Japan’s Distressed Debt MarketJapan’s Distressed Debt Market

Manmohan Singh and Kazunari OhashiManmohan Singh and Kazunari Ohashi

International Monetary FundInternational Monetary Fund

I. Why do the market bids for NPLs/SPLs I. Why do the market bids for NPLs/SPLs matter?matter?

Corporate restructuring requires recycling and replacement Corporate restructuring requires recycling and replacement of impaired capital.of impaired capital.

Bank capitalization is weak (note the high level of Bank capitalization is weak (note the high level of DTAs).DTAs).

Banks do not possess the skills to turn-around Banks do not possess the skills to turn-around distressed corporates.distressed corporates.

Thus, market clearing price is needed to attract risk capital Thus, market clearing price is needed to attract risk capital and accelerate corporate restructuring. and accelerate corporate restructuring.

Debt-equity swap + new capital.Debt-equity swap + new capital.

However, price mismatches stall efforts to create a liquid However, price mismatches stall efforts to create a liquid distressed debt market. distressed debt market.

HHow the market has graduated to SPLsow the market has graduated to SPLs

Japan’s distressed debt market started as a market for collateral sales.Japan’s distressed debt market started as a market for collateral sales. Since 1995, strict collateral valuation, along with falling land prices, Since 1995, strict collateral valuation, along with falling land prices,

forced banks to sell collaterals.forced banks to sell collaterals.

Banks at first sold high-quality collaterals at fire-sale prices.Banks at first sold high-quality collaterals at fire-sale prices. Foreign distressed debt players earned 30-50% annual returns.Foreign distressed debt players earned 30-50% annual returns. Due to the complex legal systems, reference prices were not available Due to the complex legal systems, reference prices were not available

and collaterals were priced on a bilateral basis.and collaterals were priced on a bilateral basis.

Margins on collateral sales have recently become tight.Margins on collateral sales have recently become tight. Japanese investors entered the market with lower required returns.Japanese investors entered the market with lower required returns. Banks learned to use competitive auctions.Banks learned to use competitive auctions. Quality of collaterals has become worse—asset deflation also reduced Quality of collaterals has become worse—asset deflation also reduced

collateral values.collateral values.

Foreign players started to move into the SPL maket for higher returns.Foreign players started to move into the SPL maket for higher returns.

Where do SPLs come from?Where do SPLs come from?

SPLs are special mention and near-bankruptcy SPLs are special mention and near-bankruptcy loans.loans.

Failed life insurers sell SPLs Failed life insurers sell SPLs Non-main banks sell Non-main banks sell minor stakes of minor stakes of SPLsSPLs Main bank sell SPLs when debtors file for Main bank sell SPLs when debtors file for

judicial protectionjudicial protection Bank sell “near-bankrupt” loans that have Bank sell “near-bankrupt” loans that have

potential to turn into SPLs potential to turn into SPLs

Most SPLs traded in the market are near-Most SPLs traded in the market are near-bankrupt loans. bankrupt loans.

II. Why does a price mismatch exist?II. Why does a price mismatch exist?

Banks and investors use different valuation methods Banks and investors use different valuation methods and assumptions.and assumptions.

Banks assume Banks assume future gains from debt/collateralfuture gains from debt/collateral. . ““maturity default” is not recognizedmaturity default” is not recognized Impasse between main and nonmain banks on Impasse between main and nonmain banks on

debt restructuringdebt restructuring

Distressed investors account for Distressed investors account for future gains in equityfuture gains in equity..

Maturity Default rule is not recognizedMaturity Default rule is not recognized

Allowing rollover(s) of impaired loans de facto turns Allowing rollover(s) of impaired loans de facto turns them into perpetual debt.them into perpetual debt.

Banks view their loans as a call option on Banks view their loans as a call option on Japan’s economic recovery. Japan’s economic recovery.

In default, they are legally collateralized/senior In default, they are legally collateralized/senior debt (and senior of equity).debt (and senior of equity).

Rigid reserving rules and weak capital make Rigid reserving rules and weak capital make banks downside sensitive. banks downside sensitive.

The impasse between the main bank and The impasse between the main bank and the nonmain bank the nonmain bank

Stalling debt reduction.....Stalling debt reduction.....

Nonmain banks expect main banks to bail out SPL Nonmain banks expect main banks to bail out SPL debtors (debtors (main yose –i.e the put optionmain yose –i.e the put option).).

Government may bail out main banks, Government may bail out main banks, anyway.anyway.

Main banks refuse unilateral debt reduction Main banks refuse unilateral debt reduction because they lose upside potential. because they lose upside potential.

Main banks’ upside is larger because they Main banks’ upside is larger because they hold more collateral than nonmain banks. hold more collateral than nonmain banks.

Main bank systemMain bank systemBanks optimized monitoring costs by designating a main Banks optimized monitoring costs by designating a main

bank.bank. MOF’s restrictive branching policy encouraged banks MOF’s restrictive branching policy encouraged banks

to expand credit exposures outside their territories via to expand credit exposures outside their territories via the main bank system. the main bank system.

