NPA S1 Managing-Stress

8/3/2019 NPA S1 Managing-Stress

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Case Study:Managing Stress in a Banks Balance Sheet

Bernd Morgenschweis


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Distressed debt strategies International experience in NPL management

Origins of stressOne consequence o the critical

development o the German realestate markets in recent years isa clearly increased proportion onon-perorming loans on the bal-ance sheets o many nancial in-stitutions. This in turn had ad-verse eects on their protabilityas the loan deault rate increasedand demand or new real estateloans went down. The nancialinstitutions aected, thereore,needed to optimise their loanportolios, or example by reduc-ing the proportion o non-per-orming loans in order to stabi-lise their own corporate valueand once again increase their newlending business.

The repeal o the German Mort-gage Banks Act and its replace-

ment by the Mortgage Bonds Act(Pandbriegesetz) led to changesin the regulatory powers and in-creased market pressure. The re-sult was the abolition o the ad-vantageous position o thosebanks which had hitherto domi-nated the entire sector and wherethe only players in the marketwho could issue mortgage bonds.This led to unprecedented compe-tition with other German banksin this eld.

Particularly in view o the overallsaturation o the banking market,

competition or loans unctionsthrough the relevant margins.The main target must, thereore,be to generate adequate proitmargins or the lending businessas a result o risk-orientated pric-ing methods. In this context, itwas, thereore, o undamentalimpor-tance to calculate the rel-evant risk-driving actors and thecosts o existing non-perormingloans.

Case Study:

Managing Stress in a Banks Balance SheetBernd Morgenschweis

Origins of Stress (1/2)

Repeal of the German Mortgage Act (fundamental legal changes) market and regulatory forces

no longer effective consequence:

We face stiff competition from numerous other German Banks!

An over-saturated banking market forces 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 costs

Traditional German mortgagebond banks (Hypotekenbanken)also had to contend with otheraspects, requiring new directionor the balance sheet assets:


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Case study: Managing Stress i n a Banks Balance Sheet 0/ Bernd Morgenschweis

The increasing importance o thecapital market and the resultingincrease in pres-sure made it nec-essary or nancial institutionsto optimise their own portoliostruc-ture. This involved increas-ing the proportion o income-

earning loans in the overall port-olio and reducing the proportiono non-perorming loans by out-sourcing or sale.

Finally, the new Basle II regula-tions on the provision o risk-ori-entated equity required the devel-opment and implementation o aconservative risk strategy or newlending; this strategy would meanto take more low risks on to the

books rather than buy additionalhigh risk assets.

Origins of Stress (2/2)

Increasing importance of the capital market and consequently greater pressure to enhance

interest margins and reduce bad loans

Optimise portfolio structure: push good loans and :

adjust portfolio by outsourcing or selling non performing loans

Pressure due to Basel II from the obligation to provide risk-adjusted equity

develop and implement a conservative loan risk strategy for new lending business

(prevent and increase in risk portfolio)

Ireduce risk loan portfolio to cut cost (employees, operating and risk costs)

and save equity costs

Basle II also brought the reduc-tion o the risk portolio morestrongly into ocus not least togenerate signicant cost savings(costs associated with the work-out team, operational costs o theprocessing / restructuring and

o course depreciations / valueadjustments).


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Positive Aspects (1/3)

Reduction of loan risks (transfer of risks) leads to an adjustment of the balance sheet

and to more transparency

Market awareness that your balance sheet is in good order and there are no hiddenrisk positions

Liquidity improvement resulting from lower equity requirement according to Basel II

switch the interest-free assets (sale) to interest-bearing assets (work with the purchase

price issue new loans)

2. Positive aspectsThe ollowing positive aspects,

amongst others, are resultsrom the reduction o the riskportolio:

The reduction o risk taken leadsto a qualitative improvement othe banks balance sheet. Natu-rally, other market players alsorealise this in view o the regularpublication o the gures with in-creasingly detailed inormation.The act that the relevant institu-tion is parting with its ballast,and thereby considerably reduc-ing risk potential by the consist-ent divestment o sub- and non-perorming loans, is the subjecto intense scrutiny. Rating agen-cies in turn view this positively

here too, the reduction o dis-tressed loans has a correspond-ing positive infuence on the rat-ing assessment.


