G l o b a l R e a l E s tat e C e n t e r

!@#
Global Nonperforming
Loan Report 2006
Are Governments and Banks Finally Learning How to Manage NPL Risks?
In the past 20 years, the nonperforming loan (NPL) market has changed from a small, fragmented market into a global, robust, market. Competition among
investors to acquire NPLs has intensified in many markets, NPL transactions are completed more quickly, and transaction activity is at a 20-year high as banks
continue to sell NPLs to clean up their balance sheets and meet more stringent global capital standards. Now that things are going well, there is a risk that
governments and banks could become complacent, resulting in a new wave of NPLs. Governments must remain vigilant in addressing NPL issues, and banks must
institute prudent risk management policies to prevent a recurrence of such problems.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 
Section Title
CONTENTS

2 Preface
4 Introduction
ASIA
10 China
16 India
22 Indonesia
28 Japan
32 Korea
36 Philippines
42 Singapore
46 Taiwan
50 Thailand
EUROPE
54 Germany
60 Poland
64 Other Potential European NPL Hotspots
70 Outlook
74 Ernst & Young Publications

06
75 Contacts

Global Nonperforming Loan Report 2006


 P r e fa c e

20 Years and
1987 Japanese Investment in
United States Real Estate
1989 Japanese Investment in
United States Real Estate
1986 Japanese Investment in
United States Real Estate 1988 Japanese Investment in

1987 1991
United States Real Estate

1989
U.S. $4 Trillion 1985
Plaza Accord
1986 1988 1990

Later, The NPL U.S. Tax

Reform Act
U.S. Financial Institution Japan’s bubble

Crisis Is Over.
Reform, Recovery & economy bursts
Louvre Accord Enforcement Act; creation
of Resolution Trust
Corporation

Or is It?
In 1986, when we published Japanese Investment in U.S. Real Estate, the original
ancestor of this report, it seemed that Japan would become a powerhouse in U.S.
real estate. By 1992, however, the Japanese were almost gone from the U.S. market,
replaced by investors from other Asian countries. Japan’s bubble economy had plunged
into a recession, its stock prices and property values had plummeted, and its banks
were overwhelmed with NPLs, the result of financing speculative investments in
stocks and real estate.
Meanwhile, the U.S. was struggling with the near-collapse of its savings and loan (S&L)
industry. In 1989 Congress created the Resolution Trust Corporation (RTC), which
spent billions of taxpayer dollars to acquire and restructure or liquidate thousands of
thrifts (and some troubled banks). The RTC recovered some – but not all – of this cost
by selling real estate loans and other S&L assets. The RTC’s sales attracted a number of
investors, including those who were looking for new opportunities after the Tax Reform
Act of 1986 practically eliminated real estate tax shelters. Early investors in RTC assets
were able to acquire them at deep discounts from face value and restructure and ulti-
mately sell them, often at substantial profits. Their investments gave rise to what today
is a global market in buying, restructuring, and selling distressed assets. The RTC itself
was an early model for today’s asset management companies (AMCs), which a number
of governments have created to acquire nonperforming loans from commercial banks.
In 1985, the Plaza Accord on global economic reform was signed, followed by the
1987 Louvre Accord, both of which were intended to stabilize international currencies.
One effect of these agreements was that global banks and corporations in a number

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 
1993 Japanese Disinvestment 1995/1996 Japanese Investment
in U.S. Real Estate in United States Real Estate
Global Nonperforming
Loan Report 2006
1998 U.S. Investment in
Asian Real Estate Nonperforming Loan

06
1994 Japanese Investment in 1997 Asian Investment in Report: Asia 2002
U.S. Real Estate United States Real Estate U.S. Investment in

