Non-performing loan management after the intervention

This is the third instalment of the written statement by Patrick Hylton, former managing director of FINSAC Limited, to the commission of enquiry examining the operation of the bailout agency.

In relation to non-performing loans I make the following observations.

The proliferation of these loans, along with an over investment in real estate, underperforming equities, as well as fairly substantial holdings in non-core businesses, characterised the asset side of the balance sheets of the failed or failing financial institutions.

It is from the cash flows of these assets that these financial institutions would normally be able to fund their continuing operations, including payments to depositors, policy-holders and pensioners.

The distressed status of these institutions reflected the fact that too many of these assets were either under or non-performing creating for the institutions a severe liquidity shortfall, consequential losses and, ultimately, their insolvency.

FINSAC intervened in many of these institutions by issuing FINSAC notes as that was the only significant means of recapitalisation FINSAC had.

We also purchased, in most instances, these non-performing or underperforming loans at face value as a purchase at market or current value would have automatically resulted in the return to insolvency of the intervened companies.

The fact is that once it was decided that depositors/ policyholders would be repaid in full notwithstanding the massive insolvency of the intervened institutions, FINSAC had no other option - other than the use of FINSAC notes - for effective intervention, as we would not have had the cash resources to do a cash purchase or injection of any relevance or significance.

FINSAC notes, while addressing the solvency problem, could not deal with the liquidity problem and FINSAC was now the significant shareholder in these companies.

The only means of generating cash to redeem FINSAC notes or to pay some interest with cash, in the short term, so that these institutions could continue as going concerns, was to realise on the same underperforming assets that were acquired from them.

FINSAC also needed to move quickly in the asset realisation and disposition process given the fact that FINSAC notes accrued interest at market rates which, at the point of intervention, were somewhere in the region of 30 per cent.

Initially after purchasing the loans, FINSAC left them with the intervened institutions for collection with Finsac's involvement mainly reviewing and approving workout strategies.

collection a challenge

At the time, it seemed a logical approach given that FINSAC itself had no collections infrastructure and, in any event, logistically, a physical transfer to FINSAC would take time.

Collections through the intervened institutions, however, proved a challenge for a number of reasons:

a) It became a distraction for their management's time which needed to be focused on their own rehabilitation.

b) It was clear that in some instances, officers of the intervened institutions either were or felt compromised in as much as they had recommended or approved some of the loans when they ought not to have done so.

c) It would be easier to consolidate and do workouts in relation to debtors whose borrowings spanned several of the intervened institutions if their loans were consolidated. This borrowing across institutions was found to be a common feature.

Accordingly, FINSAC, towards the end of early 1998, went about setting up a non-performing loan unit, properly structured and staffed to undertake these activities.

To aid collections officers and to as far as possible ensure consistency, transparency and accountability, FINSAC engaged in a process of valuing each loan using an appropriate framework, as well as developing and implementing a loan policy and procedures document.

A summary of the Standard Policies for NPL Workouts, which includes a summary of the framework, was in pages 40-43 of Finsac's 2000 annual report.

The operations and policy framework of Finsac's Non-Performing Loans Unit were reviewed by an expert provided by CIBC Canada who, while being complimentary of the work done, made some recommendations for improvement, several of which were implemented.

The philosophy underpinning our collection efforts was a preference for consensual agreements with litigation and the realisation of security being a last resort.

An examination of our public statements, annual reports, etc, underscore this point. A detailed examination of all loans managed and worked within this unit will confirm that this was by far the dominant approach.

Quite apart from the fact that from a common-sense perspective it suited us to firstly seek a consensual settlement or agreement, there was another powerful reason for seeking agreement.

It is that we also recognised from the outset that a bad debt did not automatically make the debtor a bad person.

There may have been issues of bad judgement or bad timing or bad idea or rapidly changing circumstances which may have impacted persons or their businesses. The important thing was to seek to understand the circumstances and try to accomplish some reasonable compromise.

significant compromises

While there was no explicit undertaking to bail out borrowers — which would have compounded the moral hazard problem associated with waiving repayment requirements and the cost of the financial-sector intervention — the reality of the circumstances conspired to effectively result in significant compromises to debtors at taxpayers' expense.

