Restructuring, foreclosure, insolvency or sales?
By Erol Riza
The various stake holders in the financial sector programme for Cyprus be that the troika, the government, the parliament or the Central Bank have all, for over a year, agreed that the biggest challenge facing the economy is the size of the non-performing loans (NPLs).
Cyprus’ case is unique as the troika agreed to the establishment of three internal bad banks to manage the financial sector crisis and seem to be challenging the best minds of the IMF who until recently were informing us that the levels were within the PIMCO extreme case and not unexpected.
Over the past two years various options have been considered including an asset management company, a bad bank and of course the development bank to asset manage these NPLs. It seems that after the successful equity raising by two banks, and the ministry of finance’s refusal to use public funds for a bad bank, there will be no resolution across the banking system for NPLs, and the delinquent borrowers will have to be managed by the letter of the law which includes the foreclosure law, the insolvency law and now the sale f loans law.
The following article is an updated reprint of the article published in August 2014 by the author and the numbers of NPLs speak for themselves.
We know that restructuring of loans has been the preferred course of action for the government, the troika and most of the establishment in Cyprus. I do not think there is anyone who would not favour this option of dealing with NPLs but as the Central Bank Directive sets out, the restructuring of NPLs had to be under taken so that the restructured debt was sustainable and fair (see their Code of Conduct for Arrears Management of June 2015).
In other words the debt repayments to be agreed for the restructured loan under the new terms had to be sustainable and within the ability of the borrower to pay principal plus interest. The big problem facing the borrowers and lenders alike has been that very few NPLs were able to be restructured in a sustainable manner especially where the NPL was used to acquire a land bank which produces no revenues.
Where there are operating businesses they may be over leveraged and hard to service the debt by extending repayment period and lowering interest rates. The evidence hitherto of restructuring has not been what was expected and hence the continued concern of the troika after their recent visit.
Another option, which has been hotly debated, is the easing of foreclosure by banks in Cyprus whereby the long time it takes banks to enforce their collateral is expedited and done privately as opposed to via the Land Registry; the jury is still out on this. The troika must have insisted on this as they know the private market works with greater efficacy than the public sector given their experiences in programme countries.
Is the real danger that the banks will go to the extreme case of foreclosing en masse on the big borrowers? In my view not really, and this is shared by the former attorney general (Alecos Markides) who advised an invited audience a couple of months ago that the banks should focus on restructuring instead.
It must certainly not be the preferred route for the banks since if such sales were to take place the underlying collateral value of the whole banking system would suffer and the banks would probably require more equity to cover their security deficit as the collateral value is a major determinant of the level of provisions required.
Hence the troika came up with the need to reform the in solvency law in Cyprus which was outdated. The threat and ease of insolvency, to force delinquent borrowers to produce funds to repay their loans, is something the IMF likes to see in programme countries as it focuses minds of the borrowers so that they pay up.
It was expected that the threat of insolvency and loss of property would make borrowers more compliant. Yet, the outcome of the insolvency law passed in Cyprus has complicated things for the banks if anything. Here again this might work in Anglo Saxon countries, but in my view it is not easy where a borrower is also a major employer.
It is not just a matter of reputation and procedure but a social issue of creating more unemployment at a time when the job market is bad and also the political interference can expect. Nevertheless, there are those who are living with the hope that this will magically make borrowers able to repay their loans.
If all the above are hard to achieve what way out is left? The answer must lie in the most efficient manner for the owners of banks to take the NPLs off the balance sheet; if not by selling to a bad bank sell then to other investors including private equity and hedge funds.
The new owners of the banks are investors who have an exit strategy of three years, sometimes if markets are not favourable up to five years. Whatever hedge fund managers say, their objective is to make money for their investors and of course for the owners of the hedge funds. “Our goal is to provide a solution that represents an opportunity to deliver risk-adjusted returns for our investors,” Are the famous words of a leading hedge fund owner.
Why not, one might ask, when they take the risk? The good news for the small borrowers is that the proposed law will protect those with an original loan of up to one million euros.
So if it will be hard to foreclose or bankrupt a delinquent borrower, why are such investors in banks taking risks in Cyprus? The simple answer is that if delinquent borrowers do not face up to their responsibilities soon the new investors on the boards of banks in Cyprus there will be no law that will prevent the banks from selling NPLs at a large discount.
Once the NPL coverage of the banks reaches a level which will enable the banks to incur a small loss, banks may prefer to sell the NPLs as it will free up capital that is expensive and no provisions will be required in future. The key is the amount of NPL coverage banks hold so that the discounted sale is not large.
In the case of other programme countries the sales discount has been as high as 65-70 per cent but it is very unlikely in Cyprus it will be so high. Given that some of the land which is the collateral of loans is located by the seaside it is likely that the secondary market of such NPLs will be closer to50 per cent of loan face value.
Should sales of loan packages take place to hedge funds these type of buyers can hold on to these NPLs for a few years and then demand repayment of their loans at a lower discount of say 20 per cent. If the borrower cannot pay, the hedge funds would be legally entitled to enforce their security or sell the NPLs to another fund.
The only way to prevent this from happening would be for the Central Bank of Cyprus to forbid the secondary market trading of NPLs, but for loans in excess of one million euros this will not happen. It is doubtful that securitisation of such loans, as provided by the former updated MOUs, will happen as this form of sales is very expensive for banks given the amount of the new bond (secured with NPLs) that has to be held by the originating bank. Currently such “risk retention” makes it uneconomic for banks to take.
In the circumstances we should expect that the sale of loans by banks is a healthy development to address NPLs, albeit rather late, and one can expect that banks will find it easier to rid themselves of NPLs linked to real estate after the law is in place (the approval of the bill by the parliament has to be made before year end) which is a precondition for the next disbursement of financing from international lenders. The countries which have used a banking system wide solution have seen a rapid recovery in the real estate market after three to four years and one hopes that it is the efficient functioning of the market that will help the fundamental problem of NPLs instead of legislation.
Erol Riza is a banking and finance consultant and former Vice Chairman of the Interim Board of Bank of Cyprus and former Managing Director of DEPFA Investment Bank Cyprus