Cut back resources required for work-outs (non-core business)Important distinction between dead loans (money irretrievably lost) and

distressed loans (remaining positive prospects)


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Case study: Managing Stress i n a Banks Balance Sheet 2/ 3Bernd Morgenschweis

Savings on the costs o bindingequity capital by concentration

on low risk loans is a urther pos-itive consequence o the divest-ment activities. These accountsin particular can be signicantlyreduced by the specic decreasein the number o loans which nolonger produce interest income.In addition, the liquidity releasedin this way (purchase price pro-ceeds and releasing equity capi-tal) can once again by protablyinvested, resulting in a urther in-crease in earning power. In thiscontext, the additional new lend-ing to low risk counterparties,or example, can in turn have anextremely positive eect on theoverall portolio structure.

Active concentration on thebanks own loan risk potentialby means o a detailed analy-sis should make clear which dis-tressed commitments are bestdealt with by the banks own (in-

house) work-out team or restruc-turing / rescuing and which loansare no longer worth the eort.The latter type o loan, or whichthe chances o success are dispro-portionately low, should then bedivested, or example by selling.

A urther cost aspect is a criti-cal view o the right size o the

work-out team. Here, it must beclear what sta levels the institu-tion is prepared to commit on apermanent basis. In the long term(with the exception o special-ised institutions), a high level oresources committed to dealingwith dicult loans does not nor-mally constitute part o the corebusiness o a successul bank.

There is also considerable poten-tial to reduce cost easily by selling

all or some troubled loans.The earnings aspect is decisiveor all considerations. Earningsand perormance dictate whatshould be done. In a rst steploans must be categorised eitheras irre-coverable dead loanswith no chance o ever retrievingthe money lent and dis-tressedloans with a good chance torecover.


No more provision for declined loan quality

selling - reduces the risk of the unsecured exposure- eliminates the possibility of future risk (fall in value of collateral)

Competitive market constantly demands result at higher pricesmoment a perfect market in Germany!

foreign investors with considerable liquidity dominate the market

Positive external effect s of proactive commitment in solving problems


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A urther extremely positive ac-tor is that a portolio no longerburdened by critical loans is con-siderably less likely to ace in-creasing valuation adjustmentsthrough a urther all in the valueo collateral (e.g. due to a vacantbuilding or a negative devel-op-ment o the market).

A demand-orientated market re-quires a consistent, stable priceniveau. The German real estatemarket currently oers the bestexample. The beneiciaries othis development are the nan-cial institutions which nancedreal estate and now wish to divestthemselves o their non-perorm-ing loans. This demand orienta-tion predominantly driven byoreign investors with consider-able liquidity reserves current-ly results in extremely attractiveprices or those loans and prop-erties subject to processing andreconstruction.

One positive side-eect o the re-duction o complex portolios isthat the expertise gained in thiscontext has a positive eect onthe overall market position o thecom-pany, both in regards to themechanisms o problem solution

patterns as well as turning intoa competent partner in handlingsuch deals.

3. Critical AspectsThere is no smoke without re.Naturally, there are clearly alsocritical aspects in connectionwith the reduction o the non-perorming loans, which are nowconsid-ered:The quality o data and close-ly connected with this the re-quired resources are o centralimportance here. The investor re-quires a considerable amount oinormation about the relevantportolios, e.g. the lie-cycle othe loan and collateral inorma-tion. During the sales process, itmust also be continually ensuredthat the data is up to date andsucient.In addition, it must be guaran-teed that the respective loan canbe sold without di-culty and

within the legal boundaries. Theinterest here centres on bankingsecrecy. A mandatory distinctionmust thereore be made betweennon-perorming loans (usuallyterminated loans or which thecustomers consent to sale is notnecessary, or no breach o bank-ing secrecy need be eared) andsub-perorming loans (wherethe borrowers consent would berequired).As the conduct o a due diligenceprocedure involves high costsand is sta-intensive, it is immi-nent that the transaction exceedsa certain value in order to bene-t both the buyer and the sell-er in equal measure. Failing this,the bank runs the risk o ailingto attract prospective purchasersin sucient number, or indeed atall.

Critical Points (1/3)

Quality of data / Need for resources Investor need considerable loan information (detailed history of the loan

life-cycle, collateral, valuation, )

Is the data of high quality or is further maintenance necessary?

Is the transaction legally permissible?


