Value Maximization of Non-Performing Loans

1
Value Maximization of Non-Performing Loans (NPL)
and Distressed Assets Pakistans Experience
(October 1999 October 2003)
Salman Ali Shaikh
2

• The composition and the inherent characteristics
  vary significantly
• between countries.

• Key variations include which economic segments
  (e.g., manufacturing,
• real estate, etc.) are most impacted,
  geographic concentrations, the
• regulatory environment, labour and employment
  sensitivities, etc.

• The measurement of success (in terms of value
  maximization) can only
• be done after the above factors have been
  carefully studied.

• The traditional yardstick of quantifying how
  many cents to each have
• been recovered is much too narrow, if your
  canvas is the whole country
• and its socio-economic framework.

• A national NPL reduction strategy entails being
  able to answer 3 very
• basic questions -

• Where are we??
• - Where do we want to be??
• - How do we get there??

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• High NPL is certainly a problem for the economy
  and the financial
• sector, but it also has up-side potential.

• With creative handling, national planners can
  change the shape of
• the future (post-NPL) economy.

• Not all distressed assets are worth reviving. It
  is important to make
• a well-reasoned judgement (sector by sector)
  on the issue of sickness
• worthy of revival.

4
Where Are We?? Pakistans NPL Profile

• At the time of independence (1947), the country
  did not have an
• industrial base.

• It was an agrarian/commodity producing economy
  with a rural
• population of over 75.

• The process of industrialization started in the
  late 1959s, and
• went through 3 distinct phases -

• Import substitution phase (up to 1980)
• emphasis on infrastructure, fertilizers,
  petroleum/energy, etc.

• Export oriented phase (1980-1995) growth of the
  textile
• industry with a five-fold increase in spinning
  and weaving
• capacity. Similar growth in down-stream
  industries e.g.,
• knitwear, garments, home textiles and man made
  fibres.

• Consumer led phase (1995 onwards) major
  expansion in
• automobiles, consumer durables cement, food
  processing
• and telecommunications.

• With a few exceptions, most of the industrial
  base is relatively modern.

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The main features of the NPL map are as follows
-

• Concentrated in the large-scale manufacturing
  sector. Key concentrations
• in textiles, sugar, cement, food processing
  and the public sector. SME
• sector not impacted owing to a culture of
  debt aversion.

• Concentrated in the public sector banks and
  financial institutions. Private
• (and foreign) banks not impacted. In the
  public sector banks, much of the
• NPL was avoidable, as the country has had
  relatively high economic growth
• throughout (except for a dip in the 1990s).
  Major chunk of industry has also
• enjoyed protection against foreign
  competition.

• Culture of zero equity projects. Started in
  the 1980s and 1990s through
• collusive lending, poor corporate governance
  and a bureaucratic regulatory
• system. Kick-backs (received overseas from
  machinery suppliers) often
• exceeded the paid-up capital of the company.
  High leverage became the norm.
• In the 1990s many of these companies could
  not withstand even a minor
• economic downturn.

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• Dilettante entrepreneurs. The 1980s and 1990s
  saw the emergence of new
• entrants from all walks of life into industry
  e.g., agriculturists, bankers,
• bureaucrats, military seniors and even
  judges. Questionable ability to
• successfully run an industrial project. These
  influential individuals
• (the protected species) constitute a major
  hurdle for meaningful
• reform in the area of NPL.

• Chronic over-capacity/lack of competitive
  advantage. Caused by the herd
• (emulative) instinct and promoted by the
  kickback culture. Several large
• segments impacted e.g., cement and food
  processing. In the latter there
• are 51 fruit juice companies and 41 dairy
  plants I guess they did not know
• about branding as a marketing concept!!! In
  some industries (e.g., sugar -
• owing to low sucrose in the local sugarcane),
  there is perpetual sickness.

• Directed lending. Political patronage in the
  public sector. Senior management
• handpicked by politicians and military
  commanders key qualification was
• the absence of professional competence. These
  favours were repaid in
• kind i.e., by approving sub-standard
  project financing loans.

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Where Do We Want to Be?? And How Do We Get
There?? Value Maximization The Basic
Imperatives and the Core Ingredients
The configuration of the countrys NPL not only
determines the choice of tools, but also
highlights desirable policy choices and desired
outcomes. In our case, an NPL reduction strategy
(involving value maximization) should have the
following features -

• Fast-track implementation. Distressed assets
  (well over 75) were
• concentrated in manufacturing companies (with
  modern equipment).
• Avoidance of closures was a key issue once a
  plant closes down there
• can be rapid degeneration, leading to a higher
  cost of rehabilitation. Banks
• (and bankers) who moved fast (in
  decision-making terms) were able to extract
• values ranging from P (Principal) 25 to P
  50 in the late 1990s.

