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

William Willms

Asian Development Bank

+63 2 632 5469

wwillms@adb.org