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Case study: Managing Stress i n a Banks Balance Sheet / Bernd Morgenschweis

The central theme o the analy-sis o existing loans which pre-cedes portolio selection mustbe the clarication o sucientcollateral / shielding with valua-tion adjustments. I, or example,only 30% o the claim is collat-eralised or shielded by valuationadjustments (i.e. the bank is letwith a 70% unsecured portion)and the potential investor is onlyprepared to pay 50% o the claim(e.g. i he evaluates the collater-al dierently), the successul con-clusion o the transaction is seri-ously in danger (in this example,the bank would have to realise aclaim waiver o 20% in additionto necessary direct depreciation).

It must be ensured that the port-olio selection is overall consistent.This means that it is acceptableor the selection to contain sever-al relatively badly-shielded loansas long as the risk o subsequentimprovement can be compensat-

ed by direct depreciation on other,better-shielded loans.

Beore approaching the market,there must, thereore, be a veryprecise examination o theintrinsic value o the portolioto be sold. I the deal ails, there

is a clear reputation risk. Eachmarket player / observer canconclude rom an announcedbut ultimately ailed portolio

deal that the price was too highor the shielding inadequate. This

then leads to urther speculation(e.g. the insucient quality o theoverall portolio o the relevantinstitution).


Crucial !! If the investor only pays 40% of the loan and you need more

transaction / closing is at risk!

Individual analysis vs. analysis of the portfolioPortfolio selection satisfactory or several critical loans?

Reputation risk: before going to market, check the figures to be

sure the buyer wont cancel the deal


Warranties / VAT problemes?

Is there upside potential? price in


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It must be examined whether theanticipated loan cash-fow is inproportion to the expected price.In principle, the higher the uturecash-low expected rom theseloans, the higher the purchaseprice. This must naturally be an-alysed in the course o the port-olio selection and taken into ac-count when pricing it.It must also be claried who willbear the German value added tax

/ turnover tax (i applicable aissue which has not yet been le-gally settled). Usually, this will betaken into sucient considera-tion in determining the purchaseprice. In addition, commitmentsparticularly complicated collat-eral structures (i.e. security pool,syndicated transactions, guaran-tees/warranties rom the publicsector) should, i at all possible,not be included in the portolio,in order to counteract subsequentcomplications resulting romawkward handling / transering

o the claim.

4.1. Reasons for NPL stress onthe balance sheetThere is usually intensive dis-cussion with the rating agenciesabout the existing valuation ad-justment item, or the credit port-olio aected by valuation adjust-ment (shielding ratios, marketdevelopment, etc.). Ever-increas-ing sta levels are also re-quiredto deal with the volume o workassociated with handling non-

perorming loans. The operation-al costs increase.

Reasons for NPL Stress on the Balance Sheet

The German real estate mar-ket has also changed drasticallyin the last ew months: the mar-ket or distressed loans in Ger-many has developed in leaps andbounds in the last two or threeyears on the basis o increas-ing demand or real estate cou-pled with the growing number orisk loans. This gave rise to theopportunity to reduce risk at ac-ceptable prices more quickly than

anticipated.


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Case study: Managing Stress i n a Banks Balance Sheet / Bernd Morgenschweis

4.2. Business proess in non-performing loan sale from BerlinHyps point of viewThe course o the sale process issubdivided into the ollowing se-quential phases:

4.2.1. Fundamental decisionto sellWithin the ramework o the un-damental decision to sell, the rststep is to iden-tiy the portolio.The selection is made in accord-ance with the criteria already de-scribed (amongst other thingsnon-interest-bearing vs. interest-bearing, perorm-ing vs. non-per-orming, cash-fow expectancy,shielding ratio, etc.).The subse-quent presentation tothe Executive Board also con-tains urther representations (ineach case depending on the pa-rameters which are important orthe bank and are to be individu-ally xed). In this context, stra-tegic points (core business yes/no)must be taken into consideration.

Berlin Hyps project involved aportolio with 200 non-perorm-ing / terminated loans with a to-tal volume o around EUR 500million. Most o them no longerpro-duced any return. This port-olio was subdivided into two sub-

portolios in order to improve thesale prospects: (1) a retail porto-lio (small-volume loans) with 80

Berlin Hyps practical experience

Fundamental Decision (1/3) Process of the deal


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debtors and a volume o aroundEUR 50 million and (2) a porto-lio comprising 120 debtors whosloans, collateralised by both res-idential and commercial proper-ties, amounted to around EUR450 million.

