Evaluation
Credit Risk Evaluation: Focusing Borrowers Perspective
Evaluate a borrower’s ability and willingness to repay
Three Questions to address:
What risks are inherent in the operations of the business?
What have managers done or failed to do in mitigating those risks?
How can a lender structure and control its own risks?
Arcil NPA Seminar - Mumbai 2007
16. Managing NPA from a Banks perspective: Evaluation
Reasons for Distressed Debt
Reasons for distressed debt from banks‘ perspective (% of banks)1)
Liquidity crisis 73,9%
Decrease in sales 69,6%
Endangered equity 65,2%
Uncompetitive cost base 60,9%
Strategic reorientation 56,5%
Drop in prices 43,5%
Negative earnings 43,5%
Safeguard rating 13,0%
Earnings lower than target 8,7%
1) RB Study on German Banks, 2006
Banks identify liquidity crisis, sales decreases and endangered equity as the most
common reasons for distressed debt
Arcil NPA Seminar - Mumbai 2007
17. Managing NPA from a Banks perspective: Evaluation
The dynamics from the corporate perspective
Urgency
Small Large
INSOLVENCY
LIQUIDITY
Scope for Action
CRISIS
Need for Action
EARNINGS
CRISIS
STRATEGIC
CRISIS
Large Small
Time
Arcil NPA Seminar - Mumbai 2007
18. Managing NPA from a Banks perspective: Evaluation
Causes of Corporate Strategic Crisis
External causes of crisis Internal causes of crisis
Structural change, e.g. due to Management problems
Globalization – Ignoring the signs of crisis
Integration – Wrong HR policy
Technology leaps
Shareholder value orientation Focus on sales rather than
profit
Cyclical problems
Drop in demand Growth trap
Change in the dynamics of
competition Increasing complexity of
Sales channel switch the product portfolio and
customer focus
Unpredictable changes to the
market/competitive framework Insufficient transparency
Drop in public-sector demand for corporate control
Ban on certain products
Arcil NPA Seminar - Mumbai 2007
19. Managing NPA from a Banks perspective: Evaluation
Analysis of the Crisis: Put Your Focus on…
1 2 3
Financials Operations Strategy
Revenue and cost Structure Product portfolio
Revenue, cost and profits by Departments (structure/heads) Product mix
products, markets, customers Hierarchical levels Complexity
Benchmarking by cost type Regional coverage Innovation
(material, person., overhead) Holding structure Pricing model
Main causes of losses/risks (subsidiaries)
Market and customers
Cash flow Key processes Market segment development
Monthly develop. /forecast Decision-making/ reporting Trends & key success factors
Accounts receivable Value chain (in/outsourcing) Market access and distribution
Inventory Sales/marketing efficiency Customer and order structure
Investment/divestment Purchasing efficiency
Production efficiency Competitive position
Capital structure Logistics efficiency Existing and potential
Excessive debt/loss of equity competition profiles
Hidden risks in balance sheet Management/ personnel Relative positioning (market
Need for „fresh money“ Qualification share, success factors)
Motivation
Arcil NPA Seminar - Mumbai 2007
20. Managing NPA from a Banks perspective: Evaluation
Mastering Crisis: Most difficult & demanding mgt. tasks
• 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.