1993 1995 1999

Global Nonperforming

1997 2003 2005

Asian Real Estate 2000 Loan Report 2004

2001
1992 1994 1996 1998 2000 2002 2004
NPLs spread China, Taiwan, and Germany and Europe
Japan into Europe the Philippines become gear up and China
banking active in NPL Market slows down
crisis
Asian and Mexican
financial crisis Germany, Poland, and
others enter NPL Market

of countries borrowed huge amounts of international capital, much of it short-term,
denominated in foreign currency, and unhedged, making them vulnerable to currency
depreciation. Foreign lenders and investors readily provided loans and investments to
banks and companies in these countries, often without proper risk management. When
the Asian financial crisis hit in 1997, the values of Asian currencies plummeted and
the values of real estate and other assets fell; many borrowers defaulted on their loans;
the NPLs of local banks soared; and foreign capital exited local markets.
While many Asian markets have slowly recovered from the crisis, the NPL contagion has
spread to other markets including China and India, as well as Europe, Russia, Argentina,
and other regions and countries; and NPL investors have followed. In the mid-1990s,
U.S. investors began to buy distressed assets and make direct property investments in Ja-
pan, and, subsequently, other Asian countries, which we documented in an earlier report,
U.S. Investments in Asian Real Estate. In recent years, the NPL market has gone global,
with opportunity funds, pension funds, investment banks, real estate companies, and oth-
er investors buying distressed assets world-wide. Investors now include REITs that are
acquiring distressed real estate for their portfolios, and institutions that have packaged
and securitized portfolios of NPLs. Over the past 20 years, poor lending practices, in-
adequate government regulation, failure to reform banking systems, and other problems
have resulted in banks accumulating what we estimate were U.S. $4 trillion in NPLs.
(By comparison, the proposed U.S. budget for fiscal year 2007 is U.S. $2.7 trillion.)
The failure of banks to put this capital to productive use slowed the growth of national
economies or contributed to economic recessions. So, has a generation of bankers and
government regulators learned from past mistakes? Will they help the next generation to
prevent a recurrence of NPL problems? Or will the NPL cycle repeat itself? These are
questions that we address in this report.


 More Opportunities
for NPL Investors
In our Global Nonperforming Loan Report 2004, we reported on the substantial
progress that governments and banks worldwide had made in resolving their NPL
problems. This report looks at what they have accomplished since then, how they Key Trends
can continue to make progress, and, equally important, what they must do to pre-
Total Financial Institution Assets*** $ U.S. Billions*
vent another cycle of NPL problems. We also provide a detailed analysis of each

0
0
0
00
00
00
00
00
00
00
00
00
00
00
00
global NPL market and opportunities for global investors.

10
20
30
40
50
60
70
80
90
10
11
12

0
0
20

30

40

50

60

70

80

90
10
0
Key Trends

Total NPLs** $ U.S. Billions*

Japan
Germany
0
0
0
0
0
0
0
0
0
10
20
30
40
50
60
70
80
90
10

15

20

25

30

35

China
0

China Korea

Germany Taiwan

Japan India

India Poland

Thailand Thailand
Poland Indonesia Shaded area indicates change in scale

Indonesia Philippines

Taiwan *** Various dates from June 2005 to December 2005

Source: Various sources as compiled by Ernst & Young

Korea Shaded area indicates change in scale

*All currencies in this report exchanged as of December 31, 2005
Philippines

**Estimates as of December 31, 2005

Source: Various sources as compiled by Ernst & Young

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 

Among the key trends since the publication of our 2004 report:
 National governments have continued to make progress in implementing financial
system reforms and assisting banks with NPL workouts and dispositions.
 With the notable exception of China, almost every country covered in our 2004 report
has managed to reduce its legacy NPLs (i.e., loans made before 1997, including those
made before the Asian financial crisis).
 More countries, including some in Europe, are seeing an increase in NPL reporting,
restructuring, and disposition activity. (See “Europe’s Newest Watchlist” on page 69.)
 Germany will remain the leader in Europe’s NPL market because of its sheer size and
attractiveness to investors, but it is a highly competitive market, and investors can
find other choices in smaller, attractive, less competitive markets, such as the Czech
Republic, Turkey, and Portugal.
 The global NPL market has evolved and matured into a more efficient platform that
enables faster resolution of NPLs by financial institutions that follow international
reporting and loan classification standards and best practices.
 Banks that provide investors with complete, well-organized, current, and accurate
portfolio information are realizing higher prices in NPL sales – the better the informa-
tion, the more investors are willing to pay.
 Because of competitive pressures in the banking industry, financial institutions are
accelerating NPL restructurings and dispositions, improving risk-management of loan
portfolios and increasing transparency in portfolio management.
 The quality of banks’ NPL offerings is improving. More loans are backed by real
estate assets in better condition and in better locations than before.
 Some investors who were among the first to enter now mature markets, such as Korea,
are selling their NPL portfolios at substantial capital gains and exiting the market.
 A second wave of global investors recently has begun investing in NPL markets rang-
ing from emerging markets such as China to mature markets such as Japan.
 Investors have broadened their investments from NPLs to performing loans, from real
estate to a broad range of assets, and to buying interests in banks, corporations, and
other operating businesses.
Convergence
A convergence of regulatory, accounting, and reporting standards and best practices is
bringing greater transparency and accountability to the management and disposition of
loan portfolios including NPLs. For the first time in the 20-year history of NPL report-
ing, an NPL in the U.S., UK, Germany, China or Japan will be measured, evaluated,
and reported based on relatively comparable reporting standards.

