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Auctions fuel growing distressed debt market

The Czech Republic’s distressed debt market is burgeoning. If insolvency law and other legal obstacles are addressed, banks could begin to extend new loans with confidence, says Robert Anderson.
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The Czech Republic is setting the pace in post-communist central Europe as governments and banks begin to tackle the huge volume of non-performing loans (NPLs) left over from the difficult first decade of transition to a market economy. Through auctioning big packages of NPLs the Czech government has created central Europe’s most developed market in distressed assets.

The Czech example has already been copied by Slovakia, and now Poland is looking hard at the lessons of the auction programme. The Czechs led the way because they were forced to: delayed bank privatisation gave the country the worst NPL problem in the region.

Yet, although yields in the distressed assets market are growing gradually, investors have problems in realising value, hampered by a cumbersome legal framework that makes enforcing claims and insolvency a long, drawn-out process.

The ‘hospital’ bank

When the Czech economy entered recession in 1997, and the central bank hiked interest rates and tightened provisioning rules, one big private bank collapsed and two state-owned ones became, in effect, insolvent because of the provisions they had to make on their NPLs. To rescue the banks and attract potential buyers for them, the government transferred the bulk of their NPLs (usually at close to book value) to Ceska Konsolidacni, a “hospital” bank for the revolving stock loans that made the Communist enterprise system run. In the five years between 1998-2002, Konsolidacni took over assets with a book value of Kc264bn (now $10bn) for Kc218bn, pushing it into losses over those years of about Kc200bn.

Initially, there was a strong temptation to leave the problems out of sight and out of mind on Konsolidacni’s balance sheet. However, this would mean that the eventual bill for the state would be even bigger because the loans would deteriorate sharply as their borrowers’ remaining assets were stripped or became worthless. In addition, the longer Konsolidacni dithered, the longer the debt-ridden companies would stagger on without a real chance of recovering.

The government first chose to focus on the big debtors through a Revitalisation Programme. This was launched in 1999, with a consortium of Lehman Brothers and Latona Associates of Europe as advisers. Troubled but strategically important companies whose loans ended up in Konsolidacni’s hands were pressed to agree to debt-equity swaps that would bring them back under state control. After restructuring their debt and basic rationalisation, the advisers then tried to find strategic investors for the companies.

Clash with reality

The programme chalked up some successes but the political wish to save sensitive companies soon clashed irreparably with commercial reality. Konsolidacni sacked its advisers in 2001 and soldiered on by itself, to less and less effect.

A more promising approach was launched in 2001, when Konsolidacni held an auction of a pilot package of 503 loans worth $554m in nominal value. Goldman Sachs, together with local real estate group Flow East, won the tender with a bid of Kc1.35bn (then $35m), 7.1% of the nominal value.

The unexpectedly poor yield from the pilot package caused the government to pause. But after being re-elected in June 2002, the Social Democrats decided to complete the sale of Konsolidacni’s entire portfolio as soon as possible, with the aim of abolishing the agency in 2007. This forced Konsolidacni to speed up its auction process rather than try to realise the maximum value from each loan individually.

Its second package was double the size – 938 loans worth $1.1bn – and was sold for Kc3.4bn, a more generous 9% of the nominal value. But it was still controversial because the winner was EC Group, a shell company linked to Motoinvest, which is an aggressive local corporate raider. Rival bidders, such as Flow East, said the government should not have allowed such companies to compete in the tender.

Specialised auctions

Last year, Konsolidacni completed two specialised auctions. One package of 1634 loans to mostly insolvent companies with a total value of $1.8bn was sold for Kc1.26bn, 2% of the nominal value, to a consortium of CSFB, local financial group PPF and Penta Group, a Slovak corporate raider. Another package of 49 loans connected to the local Charouz car dealership group totalling $185m was sold for 10.2% of its nominal value to a shell company.

The process is now on hold again. EC Group, the winner of the 2002 tender, recently won Kc370m compensation from Konsolidacni in arbitration proceedings when it disputed whether the agency had clear legal title to some of the loans it had sold. The finance ministry has ordered an investigation before what is expected to be the last big auction later this year.

Despite the hiccups, Konsolidacni has now sold off around Kc125bn of distressed assets in major auctions, making a big dent in its portfolio. The agency is also holding frequent sales – by advertisement, public auction and over the internet – of individual loans, usually of higher quality, for which yields are more favourable. Its consolidated portfolio, which peaked at about Kc400bn in 2002, should fall to just over Kc100bn this year.

Yields grow

The auctions show a positive trend of gradually growing yields. This is proof that the secondary market in distressed assets is taking off. The size and deal flow of the market are now interesting to international investors and one –GE Global Financial Restructuring – has established a permanent team in Prague.

“Local infrastructure and understanding the local environment are crucial in realising NPLs,” says Ladislav Nussbauer of GE.

The maturing of the market has also encouraged the big banks to hold their own auctions. Last year, Komercni Banka (owned by Société Générale of France) sold a package of Kc20bn of loans to GE Global Financial Restructuring for an estimated Kc4bn, 20% of nominal. Ceska Sporitelna (owned by Erste of Austria) sold loans worth Kc12.3bn to JP Morgan for Kc775m, a yield of about 6% compared with nominal, 9.7% compared with book.

Selling packages of distressed assets allows banks to clean up their balance sheets swiftly and improve their financial ratios. It is more efficient to let others try to extract value from distressed assets than to tie up hundreds of employees in the long and depressing task of coaxing or forcing borrowers to pay up. The new foreign owners of the big three banks are trying to make their new acquisitions focus on new business; recovering unpaid loans reminds employees of their banks’ less than illustrious recent history.

“We felt it would be easier to rid ourselves of the debts of the past,” says Frank-Michael Beitz, head of credit risk management at Ceska Sporitelna. The auction enables Ceska to release 250 people from its 350-strong work-out department.

More clout

Distressed asset investors, who aim to realise annual returns of 30%, can be more flexible in reaching deals with debtors, and can take a tougher line in seizing collateral and filing for insolvency. Banks cannot afford to forget that their debtors, and their debtors’ employees, are often customers as well.

“They don’t have reputations to risk,” says Mr Beitz. “And people are more prepared to pay if someone else comes collecting.”

Yet, realising value from distressed assets is still a thankless task in the Czech Republic. The legal framework is cumbersome for enforcing claims and forcing debtors into receivership. Moreover, Chapter 11-style reorganisations, in which the company stays in business but agrees to pay back part of its loans over time, are virtually impossible.

According to the World Bank, the average Czech receivership takes nine years, by the end of which there is usually little left for creditors.

“Time is the biggest problem,” says Roman Mentlik, consultant to Konsolidacni’s chief executive. “If we are waiting for a [liquidation] decision for three years, the value [of our asset] falls 30%-40% each year,” he says.

The government promises a “big bang” reform of the insolvency law this year. Only when this and other legal obstacles are addressed will the value of distressed assets increase significantly and banks will feel more secure in extending new loans.

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