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Non-performing loans and the moral hazard of investment decisions
Published: Sunday | May 22, 2011
In this April 2008 Gleaner file photo, Carvel Stewart holds up a copy of a notice to be posted by the Association of Finsac'd Entrepreneurs (AFE) at properties confiscated by FINSAC and due to be sold at an AFE meeting held at the Stella Maris Auditorium in Kingston. - File
The fourth instalment of Patrick Hylton's statement to the FINSAC commission of enquiry.
One of the questions frequently asked is: Why did FINSAC continue to charge interest on loans that were already in default or non-performing?
The rationale for FINSAC charging interest on loans is as follows:
a) First, it was important that persons who were holders of the debt acquired by FINSAC be incented to come in and negotiate a settlement quickly. Continued interest accrual would represent a powerful incentive in this regard. The fact that FINSAC accrued interest was no constraint on our ability to write back that interest as well as in some cases part of the principal in reaching settlement within our policy framework;
b) The notes which FINSAC issued accrued interest at market rates. These notes were used to fund the acquisition of the loans at their full book value. It was therefore also important that FINSAC apply and collect interest on those loans when it was fair and equitable to do so. The rates charged by FINSAC were also consistent with existing market rates and primarily at the lower end of those rates;
c) To have stopped accruing interest would had the potential to create perverse incentives in the industry. It would be seen as unfair on the face of it to the customers who continued to pay on performing loans in both the intervened and non intervened banking sector. We need to always remember that even as FINSAC managed non-performing loans, it also had a significant interest in existing performing loans in the 60-plus per cent of the banking sector it controlled;
d) Worse than that it could create a powerful incentive for borrowers to default particularly in banks that were controlled by FINSAC, so that their loans could be sold to FINSAC thereby giving them a break on interest accrual but creating worsening problems in the financial sector;
e) There may have been instances where persons were delinquent in one institution, but have significant resources in another institution, or invested in GOJ LRS (local registered stock), earning high rates of interest, whether in their own name or that of an entity they controlled;
f) Our experience also supported that continued application of interest could be beneficial as we on several occasions were able to collect some of this interest;
g) If FINSAC did not charge a rate commensurate with the market rate on the loans it bought, a delinquent borrower would be incented to sell assets and instead of paying FINSAC, invest in GOJ paper and earn those levels of interest from the same Government that bought his debt with an instrument on which the government was accruing interest obligations.
Therefore, the continued accrual of interest at market rates was appropriate in that it served as an incentive for borrowers to want to settle their loans and a disincentive for performing borrowers within FINSAC controlled institutions to default on their loans.
We often discovered many of the borrowers who were more than six months or more in arrears with the banks from whom we bought the loans had received no more than a single call or perhaps only a single letter from the legacy bank.
Consequently, we did find instances where we were able to collect not only what was due to the legacy institution but also some of the interest we accrued thereby maximising the returns to taxpayers.
Some of these persons had not paid, simply because no pressure had been put on them to repay.
There were also loans which we restructured with write-offs and moratoriums to which the application of interest was also appropriate given the circumstances and future prospects of the borrower.
Even after the application of the valuation framework for the loans which I mentioned earlier, there was a hierarchical basis for further compromises, starting within the Non-Performing Loan Unit, through the head of that unit, and the credit committee all the way up to the board.
The structure was in this regard, similar to that of a bank, appropriately so as FINSAC had purchased bank debts and itself had obligations to satisfy which would be affected by the debt recovery.
Moral hazard
Many debtors failed to acknowledge that FINSAC had no mandate to rescue or bail out borrowers.
In any event, my own view is that as a general rule this would be at best inappropriate and at worst perverse.
While we empathised with many of these borrowers, we also need to recognise that we had taken over private arrangements from the private sector imposing a cost on taxpayers.
While the same is true of depositors, it is the potential damage to economies caused by their non-rescue and loss of confidence which forces authorities the world over to rescue them.
It is to be noted that the rescue of depositors in failed or failing financial institutions can create its own moral hazard problem within our society, in which people are unwilling to take responsibility for their own financial and investment decisions.
Indeed, there was some evidence of this as persons continued to place their money with Workers Savings and Loan Bank even after that institution had publicly declared its insolvency.