These standards include:
International Financial Reporting Standards (IFRS)
As more real estate investors expand into global markets, they face the same prob-
lem as investors generally: how to make informed investment and business decisions
based on different national standards (i.e., generally accepted accounting principles,
or GAAP) in use around the world. In response, efforts are underway on several fronts
to develop more consistent and transparent global accounting standards that could fa-
cilitate global real estate investment including investments in NPLs. Almost all listed
companies in the European Union (EU) were required to adopt and apply International
Financial Reporting Standards (IFRS) to their consolidated financial statements begin-
ning in 2005. A number of countries have plans to converge with IFRS.
Basel II
In 2005 The Basel Committee on Banking Supervision issued an updated version
of the Basel II capital standards for banks. Basel II sets out the details for banks to
adopt more risk-sensitive minimum capital requirements and enhance the transparency
of their financial reporting. Some countries and banks are preparing to adopt Basel II
at the end of 2006. Basel II’s implementation could result in banks identifying and dis-
closing problem loans more quickly and taking faster action to address loan problems.
R egulatory Standards
Government regulators in a number of countries such as India and Taiwan are further
tightening standards for banks’ capital adequacy and risk management in anticipation
of Basel II.
Best Practices
While there is no global accounting or regulatory standard for reporting NPLs, more
countries are moving toward adopting global best practices for such reporting. Feder-
ally regulated banks in the U.S. use a five-tier NPL classification system (Category 1
– Pass; Category 2 – Special Mention; Category 3 – Substandard; Category 4 –
Doubtful; and Category 5 – Loss). Under the five-tier system banks must provide loan
loss reserves ranging from .05 % of outstanding loan amounts for Pass loans to 100%
for Loss. Other countries such as China and Taiwan are gradually adapting similar
systems, with some countries using a dual five-tier and domestic classification system.
More countries are also shortening to 90 days from 180 days or more the period when
unpaid past loans become delinquent. By requiring lenders to put problem loans on
their watch lists sooner, regulators hope that banks will move more quickly to address
such loans.
 I n t ro d u c t i o n

Securities Laws Sarbanes-Oxley

NPL reporting could be improved by a gradual shift of NPL portfolios from state-
owned or private banks to publicly traded institutions that are subject to disclosure
requirements under national securities laws. Investors also are securitizing NPL port-
folios, and in the process, bringing them under securities laws.
The U.S. Sarbanes-Oxley Act of 2002 (SOX) requires publicly traded companies to
establish an internal audit function certified by external auditors and to attest to the
reliability of their internal controls for financial reporting. Similar reporting and at-
testation guidelines are gradually being adapted by companies, banks, and investors
globally. This could result in greater transparency in banks’ management of their loan
portfolios that include NPLs.