The subject o loan quality is par-ticularly important because it hasa direct inlu-ence on the pur-chase price. The rule o thumbis: the more up-to-date and exten-sive and the better the qualityo the data, the higher the pur-chase price. Eve-rything whichis not clear rom the data tapeproduced can lead to deductionsrom the purchase price by theinvestor.

I the quality o the data or theidentiied portolio is not per-ect, the implementa-tion o adata quality assurance procedureis recommended, in which thedata is subsequently improved. It

is also important to answer thequestions whether the existingcollateral / valuation adjustmentsare sucient or whether urtheradjustments are required.

In addition, the evaluation opossible purchase price proceeds

must strike a balance between theloss o interest income by reduc-ing distressed) and the in-creasein value adjustments (through

outside inluences) which maythreaten in uture. It must alsobe taken into consideration theextent to which the stang lev-els can perhaps be corresponding-ly reduced by a disproportionate

reduction o particularly arduousand time-consuming restructur-ing / processing loans.

In the Berlin Hyp project, around350 data elds per debtor had tobe provided, o which most othem ullled the requirements,

whereas the remaining elds hadto be updated / supplementedwithin the ramework o a dataquality improvement project.

The intrinsic value o all indi-vidual loans selected or the dealwas examined by suitably quali-ied experts over two months,which led to 220 amended rat-ings. In total, 620 working hours

were necessary or the work con-nected with this, in particularor copying and administrativework, with the aid o an externaltemporary employment agency.One o the technical / organisa-tional challenges was, or exam-ple, the preparation o ve sets o

800 loan les with approximately22,000 inscribed le dividers hadto be sorted.

Check the in-house effects

Data quality OK or is there homework

to do? (Scheduling time/man-power/

requirements)

Adequate collateral/depreciation?

Upside potential?

Find the balance: loss of interest or

rise in depreciation

Check numbers of employees reduction

in staff feasible?

Berlin Hyp Project:

Check 200 loans for adequate

collateral / depreciation (220 new

valuations by surveyors in 2 month)

620 hours of external help from a

temporary employment agency

(e.g.: scanning 22000 pages of loan

documents)

Fundamental Decision (2/3)

Process of the deal


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Case study: Managing Stress i n a Banks Balance Sheet / 9Bernd Morgenschweis

tion o whether this price appearsto be realistic (an up-to-datemarket assessment and detailedknowledge o the market is essen-tial). Likewise, intense considera-tion must also be given to the rep-

Portfolio clustering

Local / international properties / geographical bundling

Residential / commercial / retail Loans

Board decision

Based on: full report specifying all advantages and disadvantages

Discussion of reasons for and against sale

Final decision

Fundamental Decision (3/3)

Process of the deal

Various analyses / representationsin accordance with any existingocal points (e.g. geographical lo-cation o the properties and theiruses) are necessary to in-creasethe transparency or the poten-

tial purchaser.

A nal Executive Board decisionconcludes this process phase. Thisis based on a complete report set-ting orth all the advantages anddisadvantages o the transaction.This must be prepared in detail

with all the positive and nega-tive criteria, and must contain arecommendation or the urtherprocedure.

4.2.2. PreparationThe preparation o the porto-lio starts with an internal valua-

tion o the existing risk to be sold.The result is an assessment othe price the seller would like toachieve and the subsequent ques-

utation risk. I the deal ultimatelyails due to the price set, this maycause the market to conclude thatthis individual portolio, andpossibly the entire loan book, isinsuciently collateralised.

In-house portfolio valuation

Result of the portfolio check whats the realistic price?

can we sell the portfolio at this price? (reputation risk if not)? Why cant we manage the problem by ourselves (experience)?

What is our economic valuation of the property market in the near future?

Board decision

Involve a legal advisor or consultant for the deal

Prepare all legal documents and check them carefully (the data in the system must

Prepare the sale contract (with all details)

Preparing the Deal (1/2) Process of the deal


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For the due diligence phase, theinvolvement o a law or consul-tancy rm is very strongly advised.The rm must ensure by means oa neutral quality and quantity as-surance process that the les con-cur with the published data andare complete. All legally requireddocuments must be prepared andsubjected to close examination.In addition, the nal drat o thepurchase contract should also beprepared, to reduce subsequentdiscussion about details.