Arcil NPA Seminar - Mumbai 2007
21. Managing NPA from a Banks perspective: Evaluation
Regain Corporate Value: Critical Balance for Renewal
Liquidity Profitability
Sales up
Reduce investments to absolute - Increase prices where possible
minimum - Focus sales efforts on customers
(only essential repairs/replacements) - Speed up new product launches
Reduce inventories Reduce procurement costs
- Lower safety stocks - Lower material/service standard
Regain
- Dispose of slow movers - Negotiate with suppliers
- Increase quality in delivery Value - Change suppliers
Reduce accounts receivable Reduce personnel costs
- Intensify claim management - Layoffs/part-time employment
- Speed up settlement - Reduce/waive salary
- Push for faster payment terms or - Stop employment
advance payments - Reduce overtime
Reduce overhead costs
Sell fixed assets
- Cut travel budgets
- Real estate
- Reduce perks
- Machinery
- Negotiate interest relief
- Holdings
Arcil NPA Seminar - Mumbai 2007
22. Managing NPA from a Banks perspective: Evaluation
Turning around: The Path back to Value
Redefine the product Identify extra sales and Focus on the profitable
mix earnings potential elements of the value
- Focus on quality of chain
Reduce complexity customer handling
costs - Enter complementary Develop a business
- Eliminate unprofitable markets model that creates
products value
- Reduce no. of product Choose unusual market
variants entry or exit strategy Optimize business
- Introduce a modular units/ jettison non-core
system business segments
Product portfolio Target markets Business model
Arcil NPA Seminar - Mumbai 2007
23. Managing NPA from a Banks perspective: Evaluation
Turning around: Speed is Key for all Parties
Phase 1: 4-8 weeks Phase 2: 6-24 months
Firms „fact book“ Restructuring conecpt Detailed restructuring plan
Financials Restructuring
Further detailing
- Revenue and cost concept
- Cash flow - Financial the restructuring
- Capital structure - Operational concept
- Strategic
Operations Bottom-up
- Structure Top-down planning of
- Key processes improvement remedies
- Management/personnel
targets
Strategy
- Product portfolio Integrated business
Change management
- Markets/customers plan
- Regain confidence of
- Competitive position - Base case
stakeholders and transform
- Restructuring targets
management/employees
Implementation
Quick wins Project organization Activity management
- Costs down/sales up - Establish strong leadership - Monitor progress of action
- Raise cash and clear responsibilities plans and results in business plan
Arcil NPA Seminar - Mumbai 2007
24. Managing NPA from a Banks perspective: Evaluation
Turning around: Critical Success Factors
MANAGEMENT COMMITMENT
The most important success factor in restructuring –
implementation has room for improvement
1.
HOLISTIC CONCEPT – Strategic, Operational and
Financial
Very important (P&L, balance sheet, cashflow, strategy,
systems) – implementation has improvement potential
2. SUCCESSFUL
RESTRUCTURING
QUICK IMPLEMENTATION – Speed is of essence
Rated as very important; but low rate of early warning
systems implementation
3.
Successful restructuring projects are fast, require management commitment
and affect the entire company
Arcil NPA Seminar - Mumbai 2007
25. Managing NPA from a Banks perspective: Evaluation
Identifying Distressed Debt
Mechanisms to identify credit as distressed debt (% of banks)1)
In identifying a loan as
Internal early distressed debt, 73,9%
warning system 73,9%
of respondents rely on
Credit risk criteria internal early warning
52,2% systems
pursuant to Basel II
General default in Credit risk criteria
26,1% pursuant to Basel II are
payment
applied in 52,2% of
Inconsistent cases
8,7%
payment behavior
General default in
Other 34,8% payment and
inconsistent payment
behavior are more rarely
used as indicators
1) RB Study on German Banks, 2006
To identify a loan as distressed debt, most respondents rely on their
internal early warning systems
Arcil NPA Seminar - Mumbai 2007
26. Managing NPA from a Banks perspective: Evaluation
Conclusion:
Each bank has its unique situation in a loan - recognize it and
reduce uncertainty and stress
NPL Managers job - view the NPL portfolio like a fund manager,
maximizing the value from the portfolio
Leaving it to specialists – create NPL management competencies
Acting decisively , on a commercial basis
Improved risk management & early warning mechanisms (e.g.
early symptoms approach “ common cold or terminal illness”)
Relationship management is key – communicate!