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• Avoidance of cosmetic tools. Traditional
  methods of debt re-scheduling
• cause much harm. The company returns to NPL
  status every 3-4 years and
• a myth (that all NPL can be recovered) is
  perpetuated. There was an urgent need
• to devise a methodology for determining the
  sustainable debt level (through
• forensic accounting) of projects. With write
  offs becoming an offence under the
• militarys accountability law, bankers played
  it safe and the use of cosmetic
• tools continued.

• Change of management as a value maximization
  tool. The poor quality of
• sponsors/management was the main reason for
  the asset becoming distressed
• in the first place. Value maximization
  required a change of management.
• This can only be done if the larger players
  (i.e., banks and or AMCs) have the
• capability to keep the company running till
  the new management can be
• inducted.

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• Creating a (national) scale of priorities. Loan
  loss reserves were low and
• often created by cosmetic tools (major
  re-capitalization of public sector
• banks). In this scenario, prioritising
  industrial segments should be a key
• priority. Priority segments (e.g., textiles),
  which have the capability to
• jump-start the national economy, should get a
  larger share in terms of
• resource allocation (e.g., write offs based
  on sustainable debt calculations).
• Conversely, the early demise of segments that
  are perpetually sick (e.g.,
• sugar) should be encouraged through denial of
  resources.

• Clarity and consistency is required in terms of
  regulatory signals to the
• market. Both banks and borrowers watch these
  carefully. Regulators should
• devise and implement strategy and not waste
  time in seeking consensus-based
• solutions. In Pakistan, we have wasted the
  better part of a decade by doing
• the latter.

• The need for capacity building. The NPL crisis
  highlighted the absence of
• skills in several areas of expertise and
  specialization e.g., professional
• receivers, auctioneers, administrators,
  forensic accountants, evaluators
• and asset tracing specialists.

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Value Maximization Challenge and Response

• The period under review saw several challenges
  e.g., growing NPL, low
• economic growth, and decline in fixed
  investment, increases in military
• expenditures, etc.

• How well did the countrys planners and the
  regulatory system respond to
• these challenges??

• In October 1999 the military seized power. The
  first law passed was the
• National Accountability Ordinance leading to
  the creation of the NAB
• (National Accountability Bureau).

• Concept was that NPL is recoverable in full.

• Assumption was that if a company is making a
  loss then an amount
• equivalent in cash has to be somewhere (e.g.,
  under a mattress) - i.e.,
• a genuine business loss is a fiction.

• A 30-day deadline (for defaulting borrowers) to
  settle with banks was
• announced.

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• In November 1999, the first batch of
  industrialists were arrested and subjected
• to inhumane treatment.

• NPL did not go down it went up. The economy
  went into a tailspin and
• fresh investment stopped.

• Bankers (potential NAB targets) stopped making
  decisions in sensitive
• areas (debt restructuring and write offs).

• And yet this (Sheriff of Nottingham) approach to
  NPL reduction through
• coercive means was allowed to continue for
  over a year.

• The countrys economy slowed down considerably
  causing fresh NPL
• flows to the existing stock. This can be
  clearly seen in the chart given below.

3.4 billion (December 31, 1998) 3.9 billion
(December 31, 1999) 4.9 billion (December 31,
2000) 5.4 billion (December 31, 2001) 5.1
billion (December 31, 2002) 4.9 billion (June
30, 2003)
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NPL peaked in 2001 at peak it was over 25 of
total loans.

• To disguise this growth, the regulators started
  reporting net NPL and not
• the total figure.

• Net NPL is Gross NPL minus provisions held and
  minus NPL transferred
• to CIRC.

• CIRC (Corporate and Industrial Restructuring
  Corporation) is a public sector
• asset management company (AMC).

• Another data integrity problem is the existence
  of 2 separate regulators
• in the financial system.

• The State Bank of Pakistan (SBP) regulates the
  banking system and
• publishes NPL data regularly.

• The Security and Exchange Commission (SECP)
  regulates the NBFIs
• (non-bank financial institutions e.g.,
  leasing companies, investment
• banks, etc.). SECP does not publish NPL data.

• It is estimated that the correct NPL figure for
  the financial system as a
• whole is around 1 billion higher than the
  reported figures.

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What should you do when things are not
happening according to plan?? When in doubt,
execute a U-turn.