RUSSIA
Emerging

POLAND
Emerging
CZECH REPUBLIC GERMANY
Emerging
Sustaining
ITALY
Mature
TURKEY
Emerging
JAPAN
KOREA Mature
Mature

CHINA
Emerging
TAIWAN
Mature
Emerging: Development of an NPL market and corporate restructuring
are still in the early stages. INDIA THAILAND
Emerging Sustaining PHILIPPINES
Sustaining: NPL transactions and restructuring will continue for some Emerging
period of time.
Mature: NPL resolutions and corporate restructuring have evolved
into a mature domestic market, with little opportunity to
new foreign entrants. INDONESIA
Sustaining

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 
NPL Resolutions
As might be expected, NPL resolutions are at various stages in global markets.
These markets include:
China
China has invested heavily in recapitalizing its state banks in preparation for 2007,
when foreign investors will be allowed unrestricted access into China’s banking
industry. After a slow start, China’s NPL disposition process has accelerated in
response to the plans of some banks to go public and the entrance of foreign investors
into the banking sector. But China’s banks still have a substantial backlog of legacy
NPLs on their books. In addition, there is the question of whether another wave of
NPLs may hit China’s banks, the result of aggressive lending in a superheated
property market.
Germany
Like China, Germany started slowly in dealing with its NPL problems, but now has
an active NPL market. As of February 2006 , international investors had closed on no
fewer than 25 sales totaling at least €24 billion (U.S. $28.8 billion), with more transac-
tions in progress. Strong sales activity is expected through 2007 as German banks
continue to be aggressive in cleaning up their balance sheets. Looming bank consoli-
dation will also play a part.
India
India’s emerging NPL market is beginning to grow. More banks are offering distressed
assets for sale, market-clearing prices for NPL assets are being established, and more
global investors are entering the market.

Indonesia
NPLs of Indonesian banks increased in 2005, and the government has taken steps to
address banks’ NPL problems, such as enactment of a banking governance law and
adopting more stringent rules for loans to more than one debtor. This may lead to
increased NPL sales.
Japan
For more than a decade, Japan’s economy and NPL market stagnated. But in the
past few years, Japanese banks have reduced their NPLs by 50%. And with Japan’s
economy finally recovering, more global investors plan to enter the Japanese market.
In a sign that the market has matured, investors are shifting their focus from NPLs to
other assets.
Korea
As a result of a massive restructuring of its economy, its corporate sector, and its
banking system over the past decade, Korea has succeeded in overcoming its NPL
problems. Now its banks are planning to implement Basel II in 2007, a sign that
Korea’s NPL market has matured. The question is, can Korea prevent NPL problems
from recurring, this time in the consumer sector?
Philippines
In a relatively small NPL market, banks in the Philippines have had to compete with
other, larger markets for the attention of global investors, but they have succeeded in
selling assets. The question is whether they can keep it up.
 I n t ro d u c t i o n

Poland
Until recently, Poland’s banks have had little incentive to dispose of NPLs, due to
limited liquidity problems among other reasons. As a result, there has been only one
significant NPL transaction completed as of year-end 2005. Transaction activity is
expected to increase in 2006.

Taiwan
Thanks to a string of large corporate NPL portfolio auctions and an improving econ-
omy, the NPL ratios of Taiwan’s banks have significantly improved. Banks have made
aggressive efforts to move NPLs off their books, and Taiwan has been one of Asia’s
most active NPL investment markets.

Thailand
Progress on NPL resolutions has been relatively slow for the last two years. To accel-
erate the process, regulatory bodies have introduced new measures such as tighter loan
provisioning and bad-debt reclassification rules. The banks’ NPL ratio is expected to
continue to decline in 2006 and 2007, with NPL transfers to asset management com-
panies and auction sales continuing.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 
 Portfolio Transactions
China Germany India Japan Korea Philippines Poland Taiwan Thailand

Performing 0% 10% 0% 5% 0% 0% 0% 0% 0%
Loan Status

Subperforming 0% 30% 0% 15% 3% 0% 0% 10% 0%

Nonperforming 100% 60% 100% 80% 97% 100% 100% 90% 100%
Loan Type

Secured 60% 90% 80% 90% 30% 70% 90% 70% N/A
Unsecured 40% 10% 20% 10% 70% 30% 10% 30% N/A
Collateral Type