Arcil NPA Seminar - Mumbai 2007
28. Managing NPA from a Banks perspective: Strategy
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 you want
Follow a well defined transaction process
The different NPA strategies are dealing with stress management
Case Study: Berlin Hyp has defined NPA as core-business
Arcil NPA Seminar - Mumbai 2007
29. Managing NPA from a Banks perspective: Strategy
NPA resolution a strategic imperative for banks
Accelerating NPA resolution process and resolution in a time
bound 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 the
markets depending on level of sophistication of financial
markets and size of NPA problem
The objective is to achieve the NPA clean-up and thereby unlock
and recycle the capital blocked in NPAs
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
30. Managing NPA from a Banks perspective: Strategy
Impact on the banks: NPA exit - a “win win situation”
Advantages for banks
Impact of NPAs Consequence of sale
NPAs non core business Focus on core business
High risk potential Risk-reduction
Capital locked in unproductive Release of capital and improved
assets liquidity for business growth
Impact: (Realizable value of Improved market valuation
NPAs * cost of capital p.a.) Aid fresh capital raising
Impact on rating Better rating
Increase in administration Decrease in administration
expenses expenses
Reduced liquidity
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
31. Managing NPA from a Banks perspective: Strategy
Impact on the banks: NPA exit - a “win win situation”
Selling vs. work-out
Pros - Selling Cons - Selling
Cut-off with NPA engagement Loss of possible profitable
Positive balance sheet-effect foreclosure proceeds
Cost effective (especially staff Reputation risks
costs)
Pros – Work-out Cons – Work-out
Possible profitable foreclosure Work-out is not the core
proceeds business
Business relation Increase of staff and
Progressive portfolio administrative costs
management A new start for investors
Source: Prof. Dr. Schalast, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
32. Managing NPA from a Banks perspective: Strategy
Impact on the banks: NPA exit - a “win win situation”
Investor Side
Investors Competencies
Returns commensurate with
risks NPA core business
Attractive secondary market Quick decisions
Strategic purchase possible New start
Attractive financing Economies of scale
conditions Rich experience in work-
outs / liquidations
Highly motivated staff
Arcil NPA Seminar - Mumbai 2007
33. Managing NPA from a Banks perspective: Strategy
The NPA Transaction: The starting point
Define what you want
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
34. Managing NPA from a Banks perspective: Strategy
Critical Phases
The Transaction Process
Decision Sale Quality Sale Data Closing&
Preparation Preparation Assurance Process Room Execution
Phase Phase Phase Phase Phase Phase
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
35. Managing NPA from a Banks perspective: Strategy
Decision
Steps to success Preparation
Phase
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 Strategies
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
36. Managing NPA from a Banks perspective: Strategy
Decision
NPA Strategy Preparation
Phase
Step 1: Define your strategic goals!
Risk reduction, optimizing the loan portfolio
Use core capital to participate in the rising market
Reduction of regulatory capital requirements according 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”
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
37. Managing NPA from a Banks perspective: Strategy
Decision
NPA Strategy Preparation
Phase
Step 2: Define your portfolio categories!
Non performing loan
The loan agreement has been terminated or can be terminated
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. involvement 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
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
38. Managing NPA from a Banks perspective: Strategy
Decision
NPA Strategy Preparation
Phase
Step 3: Define necessary information – key to obtain
better value
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 success
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
39. Managing NPA from a Banks perspective: Strategy
Decision
NPA Strategy Preparation
Phase
Pricing bridge: Think about potential adjustment to prices
100% Reduction reasons
Change in
interest • Value adjustment due to variable refinancing interest
Maximum rate
Necessary
Bid Bidder reductions
Price Profit
• Expenses of bidder, risk bonus , profit
Legal • Legal enforceability, insolvency questions
Queries
structure • Missing (legal) documents (claims, guarantees etc.) regarding
Sale object &
Due
• Limited access, time etc. due diligence
Diligence
Original Transfer • Limitations, Taxes, Transfer charges Transfer
Principal questions • Due obligations, claim for damages Queries
Swap / Refinancing
Hedge • Timing Questions Queries
Costs
• Quality and Contract
Contracts
effectiveness Queries
Minimum Taxes • Fair & predictable
Bid
Price
Portfolio
Valuation
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
40. Managing NPA from a Banks perspective: Strategy
Decision
NPA Strategy Preparation
Phase
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, original
documents needs to be defined and separated
Knowledge
Is every information needed written down?