I made this observation about the moral hazard problem in relation to deposits at the time of intervention, but accepted also, and remain of the view, that repaying depositors was a 'necessary evil' to restore confidence and preserve our financial system.
One important reason why depositors needed to be treated differently from delinquent borrowers is that while delinquent borrowers are in breach of their contracts with the financial institution, depositors are not in breach.
The relationship which exists is that depositors lend their monies on deposits to banks who then invest it in assets such as loans, with the expectation that repayment of these loans will enable them to repay depositors.
It is the borrower's failure to repay, among other reasons, which puts depositors in jeopardy.
If we look at what would happen if the banks were allowed to fail, it is quite clear that a liquidator would be obliged to sell whatever assets he found, and go after debtors for the full amount owed in order to maximise the payout to depositors and other creditors.
By the Government intervening and protecting depositors, it was facilitating the continuation of these entities as going concerns and/or the sector as a whole. The Government also had a responsibility to seek to minimise the impact on taxpayers who would have to make up the shortfall in asset realisations.
The Government in guaranteeing depositors repayment, effectively subordinated themselves to the position of those depositors.
Consequently, they were entitled to pursue recovery of the loans as this represented assets in which their funds were invested.
If we were to extend some general form of rescue to delinquent borrowers of failed financial institutions, then I would argue that equity would require that the same assistance should be offered to non-delinquent borrowers who were making sacrifices to meet their obligations.
In fact, it could also be argued that the same offer should be made to all borrowers in all institutions in Jamaica who would have had to pay facilities at high interest rates.
I could then go on to argue the case for assistance for customers of these borrowers, some of whom might have paid higher prices for goods and services, given the need for these businesses to attempt to remain viable.
If I were to take this to its logical conclusion we would become a nation of bail outs which we could not afford.
Notwithstanding, we recognised the need to try to reach consensual settlements with debtors as we felt this approach would yield better results as well as facilitate greater levels of normality within the real sector.
We also, as I have said earlier, recognised that bad loan did not necessarily - and in many instances did not - equate to bad person.
FIS as well as FINSAC at the same time through Recon Trust Limited and
Refin Trust Limited had to be careful that it did not fall into the same or similar difficulties as Foboproa in Mexico which had to be disbanded as, among other things, they engaged in significant write-offs for persons who had non-performing loans only to see them shortly after engaging in lavish lifestyles.
There were good reasons for us to seek to reach reasonable compromises, as that in our considered view, represented the best way to maximise value from the portfolio.
It is far easier in many instances to realise greater value from a loan by having agreement rather than adversarially seeking to enforce security.
Once such a restructured loan performs for a while, it can be sold at par or perhaps even at a premium.
The enforcement of security on the other hand can be quite costly and can often be protracted.
There are, however, times when realisation of security is the best or only option.
It is important to recognise that the loan portfolio was not comprised of a homogenous set of borrowers, whose failure was caused only or in some instances primarily by high interest rates.
There were loans that went bad prior to the period of high interest rates and were being constantly restructured by the banks over several years.
The portfolio also contained loans to borrowers who applied for and were granted new facilities at high rates during the high interest rate period.
This would be based on their representation that based on their income or in the case of businesses, their cash flows and business models, they could comfortably service these facilities and remain viable and profitable.
There were also borrowers who took out their loans at lower rates and saw those rates increase on them. In some of these cases they tried to cope with the situation by paying down their facilities but some also borrowed more at the new higher rates for new ventures that at times were unsuccessful.
Natural tension
It is also important to recognise that there would very often be a natural tension between collectors and borrowers whose loans were bought under the aegis of FINSAC.
While the officers of FINSAC and its subsidiaries would be focused on maximising recovery based on what they believed the borrower could or should be able to repay, the borrower was naturally seeking to minimise this amount, seeing that it would have a negative impact on his or her circumstances.
Our experience, which is not unique in the financial sector - regardless of whether there is a crisis - was that some borrowers would resort to all kinds of strategies to accomplish this ranging from understating income to hiding or attempting to hide assets it to seeking interventions through politicians and other persons of influence.
FINSAC's approach, however, remained one in which it was guided by its mandate and its standard policies for non-performing loan workouts.
That way, the approach was always one we felt we could defend as being consistent and fair.