Residential Real Estate 20% 40% 5% 35% N/A 10% 10% 50% N/A
Commercial Real Estate 30% 50% 5% 55% N/A 30% 40% 30% N/A
Pri
Corporate 50% 10%
Pri 90% 10%
Res N/A 60% 50% 20% N/A
Pri Pri Pri Pri
Pri Res For
Pri Pri
Res Res Res Res Pri
Pri
Res For DPO Pri Pri Pri
Res Res
For Restructure For For Pri For For Pri Pri Res
Investor Exit Strategies

Res DPO Pri RTR Res Res Res

Pri For For
DPO
For Foreclosure DPO DPO Res DPO DPO Res Res For
For Pri RTR Res Ope For Pri For For Pri
Pri Pri Res DPO Pri DPO
RTR RTR For RTR Pri RTR For For DPO
RTR
DPO
DPO Discounted Payoff Res Ope For Ref DPO Res DPO DPO Res
Res Res For RTR Res RTR
Ope Ope DPO Ope Res Ope DPO DPO RTR
Ope
RTR
RTR Open Market Sale For
For
Ref
For DPO
DPO
Vol
Ope RTR For
For RTR RTR For
Ope
Ref Ref RTR Ref For Ref RTR RTR Ope
Ope
Ope
Ref Refinance DPO
DPO
Vol
DPO RTR
RTR Ref Ope DPO
DPO Ope Ope DPO
Ref
Vol Vol Ope Vol DPO Vol Ope Ope Ref
Ref
Vol
Ref RTR Ope RTR RTR
RTR RTR Ope Vol Ref RTR Ref Ref Vol
Ref RTR Ref Ref Vol
Vol
Vol Ope Ref Ope Ope
Ope Ope Ref Vol Ope Vol Vol
Vol Ope Vol Vol
Ref Vol Ref Ref
Ref Ref Vol Ref
Average Price Range 5%–45%
Vol 45%–70% 10%–40% 30%–40% 8%–65%
Ref 15%–25%
Vol 5%–25% 30%–50% N/A
Vol
Vol Vol Vol
Vol
Pricing and Structure

Primary Transaction Joint Venture/

Structure (Cash, Joint Cash Cash Other/Cash Cash Cash Cash Cash Cash Cash
Venture, Other)
Time to Close (from Sign- 4–8 1 3 1–2 1–2 1–3 2–3 2 6
ing Contract) in Months
Investor Recovery 2–3 1–3 1–5 1–3 1–3 1–5 2–3 1–3 3–5
Expectation (Years)

Source: Ernst & Young


 A s i a : C h i na

China: Nonperforming Loan Market Report

I n our 2004 Global Nonper-
forming Loan Report, we
noted that the disposition
of NPLs had been slower in
China than in other Asian markets. Since then, China’s disposition
process has accelerated. China is pushing ahead with banking
reform as it prepares for full integration into the World Trade Or-
ganization and the opening of its banking system to foreign com-
petition in 2007. For the country’s four large state-owned banks –
Bank of China (BOC), China Construction Bank (CCB), Industrial
and Commercial Bank of China (ICBC), and Agricultural Bank of
China – these reforms have been marked by new rounds of mas-
sive NPL transfers to the country’s four state-owned asset man-
revision” that added U.S. $278 billion to nominal GDP in 2004, an increase of nearly
agement companies (AMCs), initial public offerings (IPOs), and 17%, which was attributed mainly to higher-than-expected growth in services, includ-
pre-IPO strategic investment by foreign banks and institutions. ing banking and real estate. As a result of the 2004 revision, China said it has replaced
Against these notable accomplishments, China’s banks continue Italy as the world’s sixth-largest economy. But its economy may be even bigger: some
economists think China is still understating the size of its economy by 10%-15%.
to face difficult challenges. Questionable lending practices and
overexposure to China’s superheated real estate sector have Bank Reform
contributed to an increase in Category 2 or “Special Mention” Since 1998, China has enacted measures to more effectively regulate the country’s
loans, which suggest that banks could face another wave of NPLs banks, which dominate China’s financial system. China has adopted a five-tier, inter-
over the next few years. national classification system that ties risk to loan quality. It has issued guidelines to
tighten controls on mortgage and commercial real estate lending. The China Bank
Economy Regulatory Commission (CBRC), headed by Liu Mingkang, a respected former presi-
Fueled by an export boom, China’s economy grew 9.9% in 2005, compared with an dent of BOC, has pressured banks to better control loan and deposit growth, maintain
upwardly revised 10.1% in 2004. For 2006, a state agency has forecast that China will adequate capital, and realize acceptable returns on capital. It has pushed banks to
grow at a 9.4% rate; however, questions have been raised about the accuracy of the clean up their balance sheets, establish governing boards, and improve their due dili-
government’s economic reports. Early in 2006 the government announced a “statistical gence of borrowers’ creditworthiness. Banks traditionally have had a strong