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
41. Managing NPA from a Banks perspective: Strategy
Decision
NPA Strategy Preparation
Phase
Step 5: Define your potential transaction strategy
Bank Retains Bank Divests
100% of NPA Risk 100% of NPA Risk
High Low
Hold & manage Securitization Joint Venture Asset sale
(Workouts / (ABS) (Bulk / Single Asset,
Private Restructurings) Negotiated)
• Bank has 100% risk •Diversification of risk •Recapitalizes bank • Buyer assumes
100% of NPA risk
•Immediate capital •Equity Partner
• Bank needs significant injection; Market liquidity assumes pro-rata risk
resources & financial •Lower cost of capital •Immediate capital • Low recovery
commitment to hold and greater availability injection prices
assets
•Transactions with credit •Highly qualified &
enhancements are incentives asset • No upside
relatively easy management participation
•Work out is still in the •Positive market
bank perception
•Upside potential •Upside participation
Low Impact on stake holder confidence High
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
42. Managing NPA from a Banks perspective: Strategy
Sale strategies: Goal - Benefits analysis
Third party
Outright Synthetic ABS True Hive Bar Sub-
Joint Venture Workout
Sale Sale Sale Down Participation
Vehicle
Risk Transfer Yes Partly Yes Yes Yes Yes Yes
Depends on
Balance Sheet Off On Off Off Yes Yes
the structure
Depends on
Regulatory Capital Release Release Release Release Yes Yes
the structure
Liquidity Yes Partly No Yes Yes Yes Yes
Yes
Upside Depends on Depends on
No Partly Yes Yes depending on
Potential the structure the structure structure
Outsourcing Variable Variable Variable Variable Variable Variable Variable
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
43. Managing NPA from a Banks perspective: Strategy
Sale
NPA Transaction Process Preparation
Phase
Sale preparation phase
Final definition of sale structure
Impact on balance sheet and tax
Data gathering and information packaging
Decide on the sale process (bilateral, auction – wide or
limited)
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
44. Managing NPA from a Banks perspective: Strategy
Quality
NPA Transaction Process Assurance
Phase
Quality assurance phase
Quality review
Finalize representations and warranties
Third party discussions
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
45. Managing NPA from a Banks perspective: Strategy
Sale
NPA Transaction Process Process
Phase
Sale process phase
Organisation of Data Rooms
Organisation of Q&A Process
Set up of Confidentiality Agreement and Confidential
Information Memorandum
Definition of investors to be invited
Pre – Invitation discussions with investors
Draft of Sale and Purchase Agreement
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
46. Managing NPA from a Banks perspective: Strategy
Data
NPA Transaction Process Room
Phase
Data room phase
Advise during Data Room Phase / Q&A Process
Negotiation and finalisation of SPA and schedules
Finalisation of bid sheet documents (bid letter, bid sheet, bid
process)
Internal organisation of transfer
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
47. Managing NPA from a Banks perspective: Strategy
Closing &
NPA Transaction Process Execution
Phase
Closing & execution phase
Bid comparison
Signing and closing
Interim servicing
Transfer of loan files
Transfer of assets
Hello and good bye letter
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
48. Managing NPA from a Banks perspective: Strategy
Summery
To deal with distressed assets / impaired loans / NPAs / 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 questions
around loans that should not be in the books
Source: Mr. Peter Jark, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
49. 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
50. Case Study: The Berlin Hyp
Case Study: The Situation in Berlin Hyp
Key figures
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 surplus
36.7 24.8
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
51. Case Study: The Berlin Hyp
Case Study: The Situation in Berlin Hyp
Key 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
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
52. Case Study: The Berlin Hyp
Case Study: The Situation in Berlin Hyp
The profile
Solutions for Everything
Berlin Hyp offers their customers tailor-made financing 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
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
53. Case Study: The Berlin Hyp
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 of 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 chance
to reduce the risk portfolio faster than expected at acceptable
prices
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
54. Case Study: The Berlin Hyp
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 German banks !
An over saturated banking market enforces consolidation in
order to stabilise and increase margins
Adequate margins as a result of risk-oriented pricing methods
Identify the main “risk drivers” and analyse the bad loan cost’s
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
55. Case Study: The Berlin Hyp
Case Study: Where Stress comes from
Increasing importance of the capital market and consequently
more pressure to enhance interest margins and to reduce bad
loans
Optimise the portfolio structure: push good loans – and:
Adjust portfolio by outsourcing or selling non performing loans
Pressure due to Basel II regarding the obligation of providing
a risk adjusted equity
Develop and implement a conservative Credit-Risk-Strategy for
new lending business (stop increase in risk portfolio)
Reduce the risk loan portfolio – to cut cost (employees,
operating, risk) and save equity-costs
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
56. Case Study: The Berlin Hyp
The burning issue:
Optimise your Portfolio,
reduce the mountain of
bad debt and increase
the value of
your company !!!