At the same time we needed to recognise that the cash flows from these loans were critical to our funding needs. Our institutions were severely challenged with liquidity pressures on a daily basis even with the benefit of the flows from our other non performing assets.
It is difficult to imagine how we could have sustained our activities without these non-performing loan flows.
My own view is that even if it were desirable to bail out borrowers which I have already said I do not believe to be the case, the bottom line is that I do not believe we could have afforded that as well as the rescue of depositors, pensioners and policyholders.
Unduly hard or unreasonable
In any organisation and more so in complex ones such as FINSAC, where a lot of the work is being carried out by several persons, you will find from time to time individuals who may be unduly hard or even unreasonable in exercising judgement.
This can happen in spite of any policy framework of the organisation and its best intentions. This is why there was a system of checks and balances and an institutional framework including a hierarchy of referrals for persons who wanted their cases reviewed for whatever reason. Many borrowers utilised this framework when they were dissatisfied with the decisions at first communicated to them.
The primary consideration in determining the extent or the amount of a compromise would be the prospects for recovery.
This would be assessed taking into account such issues as the financial circumstances of the borrower, the quality of the security, if any, quality of the documentation for the loan, the way in which the loan was managed or administered and the time of recovery.
We also need to remember that almost by definition, with the exception of a few performing loans, acquired form Blaise and Century, FINSAC's loans would have been loans that had reached classification.
That is according to the legal definition within a banking context they were non-performing loans which had reached the stage at which the institution should fully provide for the loan as being a bad debt.
Typically, in a normal bank this would result in the bank going after realisation of the security held to maximise on the recovery as other means of recovery had been exhausted and had failed.
Thus, even if the banks had not required intervention, they would have like FINSAC attempted to collect on these loans, if they were being operated normally.
FINSAC's arduous task was now to maximise on the recovery of these loans, to minimise the cost of the intervention and provide urgently needed liquidity for its own operations internally as well as those of the financial institutions it had intervened.
The difficulties in such an undertaking by itself were compounded by weak economic conditions including soft markets generally, as well as poor documentation and records for many of the loans acquired from the legacy institutions.
See final instalment Friday in the Financial Gleaner.
Published: Sunday | May 22, 2011
In this April 2008 Gleaner file photo, Carvel Stewart holds up a copy of a notice to be posted by the Association of Finsac'd Entrepreneurs (AFE) at properties confiscated by FINSAC and due to be sold at an AFE meeting held at the Stella Maris Auditorium in Kingston. - File
The fourth instalment of Patrick Hylton's statement to the FINSAC commission of enquiry.
One of the questions frequently asked is: Why did FINSAC continue to charge interest on loans that were already in default or non-performing?
The rationale for FINSAC charging interest on loans is as follows:
a) First, it was important that persons who were holders of the debt acquired by FINSAC be incented to come in and negotiate a settlement quickly. Continued interest accrual would represent a powerful incentive in this regard. The fact that FINSAC accrued interest was no constraint on our ability to write back that interest as well as in some cases part of the principal in reaching settlement within our policy framework;
b) The notes which FINSAC issued accrued interest at market rates. These notes were used to fund the acquisition of the loans at their full book value. It was therefore also important that FINSAC apply and collect interest on those loans when it was fair and equitable to do so. The rates charged by FINSAC were also consistent with existing market rates and primarily at the lower end of those rates;
c) To have stopped accruing interest would had the potential to create perverse incentives in the industry. It would be seen as unfair on the face of it to the customers who continued to pay on performing loans in both the intervened and non intervened banking sector. We need to always remember that even as FINSAC managed non-performing loans, it also had a significant interest in existing performing loans in the 60-plus per cent of the banking sector it controlled;
d) Worse than that it could create a powerful incentive for borrowers to default particularly in banks that were controlled by FINSAC, so that their loans could be sold to FINSAC thereby giving them a break on interest accrual but creating worsening problems in the financial sector;
e) There may have been instances where persons were delinquent in one institution, but have significant resources in another institution, or invested in GOJ LRS (local registered stock), earning high rates of interest, whether in their own name or that of an entity they controlled;
f) Our experience also supported that continued application of interest could be beneficial as we on several occasions were able to collect some of this interest;
g) If FINSAC did not charge a rate commensurate with the market rate on the loans it bought, a delinquent borrower would be incented to sell assets and instead of paying FINSAC, invest in GOJ paper and earn those levels of interest from the same Government that bought his debt with an instrument on which the government was accruing interest obligations.
