Non-performing loans (NPLs) are an issue for the Ukrainian economy as they are becoming an increasing percentage of bank balance sheets. NPLs have risen in a steady upward trend from a low of 3.88% in 2008 to more than 30% of gross loans in 2016 according to statistics released by the World Bank. A clear resolution of the situation has so far been elusive. The most common methods used for addressing NPLs across Europe are the bad bank model and the private sale model.
Bad banks and private sales
The bad bank model involves the use of a state sponsored bad bank structure. Examples of bad banks are SAREB in Spain, the CKA in the Czech Republic, and NAMA in Ireland. In short, banks sell/transfer their NPLs to the bad bank in return for government securities. The bad bank then manages the NPL portfolio by selling the NPLs on via transparent/competitive auctions or it realizes what income it can from the NPLs on its books through enforcement etc.
The private sale model does not require the formation of special institutions and instead sees banks sell their NPLs directly to investors. In many cases, sales are negotiated on a bilateral basis and do not involve a competitive bidding process. Both models transfer the ownership of the NPLs and therefore the responsibility for their collection. However, both models also require investors to have a certain level of comfort with the relevant market. Achieving the required level of comfort could be a problem for Ukraine given the portrayal of the country in the press. Clearly, what is needed is a structure that achieves the necessary disposals while at the same time insulating potential investors from Ukraine’s perceived image. Securitization may present an alternative to the above models for dealing with NPLs in the Ukrainian context.
Securitization has gained a bad reputation as the mechanism that allowed for the inflation of bank balance sheets that, in turn, caused the unrestrained lending that culminated in the 2008 financial crisis. While the unchecked use of securitisation may indeed have adverse consequences, it is our view that the same structures can be used as part of a multipronged approach to help solve the NPL problem in Ukraine.
The players in the securitisation structure are as follows: the Originator, the Issuer, the Servicer and the Investor. The Originator is the lender of record or holder of the loan. The Originator sells (at a discounted value) the NPLs to the Issuer. The Issuer is a vehicle that is unrelated to the Originator and, as such, the sale is a “true sale” meaning that there is no “look through” back to the Originator. The purchase of the NPLs is funded by the issue and sale of debt securities (Notes) by the Issuer and purchased by the Investor(s). The Servicer manages the portfolio of the NPLs on behalf of the Issuer with a view to maximizing cash flow. Cash flow generated by the Servicer is used to meet interest payments and principal payments owed to the Investors. Hedging and other credit enhancement mechanisms can be employed to mitigate risk associated with the NPL portfolio and decrease the risk profile of the Notes. A key feature of the structure is the fact that the Servicer must take an active role in the resolution/collection of the NPLs. Funds raised by the sale of the Notes by the Issuer at the outset are used (at least in part) to pay the Originator(s) for the NPLs.
Secured and unsecured loans
NPLs can be divided into two categories: secured and unsecured loans. Secured NPLs are the more attractive. They can be subdivided into corporate secured loans and residential secured loans, each of which present their own particular challenges. The ability to recover in both cases depends greatly on the quality of the asset the NPL is secured against, and the rights granted to the holder of the security in the relevant jurisdiction. The ability to recover unsecured loans is strictly a function of the ability of the debtor to pay and the legal recourse granted to the holder of the debt. The age, or “staleness”, of the NPL is important since both the ability of a debtor to make payments and the value of real estate may vary with time. This is particularly true with commercial assets where troubled debtors may be unable, unwilling, or indeed incapable of managing the relevant asset properly, with the result that assets fall into disrepair and thus lose value. Since time is a factor, the speed with which a transfer is agreed/price negotiated is critical when dealing with NPLs. This involves a balance being struck by both the Issuer and the Originator that involves price, representation and warranties and due diligence when agreeing the transfer of the NPLs to the Issuer.
A key component to the success of the NPL securitisation model is the quality of the Servicer. By quality we refer to the track record and experience of the Servicer with similar transactions. The reputation of a Servicer is key to mitigating the reputational risks that may be associated with the relevant NPLs. It is of course up to the Servicer to retain advisors with the expertise needed to deal with the NPL portfolio and meet the challenges presented by the legal environment. The servicing agreement between the Issuer (and ultimately the Investors) and the Servicer must balance the Servicer’s need for latitude with adequate oversight that, together with the Servicer’s reputation, can help build confidence and, in turn, create Investor demand for the Notes. The Servicer does not act out of charity. As such, adequate remuneration and performance incentives must be agreed.
Another key factor in the success of the securitization model is the legal environment/governing law of the NPLs and (more importantly) the security. By this, we mean both the rights granted to creditors to compel debtors to pay recognised debts or enforce against security, and the ability of debtors to frustrate enforcement.
Best available option
While we recognize that NPLs are a complex asset class, particularly within the context of Ukraine’s current position, we also see that the securitization model has certain advantages over the bad bank and private sale models. A Servicer with sufficient international/market standing can use its reputation to (at least in part) mitigate some of the reputational risk associated with Ukrainian NPLs, and thereby generate Investor interest in the Notes that, in turn, provides the fuel for the structure. Furthermore, the structure is private and as such does not require the formation of specialist semi-state institutions such as “bad banks”, thus avoiding delays that could worsen the quality of the NPLs. While many considerations remain, we think that serious thought should be given to the use of securitisation as part of an overall strategy to deal with Ukraine’s NPL problem.