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
57. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Strategic goals defined for NPA Management
Reduction of loan risks (transfer of risks) leads to an adjustment
of the balance sheet and to more transparency
Market knows – your balance sheet is in good order and
there are no hidden risk positions
Positive influence on the evaluation of rating agencies
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)
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
58. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Strategic goals defined for NPA Management
Focusing the existing work out competence on problematical
cases with profit-yielding
Cutback of resources needed in the work-out field (no core
business)
Performance and profit determines actions
It’s important to distinguish between “dead loans” (there is
no chance to get the money back) and “distressed loans”
(there is a positive view on recovery)
Reducing the bad loan portfolio offers the chance to make
the employees in the work out group redundant (cut cost)
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
59. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Strategic goals defined for NPA Management
No more provisions caused by a declined loan quality
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 prices
The higher the price for bad loans - the bigger the profit for
the company – at the moment a perfect market in Germany!
Highly liquid foreign investors dominate the market
Positive external effects of being proactive in problem solving
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
60. Case Study: The Berlin Hyp
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 portfolio in order to be
profitable both for the seller and for the buyer
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
61. Case Study: The Berlin Hyp
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!!!
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
62. Case Study: The Berlin Hyp
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 of securities /
syndicated loans / public guarantees)!
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
63. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Process of the deal
Fundamental Preparing Deal
Closing
decision the deal process
Portfolio- In house Portfolio Confidentiality Bid analysis
Identification Valuation statement
Accept the tender
Check the in- Projecting the Information (best price)
house effects Due Diligence letter with
procedure In-house decision
Portfolio- Investor selection details
Clustering (long list) Conclusion of the
Opening of the contract
Board decision Setup Data room Data room
(equipment and Transfer (loans)
security) to the new owner
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
64. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Fundamental Decision (1/3)
Berlin Hyp Project:
Portfolio-Identification
200 non performing loans,
volume 500 Million €
Performing/ sub-performing /
non-performing ? Most of them interest-free and
Strategic/ non strategic ? cancelled by the bank
Depreciation/ interest arrear / Selected in two deals:
interest-free?
• Retail portfolio
(80 customers, loan volume 50 mil. €)
• Mixed portfolio
(120 customers, loan volume
450 mil. €) residential and commercial
properties
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
65. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Fundamental Decision (2/3)
Check the in-house effects Berlin Hyp Project:
– Data quality OK or is there – Fill 350 data fields for 1 customer,
“homework” to do? thereof only ∅ 150 OK
(scheduling time/man- – Check 200 loans for adequate
power/requirements) collaterals / depreciation (220 new
– Adequate collaterals/ valuations by the surveyor in 2
depreciation? Upside months)
potential? – 620 hours of external help from a
– Find the balance: loss of temporary employment agency
interest rise in depreciation (e.g.: scanning 22.000 pages loan
– Check number of employees documents)
– reduction in staff feasible?
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
66. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Fundamental Decision (3/3)
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
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
67. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Preparing the Deal (1/2)
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)
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
68. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Preparing the Deal (2/2)
• Investor selection (long list)
– Select the potential investors (by yourself or through 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
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
69. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
The Deal Process (2/2)
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 process
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
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
70. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
The Closing
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 agreement
Transfer (loans) to the new owner
Send a letter to all customers with brief information 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
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
71. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
Review on the Goals
A fundamental reduction in the bad loan portfolio resulting in a
large profit (purchase price higher than expected)
A positive attestation by the rating agency
The internationally renowned rating agency Moody's has
awarded the bank's mortgage bonds the good rating Aa1. This is
evidence of good structure of the assets serving as collateral and
the progress the bank has made in optimising its risk profile.
Berlin Hyp already has two independent rating results with the
top “Triple-A-Rating” for its public mortgage bonds.
• Reduction in staff
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
72. Case Study: The Berlin Hyp
Case Study: Strategy of Berlin Hyp
The Outlook
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. €)
Source: Mr. Bernd Morgenschweis, NPA Summit 2006
Arcil NPA Seminar - Mumbai 2007
73. Managing NPA from a Banks perspective: Strategy
Thank You
Arcil NPA Seminar - Mumbai 2007