• By the autumn of 2002, realization dawned that
  all is not well on the NPL front.

• Through NAB the draconian approach had been
  tried and it failed.

• By creating CIRC (the AMC) in 2000, it was hoped
  that the stock of old
• NPL would be drastically reduced. CIRC had
  not delivered meaningful results.

• The informal loan workout process (through a
  national committee)
• was also a failure.

• The SBP executed a sharp U-turn in the NPL
  reduction strategy a
• somewhat desperate manoeuvre.

• A directive was issued to the banking system in
  October 2002 asking
• make aggressive settlements with their
  defaulting borrowers at values
• well below actual debt outstanding and/or the
  decreed amount through
• recovery suits in the court.

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• Instead of using a balanced yardstick of
  sustainable debt (going concern
• valuation), this directive sets the
  settlement amount at the fire sale value
• (FSV) of the distressed asset.

• Conceptually, this is a very major U-turn from a
  stated position (only 2-3
• years earlier) of NPL being inherently
  recoverable in full and that write offs
• were not required.

• Needless to say, borrowers are going berserk
  with delight.

• This approach has some positive features.

• Firstly, it is expected that NPL of over 1.5
  billion will be settled.

• Second, large haircuts will improve the balance
  sheets of borrowers opting
• for such settlements.

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These benefits are out-weighed by
several negatives, which are as follows -

• Heavy guzzler of provisions. A few years
  earlier, smart banks were settling
• NPL at values approaching P (Principal) 25
  to P 50. Now, similar
• assets are being settled at P 75 to P 25.
  This scheme could eat up
• nearly 1 billion of loan loss reserves. Some
  of the weaker banks may
• require re-capitalization. Rather than maximize
  values (from distressed
• assets) this scheme minimizes values.

• The mechanics of determining FSV. Evaluators
  determine FSV. Gives them
• enormous power. There are several reported
  cases of major under-valuation
• to make the settlement extra sweet for all
  concerned except the hapless bank.

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• This scheme protects all existing managements.
  It makes it almost impossible
• to evict inefficient sponsors. Very unfortunate
  as many of these companies
• will return to NPL status within 5-6 years.

• Promotes a continuation of the default culture.
  The SBP had a similar
• (incentive) scheme 6 years ago. These periodic
  amnesty schemes are
• causing havoc making borrowers who repay
  regularly feel like and look
• like idiots. Overall, retards the development
  of corporate good governance
• and the improvement in financial disclosure
  standards.

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Corporate and Industrial Restructuring Corporation
(CIRC)

• Discussed at FAIR II last year. Hence, this is
  just an up-date.

• CIRC was created in 2000 as a public sector AMC
  with a sunset clause.
• It was designed to complete its business and
  be wound up by September 2006.

• Banks have referred 722 cases (of distressed
  companies) to CIRC with an
• NPL of 2.1 billion.

• 387 cases (with an NPL of 1.0 billion) were
  returned to the banks.

• Of the balance 1.1 billion, CIRC has settled
  NPL of 0.2 billion (around 4
• of countrys NPL).

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• The World Banks recent report on CIRC
  recommended major changes in
• order to improve its performance.

• Lack of any action by the government suggests
  that they are treating CIRC
• as a lost cause and will let it fade away
  during the next 2 years.

• We have incorporated enabling provisions for
  private sector AMCs in the
• new corporate rehabilitation law (CRA).

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The Beginning of the End or the End of
the Beginning???

• It has been 6 six years since NPL hit the
  national radar as a key issue.

• While there has been progress in many areas of
  financial sector reform,
• the handling of maximizing value from NPL
  remains seriously flawed.

• The battle against increasing NPL is finally
  being won thanks to the War
• On Terror!!!

• Pakistans debts have been re-scheduled and most
  economic indicators are
• quite positive.

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• This (plus the recent amnesty scheme) is helping
  to reduce both stock and
• flow of NPL.

• The CRA (once enacted) should improve the legal
  environment it will help
• to restore the balance between debtors and
  creditors rights and enhance
• predictability in the legal process.

• However, there has been little or no progress on
  long-term institutional
• and capacity building issues.

• Till than happens, no law (however, well
  conceived and drafted) can fulfil
• its design potential.

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Turning and turning in the widening gyre The
falcon cannot hear the falconer Things fall
apart the centre cannot hold Mere anarchy is
loosed upon the world, The blood-dimmed tide is
loosed, and everywhere The ceremony of innocence
is drowned The best lack all conviction, while
the worst Are full of passionate intensity.
William Butler Yeats (1865-1939)