Main banks monitored the solvency of borrowers, not Main banks monitored the solvency of borrowers, not their profitability.their profitability.

Main banks bailed out nonmain banks when borrowers Main banks bailed out nonmain banks when borrowers experienced financial problems—in turn, main banks experienced financial problems—in turn, main banks took first-rank collaterals, which fully protected them.took first-rank collaterals, which fully protected them.

Decline in land prices revealed asymmetry between main Decline in land prices revealed asymmetry between main and nonmain banks in valuing loans.and nonmain banks in valuing loans.

Syndicated loans had not been introduced until 1997. Syndicated loans had not been introduced until 1997.

Classification of SPLs –as defined in our Classification of SPLs –as defined in our paper (roughly in line with official paper (roughly in line with official

classification)classification) Percentages indicate the ‘loan loss provisions’ applicable in Percentages indicate the ‘loan loss provisions’ applicable in

each category. SPLs are ‘special mention’ and some ‘near each category. SPLs are ‘special mention’ and some ‘near bankrupt’category loansbankrupt’category loans

Underwatch5%

Special mention15%

Near bankruptcy70%

De facto bankruptcy100%

Judicial bankrutpcy100%

55% wedge

Bank’s view and the collateral optionBank’s view and the collateral option

Banks seldom resort to debt-equity swaps as it Banks seldom resort to debt-equity swaps as it requires coordination among main banks and requires coordination among main banks and nonmain banks– very few cases of DESnonmain banks– very few cases of DES

Collateral as an option where liquidation prices Collateral as an option where liquidation prices is ‘strike’ priceis ‘strike’ price

Debt price (including the option) is capped at Debt price (including the option) is capped at par; however if potential upside gain is par; however if potential upside gain is sufficiently large, the equity view of the SPLs sufficiently large, the equity view of the SPLs should price it higher than debtshould price it higher than debt

Debt is senior to equity in bankruptcyDebt is senior to equity in bankruptcy

Values (after the haircut i.e. B/A vary widely but generally in Values (after the haircut i.e. B/A vary widely but generally in the 60 -80 cents/$ range). This is the bank’s view of their the 60 -80 cents/$ range). This is the bank’s view of their restructured portfoliorestructured portfolio

In ¥ 100 millionInitial Loan Present value

Name of company A B B/A C C/AIchita 284 71 25.0% 5 1.8%Chiyoda Kakou Kensetsu 839 373 44.5% 18 2.1%Daikyo 10,729 5,243 48.9% 600 5.6%Mitsui Kensetsu 4,226 2,493 59.0% 205 4.9%Kumagai gumi 10,572 6,455 61.1% 200 1.9%Itsuzu Motor 10,682 6,782 63.5% 1,000 9.4%Daiei 25,641 16,948 66.1% 2,300 9.0%Sumitomo Kensetsu 3,149 2,097 66.6% 300 9.5%Hazama 4,224 2,861 67.7% 82 1.9%Hasekou 5,211 3,970 76.2% 1,500 28.8%Toyo Shutter 287 245 85.4% 10 3.5%Kenwood 1,224 1,076 87.9% 250 20.4%Dia Kensetsu 3,188 2,880 90.3% 32 1.0%Nihon Bankin 1,480 1,383 93.4% 150 10.1%

Cases of debt restructuring

Debt equity swap and new captal

III. Equity play: Investor’s bid price III. Equity play: Investor’s bid price

1.1. LeverageLeverage

Actual return on asset is not as high as publicized.Actual return on asset is not as high as publicized.

rraa = (r = (ree + + llrrbb) / (1+) / (1+ll)) rraa : rate of return on assets : rate of return on assets

rrbb : borrowing rate : borrowing rate

ll: leverage factor: leverage factor

Average spread of distressed corporates: 600-800 Average spread of distressed corporates: 600-800 bps (these are BB to C corporates)bps (these are BB to C corporates)

When rb = 4%,

1 2 3

(when re = 15) 9.5 7.7 6.8

(when re = 20) 12.0 9.3 8.0

Leverage =

ra =

2. Bid price (X2. Bid price (XTT), based on Internal rate of return), based on Internal rate of return

nn

XXTT = ∑ R / (1+r = ∑ R / (1+raa))tt + X + XT+n T+n / (1+r/ (1+raa))nn

t=1t=1

R: annual returnR: annual return

Assume XAssume XTT = X = XT+nT+n. Then, . Then,

XXT T = R / r= R / raa

Bottom priceBottom price Assume R is the inherited interest.....Assume R is the inherited interest.....