Therefore, the continued accrual of interest at market rates was appropriate in that it served as an incentive for borrowers to want to settle their loans and a disincentive for performing borrowers within FINSAC controlled institutions to default on their loans.
We often discovered many of the borrowers who were more than six months or more in arrears with the banks from whom we bought the loans had received no more than a single call or perhaps only a single letter from the legacy bank.
Consequently, we did find instances where we were able to collect not only what was due to the legacy institution but also some of the interest we accrued thereby maximising the returns to taxpayers.
Some of these persons had not paid, simply because no pressure had been put on them to repay.
There were also loans which we restructured with write-offs and moratoriums to which the application of interest was also appropriate given the circumstances and future prospects of the borrower.
Even after the application of the valuation framework for the loans which I mentioned earlier, there was a hierarchical basis for further compromises, starting within the Non-Performing Loan Unit, through the head of that unit, and the credit committee all the way up to the board.
The structure was in this regard, similar to that of a bank, appropriately so as FINSAC had purchased bank debts and itself had obligations to satisfy which would be affected by the debt recovery.
Moral hazard
Many debtors failed to acknowledge that FINSAC had no mandate to rescue or bail out borrowers.
In any event, my own view is that as a general rule this would be at best inappropriate and at worst perverse.
While we empathised with many of these borrowers, we also need to recognise that we had taken over private arrangements from the private sector imposing a cost on taxpayers.
While the same is true of depositors, it is the potential damage to economies caused by their non-rescue and loss of confidence which forces authorities the world over to rescue them.
It is to be noted that the rescue of depositors in failed or failing financial institutions can create its own moral hazard problem within our society, in which people are unwilling to take responsibility for their own financial and investment decisions.
Indeed, there was some evidence of this as persons continued to place their money with Workers Savings and Loan Bank even after that institution had publicly declared its insolvency.
I made this observation about the moral hazard problem in relation to deposits at the time of intervention, but accepted also, and remain of the view, that repaying depositors was a 'necessary evil' to restore confidence and preserve our financial system.
One important reason why depositors needed to be treated differently from delinquent borrowers is that while delinquent borrowers are in breach of their contracts with the financial institution, depositors are not in breach.
The relationship which exists is that depositors lend their monies on deposits to banks who then invest it in assets such as loans, with the expectation that repayment of these loans will enable them to repay depositors.
It is the borrower's failure to repay, among other reasons, which puts depositors in jeopardy.
If we look at what would happen if the banks were allowed to fail, it is quite clear that a liquidator would be obliged to sell whatever assets he found, and go after debtors for the full amount owed in order to maximise the payout to depositors and other creditors.
By the Government intervening and protecting depositors, it was facilitating the continuation of these entities as going concerns and/or the sector as a whole. The Government also had a responsibility to seek to minimise the impact on taxpayers who would have to make up the shortfall in asset realisations.
The Government in guaranteeing depositors repayment, effectively subordinated themselves to the position of those depositors.
Consequently, they were entitled to pursue recovery of the loans as this represented assets in which their funds were invested.
If we were to extend some general form of rescue to delinquent borrowers of failed financial institutions, then I would argue that equity would require that the same assistance should be offered to non-delinquent borrowers who were making sacrifices to meet their obligations.
In fact, it could also be argued that the same offer should be made to all borrowers in all institutions in Jamaica who would have had to pay facilities at high interest rates.
I could then go on to argue the case for assistance for customers of these borrowers, some of whom might have paid higher prices for goods and services, given the need for these businesses to attempt to remain viable.
If I were to take this to its logical conclusion we would become a nation of bail outs which we could not afford.
Notwithstanding, we recognised the need to try to reach consensual settlements with debtors as we felt this approach would yield better results as well as facilitate greater levels of normality within the real sector.
We also, as I have said earlier, recognised that bad loan did not necessarily - and in many instances did not - equate to bad person.
