Japan’s Distressed Debt Market

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Japans Distressed Debt Market. Manmohan Singh and Kazunari Ohashi International Monetary Fund. I. Why do the market bids for NPLs/SPLs matter?. Corporate restructuring requires recycling and replacement of impaired capital. Bank capitalization is weak (note the high level of DTAs). - PowerPoint PPT Presentation

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  • Japans Distressed Debt Market

    Manmohan Singh and Kazunari Ohashi

    International Monetary Fund

  • I. Why do the market bids for NPLs/SPLs matter?Corporate restructuring requires recycling and replacement of impaired capital.Bank capitalization is weak (note the high level of DTAs).Banks do not possess the skills to turn-around distressed corporates.

    Thus, market clearing price is needed to attract risk capital and accelerate corporate restructuring. Debt-equity swap + new capital.

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

  • How the market has graduated to SPLsJapans distressed debt market started as a market for collateral sales.Since 1995, strict collateral valuation, along with falling land prices, forced banks to sell collaterals.

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

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

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

  • Where do SPLs come from?SPLs are special mention and near-bankruptcy loans.Failed life insurers sell SPLs Non-main banks sell minor stakes of SPLsMain bank sell SPLs when debtors file for judicial protectionBank sell near-bankrupt loans that have potential to turn into SPLs

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

  • II. Why does a price mismatch exist?Banks and investors use different valuation methods and assumptions.

    Banks assume future gains from debt/collateral. maturity default is not recognizedImpasse between main and nonmain banks on debt restructuring

    Distressed investors account for future gains in equity.

  • Maturity Default rule is not recognizedAllowing rollover(s) of impaired loans de facto turns them into perpetual debt.

    Banks view their loans as a call option on Japans economic recovery. In default, they are legally collateralized/senior debt (and senior of equity).Rigid reserving rules and weak capital make banks downside sensitive.

  • The impasse between the main bank and the nonmain bank Stalling debt reduction.....

    Nonmain banks expect main banks to bail out SPL debtors (main yose i.e the put option).Government may bail out main banks, anyway.

    Main banks refuse unilateral debt reduction because they lose upside potential. Main banks upside is larger because they hold more collateral than nonmain banks.

  • Main bank systemBanks optimized monitoring costs by designating a main bank.MOFs restrictive branching policy encouraged banks to expand credit exposures outside their territories via the main bank system. Main banks monitored the solvency of borrowers, not their profitability.Main banks bailed out nonmain banks when borrowers experienced financial problemsin turn, main banks took first-rank collaterals, which fully protected them.

    Decline in land prices revealed asymmetry between main and nonmain banks in valuing loans.Syndicated loans had not been introduced until 1997.

  • Classification of SPLs as defined in our paper (roughly in line with official classification)Percentages indicate the loan loss provisions applicable in each category. SPLs are special mention and some near bankruptcategory loansUnderwatch5%Special mention15%Near bankruptcy70%De facto bankruptcy100%Judicial bankrutpcy100%55% wedge

  • Banks view and the collateral optionBanks seldom resort to debt-equity swaps as it requires coordination among main banks and nonmain banks very few cases of DESCollateral as an option where liquidation prices is strike priceDebt price (including the option) is capped at par; however if potential upside gain is sufficiently large, the equity view of the SPLs should price it higher than debtDebt is senior to equity in bankruptcy

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

  • III. Equity play: Investors bid price LeverageActual return on asset is not as high as publicized. ra = (re + lrb) / (1+l)ra : rate of return on assets rb : borrowing ratel: leverage factor Average spread of distressed corporates: 600-800 bps (these are BB to C corporates)

  • 2. Bid price (XT), based on Internal rate of return n XT = R / (1+ra)t + XT+n / (1+ra)n t=1 R: annual return Assume XT = XT+n. Then, XT = R / ra

    Bottom priceAssume R is the inherited interest.....

  • IV. Perpetual debt play: Banks offer price nV = [pi(1-pi-1)L + (1-pi)Ii] / (1+ri) T=1pi : probability of default at period iL : value of the loan at liquidationIi : income from the loan at period iri : discount rate

    Todays SPL value, based on DCFTo simplify.........

  • We assume 5-year investment horizon and, Ii to be 2% of I, where I is book value r to be zero

    Assume liquidation value to be collateral value,Max L = dI, d is collateral coverage ratio.