Once this has been concluded,the next step is to put an exten-sive list o potential buyers to-gether. The selection is made ei-

ther by the bank itsel or by theconsultant.

The establishment o one or moredata rooms then begins, with allthe necessary technical and se-curity characteristics, so that anecient and ull analysis o the

documentation by the prospec-tive buyer can take place.

For the Berlin Hyp project, veully equipped data rooms wereestablished in ive dierentbuildings. Each room has itsown supply and security unit. In

addition to these oces, a virtualdata room was established orthe partial retail portolio. Thismade available around 1,400

sets o data with all importantinormation relevant to theloans. The 800 loan les in thedata rooms contained around35,000 organised pages withall inormation relevant to thedecision, and around 22,000

scanned loan documents weredeposited in the virtual dataroom.

4.2.3. Due diligence procedureThis phase o the due diligenceprocedure is based on a decla-ration o condentiality which

must be signed by all participants / teams involved in this projectphase. It must be made clear thatthe highly condential internal

inormation acquired about theportolio or the individual loansmay not be passed on. Then a so-called letter o inormation willbe distributed, which must con-tain all inormation / addresseso contact partners necessary or

handling the deal (list o the con-tact data o all responsible par-ties). This phase is concluded byopening the data room.

Preparing the Deal (2/2) Process of the deal


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Case study: Managing Stress i n a Banks Balance Sheet 0/ Bernd Morgenschweis

Ater greeting the external part-ners, the update process or theinormation base must be clari-ed (daily, weekly update o theinormation / loan les) as wellas the plan or the question andanswer process (scope o thequestions, time or answer, timeschedule or the submission oquestions, etc.).

In the specic Berlin Hyp casestudy, 2,100 questions and an-swers were dealt with by the loanspecialists. Each question was an-swered - ater several quality con-trols - within 48 hours. In addi-tion, there was a so-called loanocer call once a week. This o-

ered the opportunity o askingurther questions about the tenlargest / most important loans(time-limit or answers: 72 hoursmaximum)

4.2.4. Closing the dealThe process ends with the hope-

ully successul conclusion o thetransaction. This is based on aprecise data analysis o the un-derlying individual oers, po-tentially with the subsequent ac-ceptance (usually based on thebest price). The internal decision,which encompasses an evaluation

o all advantages and disadvan-

tages, leads to the conclusion othe deal with the investor select-ed, and consequently to the trans-er o the risk portolio with allrelevant data to the new owner.All debtors aected must be in-ormed in writing about this pro-cedure at this stage.

Deal Process

Process of the deal

Berlin Hyp concluded its two

portolio sales o non-perormingloans with Deutsche Bank Londonand was thereby able to achieve asignicant reduction in the badloan segment.


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4.3. Advantages to Berlin Hyp ofsaleThe risk loan portolio was un-damentally reduced and con-siderable contributions were atthe same time generated romthe sales themselves. The pric-es achieved were actually high-er than the initial projected

assumptions.As evidence or the healthy struc-ture o the assets side amongstother things re-sulting rom thebanks optimisation o its riskprole the internationally re-nowned rating agency Moodysclassiied the mortgage bonds

with the investment grade rat-ingAa1. Berlin Hyp also has two in-dependent rating results or itspublic mortgage bonds, bothwith the top rating AAA. Thesigniicant portolio reductionalso logically resulted in a reduc-tion o sta.

Closing Process of the deal

Our Target


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Case study: Managing Stress i n a Banks Balance Sheet 2/ 3Bernd Morgenschweis

5. OutlookIn a booming market, transac-tions with portolios o non-per-orming loans are cur-rently parto the core business o manybanks. The interest o interna-tional investors in such transac-

tions is growing steadily.A side-eect o this develop-ment is the infux o a signicantamount o capital into Germany.The probable next step is the re-structuring o the portolios bythe investors and the onward saleto new customers. Following on

rom the very positive experiencegained to date, Berlin Hyp is cur-rently preparing the next trans-action or the sale o a portolio

o non-perorming loans with avolume o between EUR 300 and500 million. Overall, the man-agement o loan risks will also bea central challenge or all bankdecision-makers in uture.

Outlook

NPA S1 Managing-Stress

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