Restructuring, Foreclosure, Insolvency or What?

The various stake holders in the financial sector program for Cyprus be that the Troika, the Government, the Parliament, the Central Bank of Cyprus and now the International Institute of Finance all agree that the biggest challenge facing the economy of Cyprus is the size of NPLs. The Cyprus case is unique in history 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.  For the past year we saw various options 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 there will be no bad bank for NPLs across the banking system and the borrowers will have to be managed by the letter of the law.  In the view of the author this may be part of the story as I attempt to explain below. We know that restructuring of loans has been the preferred course of action of the Government, the Troika and most of the establishment in Cyprus.  I do not think there is anyone who would not favour this option to deal 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.  In other words the debt repayments were possible over the term of the loan under the new terms of the loan and not as in the past to extend and pretend.  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.  In many of these cases the lender, and rightly so, would expect a partial repayment to reduce the debt before the lender restructures the debt. Another option, which is hotly debated in Cyprus, 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 Troika must have insisted on this as they now know better how the private market works with greater efficacy than the public sector given their experiences in program 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 the judicial process is not the one is efficient based on the Vienna initiative neither the government and Parliament.  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 has come up with the need to reform the in solvency law in Cyprus which is 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 program countries as it focuses minds of the borrowers so that they pay up. It is expected that instead of foreclosure of property the threat of insolvency, and loss of their property, borrowers could be led to insolvency otherwise why such urgency by the Troika to have this law in place. Here again this might work in Anglo Saxon countries but in my view it is hard to believe that a bank in Cyprus will file for insolvency if one of it major borrowers, who provides a lot of employment, will be happy to undertake.  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 in the hope that this will magically make borrowers be able, despite their troubles to fund and develop projects, let alone sell, and be able to repay their loans.  This is possible but we need to see how it works in practice; I remain to be convinced. If all the above are hard to achieve the desired result for banks to get repaid, what is the way out that is left?  Well the answer must lie in the type of ends that will take a major equity’s take in the Bank of Cyprus; this holds for any bank that has hedge funds as investors.  Typically these funds have an exit strategy which on average is three years, sometimes if markets are not favorable 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.", the famous words of a leading hedge fund owner.  Why not one might ask when they take the risk? So if it will be hard to foreclose or bankrupt a delinquent borrower why are such investors taking risks which seem to be very calculated ones in Cyprus?  The simple answer is that if delinquent borrowers do not face up to their responsibilities within the next six- nine months with the new investors on the boards of banks in Cyprus there is 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 thus is at which price can NPLs be sold so that these sales minimize the loss that is crystallised.  If the new funds raised will address the stress test concerns of the ECB it must be the case that the NPL coverage will be increased  to what is regarded in the EU as more prudent which is 50%. The equity raised is not for on lending but meeting the requirements that will emanate from the asset quality review In the case of other program countries the sales discount has been as high as 65-70% 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%.  If this were to be right then it is more conceivable that there will be good reason to see such sales which will not have an immediate impact on land prices as NPL coverage will increase to meet the stress tests.  Should sales 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% or in full.  That is 100%. If the borrower can not 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 is for the Central Bank of Cyprus to forbid the secondary market trading of NPLs.  If they have such a Directive it is good for the public to know.  If there is no restriction then the clients of the banks and the public at large should be told. In closing, an alternative the Government may wish to consider is to set up a Fund itself where by the Fund will have first refusal on such NPLs.  Such a Fund could be supported by local institution all investors, who could be given tax incentives, and overseas investors such as long term funds with return expectations around 10-12%.  Sovereign wealth funds which have increased/and are increasing their exposure to real estate(bond yields are very low and at all time low in Germany last week) could be invited to participate as investors.  In this way the upside in land prices in the medium term will provide a profitable investment to the government and not to hedge funds from overseas.  It is thus up to the government to explore such a financial structure with the EU agencies and local as well as international institutional investors' where such.  Investors have a long reinvestment horizon of seven to ten years. Such a Fund will do more to provide certainty for the consequences of easing foreclosure and in solvency and dampen the cries of imminent collapse in real estate prices if such prudent legal measures are introduced.