R [Interest rate (inherited) on books (%) ] 1.5 2 2.5Haircut to adjust for the above payment of interest (%) 77.9 70.6 63.2Bid price, cents on the dollar (1 minus haircut factor) 22.1 29.4 36.8

Haircut factor and bid price to achieve 6.8% return on assets

IV. Perpetual debt play: Bank’s offer price IV. Perpetual debt play: Bank’s offer price

nn

V = ∑ [pV = ∑ [pii(1-p(1-pii-1)L + (1-p-1)L + (1-pii))IIii] / (1+r] / (1+rii) ) T=1T=1

ppii : probability of default at period i : probability of default at period iL : value of the loan at liquidationL : value of the loan at liquidationIIii : income from the loan at period i : income from the loan at period irrii : discount rate : discount rate

Today’s SPL value, based on DCFToday’s SPL value, based on DCFTo simplify.........To simplify.........

We assume 5-year investment horizon and,We assume 5-year investment horizon and, IIii

to be 2% of to be 2% of II, where , where II is book value is book value

r to be zero r to be zero

Assume liquidation value to be collateral value,Assume liquidation value to be collateral value,

Max L = dMax L = dII, ,

d is collateral coverage ratio.d is collateral coverage ratio.

Then,Then,

V = [pd + 1.1*(1 – p)] V = [pd + 1.1*(1 – p)] II

Land prices in central cities is at 20% of the peak.Land prices in central cities is at 20% of the peak.Hence, the collateral coverage “d” is 20%.Hence, the collateral coverage “d” is 20%.

30% 40% 50% Value today (SPL) ( d = 0.20) 83.0 74.0 65.0

Today's Value

p

Tomorrow’s value (Potential future gain)Tomorrow’s value (Potential future gain)

But, what if the economic recovery increases But, what if the economic recovery increases collateral value and lowers default probability?collateral value and lowers default probability?

(‘d’ increases by roughly 5% for 5 year (‘d’ increases by roughly 5% for 5 year (compouded) or about 30%; ‘p’ decreases by (compouded) or about 30%; ‘p’ decreases by 10%)10%)

In a future state ( f ), if:In a future state ( f ), if:

d goes up by 30%: dd goes up by 30%: df f = 20% (1.3)= 26% = 20% (1.3)= 26%

p goes down by 10%: pp goes down by 10%: pf f = p -10%= p -10%

30% 40% 50% Value today (SPL) ( d = 0.20) 83 74 65

20% 30% 40%

Potential Future Value (SPL) (df = 0.20*1.3) 93 85 76

p

Today's Value and Potential Future Value

Pf

Today and Tomorrow's value of impaired loan

1982 1986 1990 1994 1998 2002 2006

Collateral value(land price)

Book value

Today's value(Default Probability = 40%)

Tomorrow's value(Default Probability = 30%)

Up 30 %

100

V. Prices that clear the ‘maket’?V. Prices that clear the ‘maket’?

Investors:Investors: Improve debtor’s cash flowImprove debtor’s cash flowIncrease their leverage?—but leverage Increase their leverage?—but leverage

works works both ways.both ways.

Banks: Banks: Conservative default assumptionsConservative default assumptions Assume upside option value in their Assume upside option value in their

collateralcollateral

When an investor owns a 50% stake.....When an investor owns a 50% stake.....

Market Clearing price 65 74 85

Required actual return (Ra) (%) 4.4 5.0 5.8

Required cash flow improvement (%) 61% 76% 95%

(ra = 6.8％, interest rate(inherited) on the books = 2% )

Required earning to achieve market clearing price

VI. Policy SuggestionsVI. Policy Suggestions

Restrict rollover of impaired loans that results in Restrict rollover of impaired loans that results in ‘perpetual debt play’‘perpetual debt play’

Swap impaired loans for equity that can be priced off the Swap impaired loans for equity that can be priced off the market (secondary market price of the corporates bonds, market (secondary market price of the corporates bonds, share price on the Nikkei etc)share price on the Nikkei etc)

Reducing the impasse between the main bank and Reducing the impasse between the main bank and nonmain banks, especially where the latter assume an nonmain banks, especially where the latter assume an (eventual) bail-out by the government(eventual) bail-out by the government

Policy Suggestions…. continuedPolicy Suggestions…. continued

Increase the use of judicial restructuring at an early stageIncrease the use of judicial restructuring at an early stage Introduce a gradual scale for loan loss reserves, thereby Introduce a gradual scale for loan loss reserves, thereby

reducing the regulatory wedge, especically that exists reducing the regulatory wedge, especically that exists between ‘special mention loans’ and ‘near-bankrupt’ loansbetween ‘special mention loans’ and ‘near-bankrupt’ loans

Upgrade loan(s) that are restructured– present regulations Upgrade loan(s) that are restructured– present regulations disallow such upgrades.disallow such upgrades.

Develop the local investor base for high yield assets (e.g. Develop the local investor base for high yield assets (e.g. Norinchukin Bank, Daido Life and Tokyo Marine and their Norinchukin Bank, Daido Life and Tokyo Marine and their search for extra yield)search for extra yield)