FIS as well as FINSAC at the same time through Recon Trust Limited and
Refin Trust Limited had to be careful that it did not fall into the same or similar difficulties as Foboproa in Mexico which had to be disbanded as, among other things, they engaged in significant write-offs for persons who had non-performing loans only to see them shortly after engaging in lavish lifestyles.
There were good reasons for us to seek to reach reasonable compromises, as that in our considered view, represented the best way to maximise value from the portfolio.
It is far easier in many instances to realise greater value from a loan by having agreement rather than adversarially seeking to enforce security.
Once such a restructured loan performs for a while, it can be sold at par or perhaps even at a premium.
The enforcement of security on the other hand can be quite costly and can often be protracted.
There are, however, times when realisation of security is the best or only option.
It is important to recognise that the loan portfolio was not comprised of a homogenous set of borrowers, whose failure was caused only or in some instances primarily by high interest rates.
There were loans that went bad prior to the period of high interest rates and were being constantly restructured by the banks over several years.
The portfolio also contained loans to borrowers who applied for and were granted new facilities at high rates during the high interest rate period.
This would be based on their representation that based on their income or in the case of businesses, their cash flows and business models, they could comfortably service these facilities and remain viable and profitable.
There were also borrowers who took out their loans at lower rates and saw those rates increase on them. In some of these cases they tried to cope with the situation by paying down their facilities but some also borrowed more at the new higher rates for new ventures that at times were unsuccessful.
Natural tension
It is also important to recognise that there would very often be a natural tension between collectors and borrowers whose loans were bought under the aegis of FINSAC.
While the officers of FINSAC and its subsidiaries would be focused on maximising recovery based on what they believed the borrower could or should be able to repay, the borrower was naturally seeking to minimise this amount, seeing that it would have a negative impact on his or her circumstances.
Our experience, which is not unique in the financial sector - regardless of whether there is a crisis - was that some borrowers would resort to all kinds of strategies to accomplish this ranging from understating income to hiding or attempting to hide assets it to seeking interventions through politicians and other persons of influence.
FINSAC's approach, however, remained one in which it was guided by its mandate and its standard policies for non-performing loan workouts.
That way, the approach was always one we felt we could defend as being consistent and fair.
At the same time we needed to recognise that the cash flows from these loans were critical to our funding needs. Our institutions were severely challenged with liquidity pressures on a daily basis even with the benefit of the flows from our other non performing assets.
It is difficult to imagine how we could have sustained our activities without these non-performing loan flows.
My own view is that even if it were desirable to bail out borrowers which I have already said I do not believe to be the case, the bottom line is that I do not believe we could have afforded that as well as the rescue of depositors, pensioners and policyholders.
Unduly hard or unreasonable
In any organisation and more so in complex ones such as FINSAC, where a lot of the work is being carried out by several persons, you will find from time to time individuals who may be unduly hard or even unreasonable in exercising judgement.
This can happen in spite of any policy framework of the organisation and its best intentions. This is why there was a system of checks and balances and an institutional framework including a hierarchy of referrals for persons who wanted their cases reviewed for whatever reason. Many borrowers utilised this framework when they were dissatisfied with the decisions at first communicated to them.
The primary consideration in determining the extent or the amount of a compromise would be the prospects for recovery.
This would be assessed taking into account such issues as the financial circumstances of the borrower, the quality of the security, if any, quality of the documentation for the loan, the way in which the loan was managed or administered and the time of recovery.
We also need to remember that almost by definition, with the exception of a few performing loans, acquired form Blaise and Century, FINSAC's loans would have been loans that had reached classification.
That is according to the legal definition within a banking context they were non-performing loans which had reached the stage at which the institution should fully provide for the loan as being a bad debt.
Typically, in a normal bank this would result in the bank going after realisation of the security held to maximise on the recovery as other means of recovery had been exhausted and had failed.
Thus, even if the banks had not required intervention, they would have like FINSAC attempted to collect on these loans, if they were being operated normally.
FINSAC's arduous task was now to maximise on the recovery of these loans, to minimise the cost of the intervention and provide urgently needed liquidity for its own operations internally as well as those of the financial institutions it had intervened.
The difficulties in such an undertaking by itself were compounded by weak economic conditions including soft markets generally, as well as poor documentation and records for many of the loans acquired from the legacy institutions.
See final instalment Friday in the Financial Gleaner.
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