The truth is that there were hundreds of millions of dollars and possibly billions of dollars of write-offs. In many instances where the circumstances dictated no other reasonable alternative, this would include some level of principal on the loans.

Another fact is that FINSAC approved significant write-offs on hundreds, possibly thousands, of debts based on the principles and policy framework within which it operated, taking into account the high rates of interest that had been applied to the facilities.

This was only pragmatic if FINSAC was to be successful in quickly and successfully raising funds to support its activities.

These principles were applied irrespective of colour, creed, race, religion or political persuasion.

The annual report for each year contained statements from the chairman, myself as CEO, and Audrey Robinson, as head of the Asset Management Division.

Where it was necessary to resort to litigation, Finsac's track record in pursuit and in defence of such litigation initiated by FINSAC or brought against it was exemplary. So far as I can recall while I was involved with Finsac, we were wholly successful in the vast majority of cases, and at least partially successful in the few cases in which we did not entirely succeed. This was partly due to the fact that where we were aware that Finsac's position could not be legally sustained, we resolved the matter without the need for it to be tried in the courts.

The FINSAC Oversight Committee also played an important role in seeking to find resolution strategies for non-performing loans of businesses that fell within the National Industrial Policy - that is, those in the productive sector.

There was also special consideration given to owner-occupied residences. An attempt was made to be consistently more lenient in those cases so as to avoid having substantial numbers of persons lose their primary place of resident.

My own view is that in order to make a determination as to whether or not FINSAC treated debtors fairly would require a careful and detailed analysis of the majority, if not all, of the tens of thousands of loans that FINSAC purchased.

This would include those loans that were reviewed by the Oversight Committee, as well as those that sought to take advantage of the special window of opportunity that was offered and publicised in the media in 2001, as these represented special efforts to give people an opportunity to resolve problem loans.

The process of loan workout by its nature involves intense negotiation.

Even though I recognise the importance of every single loan, customer, and their experience, I do not think that if we have 20 complaints out of the tens of thousands of facilities handled that such a set of circumstances can lead to any reasonable conclusion regarding whether FINSAC was generally fair to debtors and the extent to which the approach to treating all debtors was similar.

In any financial institution, the experience is that persons whose loans are non-performing and are aggressively pursued are those with the most complaints.

To my mind, the only fair way to accomplish that is to have every single debtor's file open to the scrutiny of the commission, and perhaps the public. If this is done then the original loan circumstances, the record of the negotiations which took place, the rationale for Finsac's approach, as well as the response of the debtors will be public knowledge so that an informed position can be adopted.

There is another important reason for such an approach to be taken. The fact of the matter is that to the extent that these loans were purchased by the Government and funded with taxpayers' money, then every dollar of write-off reflects a benefit at taxpayers' expense.

In those circumstances, taxpayers should be informed of who the beneficiaries were and the magnitude of the benefit they received.

That, too, is why we considered it necessary for our approach to write-offs to be well structured and carefully justified, with that justification documented, in all the circumstances.

In every case where a compromise settlement was reached, there would be a memorandum or case summary outlining the details. Those memos and case summaries represent a good starting point.

To the extent that the facts demonstrate very significant discounts and write-offs approved or offered by Finsac, where appropriate and necessary, then the impact of high interest rates on the borrowers' ability to repay is somewhat mitigated.

FINSAC had a powerful incentive to discount rates apart from its own need for cash. The fact is that the rate of accrual on FINSAC notes, and hence the need to redeem or reduce issuing them, also served as a discount factor.

FINSAC also had very urgent cash needs to enable us to assist with the liquidity needs of the intervened institutions.

One of the issues I observed was several borrowers who would eventually come in and negotiate settlements which involved significant discounts on the sums outstanding.

Several would initiate payments as agreed and then default again, seeking new and further compromises.

Even though this may have, on occasion, been as a result of deteriorating circumstances or initial projections, it was also our experience, admitted by some borrowers, that there were persons who used this as a strategy to try and get a better deal.

Moral hazard was alive and well within the non-performing loan portfolio.

Continues Sunday.

business@gleanerjm.com

'Moral hazard was alive and well within the non-performing loan portfolio.'