    Then,V = [pd + 1.1*(1 p)] I

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

  • Tomorrows value (Potential future gain)

    But, what if the economic recovery increases collateral value and lowers default probability?(d increases by roughly 5% for 5 year (compouded) or about 30%; p decreases by 10%)

  • In a future state ( f ), if: d goes up by 30%: df = 20% (1.3)= 26% p goes down by 10%: pf = p -10%

  • Debt restructuring

    Cases of debt restructuring

    In 100 million

    Initial LoanPresent valueDebt equity swap and new captal

    Name of companyABB/ACC/A

    Ichita2847125.0%51.8%

    Chiyoda Kakou Kensetsu83937344.5%182.1%

    Daikyo10,7295,24348.9%6005.6%

    Mitsui Kensetsu4,2262,49359.0%2054.9%

    Kumagai gumi10,5726,45561.1%2001.9%

    Itsuzu Motor10,6826,78263.5%1,0009.4%

    Daiei25,64116,94866.1%2,3009.0%

    Sumitomo Kensetsu3,1492,09766.6%3009.5%

    Hazama4,2242,86167.7%821.9%

    Hasekou5,2113,97076.2%1,50028.8%

    Toyo Shutter28724585.4%103.5%

    Kenwood1,2241,07687.9%25020.4%

    Dia Kensetsu3,1882,88090.3%321.0%

    Nihon Bankin1,4801,38393.4%15010.1%

    Source: Nomura Research Institute

    Haircut

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

    R [Interest rate (inherited) on books (%) ]1.522.5

    Haircut to adjust for the above payment of interest (%)77.970.663.2

    Bid price, cents on the dollar (1 minus haircut factor)22.129.436.80.65

    cash flow improvement

    Required earning to achieve higher bid price

    Offer price from bank657485

    4.45.05.8

    Required cash flow improvement (%)161%176%195%

    1.51.51.5

    222

    2.52.52.5

    Leverage

    Leverage =123

    9.57.76.8

    12.09.38.0

    Chart1

    51.3395843805

    54.6253177808

    67.5715180949

    83.5183963653

    75.7511855033

    75.8269366888

    76.4335521823

    77.4271883607

    79.8274311999

    85.1758690903

    90.8826523193

    96.1538461538

    100

    103.5

    107.433

    112.912083

    128.042302122

    156.0835662867

    172.1601736142

    200.9109226078

    226.8284316242

    217.7552943593

    192.9311908023

    171.1299662417

    154.0169696175

    138.923306595

    128.0872886806

    120.2739640711

    110.5317729813

    101.6892311428

    94.0625388071

    86.2553480861

    79.3549202392

    Land price

    7.4197151.3395843805

    6.4197254.6253177808

    23.7197367.5715180949

    23.6197483.5183963653

    -9.3197575.7511855033

    0.1197675.8269366888

    0.8197776.4335521823

    1.3197877.4271883607

    3.1197979.8274311999

    6.7198085.1758690903100

    6.7198190.8826523193106.7

    5.8198296.1538461538112.8886

    41983100117.404144

    3.51984103.5121.51328904

    3.81985107.433126.1307940235

    5.11986112.912083132.5634645187

    13.41987128.042302122150.3269687642

    21.91988156.0835662867183.2485749236

    10.31989172.1601736142202.1231781407

    16.71990200.9109226078235.8777488902

    12.91991226.8284316242266.3059784971100%

    -41992217.7552943593255.6537393572

    -11.41993192.9311908023226.5092130705

    -11.31994171.1299662417200.9136719935

    -101995154.0169696175180.8223047942

    -9.81996138.923306595163.1017189243

    -7.81997128.0872886806150.3797848482

    -6.11998120.2739640711141.2066179725

    -8.11999110.5317729813129.7688819167

    -82000101.6892311428119.3873713634

    -7.5200194.0625388071110.4333185111

    -8.3200286.2553480861101.2673530747

    -8200379.354920239293.165964828735%

    Land price (2)

    197000

    197100

    197200

    197300

    197400

    197500

    197600

    197700

    197800

    197900

    198000

    198100

    6.81982100100

    8.91983106.8106.8

    13.21984116.3052116.3052

    28.81985131.6574864131.6574864

    33.81986169.5748424832169.5748424832

    41.81987226.8911392425226.8911392425

    25.11988321.7316354459321.7316354459

    27.61989402.4862759428402.4862759428

    3.31990513.572488103513.572488103100%

    -15.31991530.5203802104530.5203802104

    -22.41992411.6838150433411.6838150433

    -18.51993335.5223092603335.5223092603

    -24.21994254.3259104193254.3259104193

    -211995200.9174692312200.9174692312

    -141996172.7890235389172.7890235389

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