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 10
 Strategic Investors
Chinese Banks Investor % Ownership
ICBC Goldman Sachs, American 10%
Express, Allianz Group
CCB Bank of America Corp. 8.67% (allowed to increase to 19.9%
in the coming 5 years)
Temasek Holdings 5.98%
BOC Royal Bank of Scotland, 10%
Merrill Lynch, Li Ka-shing
Temasek Holdings 10%
UBS 1.6%
Asian Development Bank 0.24%
Bank of Communications HSBC 19.9%
incentive to make loans regardless of the credit risk, among other reasons because Shanghai Pudong Citigroup 4.6% (to be increased to 24.9%)
their managers’ bonuses have depended almost entirely on asset growth. Chairman Development Bank
Liu has openly called for more audits and tougher regulatory scrutiny to reform the Minsheng Bank IFC 0.93%
banking system. The CBRC has issued guidelines that hold bank managers more Temasek Holdings 3.9%
accountable for the disposition of NPLs. However, despite having moved substantial Industrial Bank Hang Seng Bank 15.98%
portfolios of NPLs off their books, banks still have ongoing NPL issues. IFC 4%
Singapore Investment 5%
Corporation Pte Ltd. (GIC)
While regulators are to be commended for making progress with bank reform, further Hua Xia Bank Deutsche Bank 9.9%
reforms are needed. Banks account for about 80% of all credit allocation in China, and Sal Oppenheim 4.08%
they have invested money into exorbitant infrastructure projects and inefficient Pangaea Capital Management 6.9%
state-owned enterprises that were kept going mainly to keep people employed. Their Shenzhen Newbridge Capital 17.89% (will drop after GE’s investment)
investments have been so unproductive that China has to keep pumping even more Development Bank GE Capital 7.3% (Pending)

money into its economy to keep on growing. China needs the equivalent of almost $5 Beijing Bank ING Group 19.9%
IFC 5%
of fresh capital to generate $1 of incremental output, a far worse ratio than Western
Shanghai Bank HSBC 8%
countries and even India.
IFC 7%
Nanjing City Commercial Bank IFC 5%
Bank Recapitalization
BNP 19.2%
The government has invested heavily in the recapitalization of China’s four state-owned
Tianjin Bohai Bank Standard Chartered 19.99%
banks in preparation for 2007, when foreign players will be allowed unrestricted access
into China’s banking industry as part of its World Trade Organization commitments. At Hangzhou City Commonwealth Bank of Australia 19.99%
Commercial Bank
the end of 2003 the government injected U.S. $45 billion of foreign exchange reserves
Jinan City Commercial Bank Commonwealth Bank of Australia 11%
into BOC and CCB. In 2005 the government injected an additional U.S. $15 billion of
Xian City Commercial Bank IFC 2.5%
foreign exchange reserves into ICBC. The government also has transferred U.S. $330
Bank of Nova Scotia 2.5%
billion of NPLs from China’s banks to the four AMCs. Although these loans were re-
Ping An Bank HSBC 27%
moved from bank balance sheets, they have not been totally resolved. (See “Unresolved
Nanchong City DEG 10%
NPLs” on page 13.) Commercial Bank SIDT 3.30%
Guangdong Development Bank Citigroup 85% (not finalized yet)
Ningbo City Commercial Bank Oversea-Chinese Banking Corp. 12.2%
Source: Various sources as compiled by Ernst & Young

11
 A s i a : C h i na

Strategic Investors
Looking to 2007, a growing number of global investors are interested in acquiring or access to management and rural branches (these are often run poorly compared to
already have bought stakes in China’s banks ranging from the Big Four state banks to branches in first-tier cities) and government pressures to quickly complete due dili-
smaller banks. Among the deals that have been completed or are pending: gence. Furthermore, the government has refused to provide guarantees against risks
such as a bank’s capital inadequacies. Nevertheless, investors are eager to acquire in-
• Prior to its IPO in October 2005, CCB raised U.S. $4 billion from selling stakes terests in banks as an entrée into China’s fast-growing economy and financial markets.
of 9% to Bank of America and 5.1% to Temasek Holdings, a global investment McKinsey & Co. has forecast that by 2013, China will be the third-largest financial
company headquartered in Singapore. market in the world behind the U.S. and Japan. Because investors are to some degree
buying on “trust,” the government has been willing to sell them interests at attractive
• Goldman Sachs Group Inc, Allianz AG, and American Express Co. bought 10% prices relative to the banks’ IPO listing multiples. It was reported that investors bought
of ICBC for U.S. $3.78 billion in early 2006, subject to the approval of regulators. pre-IPO interests in CCB at 1.15 to 1.19 times book value. CCB went public at
1.95 times book.
• In 2005 Newbridge Capital, a private equity investor specializing in direct invest-
ments in Asia, became the first foreign investor to take management control of a Asset Management Companies
Chinese bank, when it acquired a 17.89% interest in Shenzhen Development Bank
(SDB). Frank Newman was named the chairman of the bank, the first foreigner ever Overview of China’s Prominent NPL Transactions in 2005
to hold such a post in China. Newbridge is an experienced opportunistic investor that SELLER BRANCH BUYER(S) FACE VALUE
acquired Korea First Bank and subsequently sold it to Standard Chartered Bank in (RMB BILLION)
one of the more successful turnaround transactions in banking history. GE Consumer Cinda Qingdao Great Wall 6.66
Finance is also awaiting regulatory approval to acquire a 7.3% stake in SDB. Tianjin Avenue Capital 5
Huarong 16 branches Huarong/Deutsche JV 14.5
• Bank of China is preparing a stock offering in Hong Kong. In August 2005, Royal 27 provinces Silver Grant 36.44
Xiamen International investors 1.7
Bank of Scotland Group Plc, Merrill Lynch, and Hong Kong tycoon Li Ka-Shing
acquired a 10% stake in the bank for U.S. $3.1 billion. Other acquirers include Orient Shandong PPF Group 3.12
Source: Ernst & Young
Temasek Holdings, UBS, and Asian Development Bank, with interests of 10%,
1.6% and 0.24% respectively. China’s AMCs have done well in meeting their recovery targets. For example, as of
year-end 2005, China Cinda AMC (Cinda) reported collecting RMB 62.84 billion
• Citigroup leads a consortium seeking control of troubled Guangdong Develop- (U.S. $7.8 billion) of cash from RMB 201.21 billion (U.S. $24.9 billion) of face value.
ment Bank for U.S. $3 billion. The negotiations could set a precedent: for the In addition, NPL sales by the AMCs are accelerating, with Huarong selling
deal to go through, China would have to waive its current rule limiting individual RMB 36.4 billion (U.S. $4.5 billion) of Category 5 NPLs to Silver Grant,
foreign investors to a 20% stake, 25% in a consortium. a Hong Kong listed asset management and investment company.

By investing in China’s banks, strategic investors face problems such as the govern- Huarong also sold RMB 14.5 billion (U.S. $1.8 billion) of assets to an Equity Joint
ment’s reluctance to provide complete information necessary for due diligence, limited Venture (EJV) with Deutsche Bank/AIG. Huarong and Deutsche Bank/AIG will

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 12

jointly manage the entity. Huarong is the majority shareholder and has a majority of
the seats on the board. The EJV has a 15-year life and will function as an operating
platform for a variety of investments. The EJV structure is a pioneering effort to help
the AMCs transform themselves into independent commercial investment companies
(subject to the approval of regulators).
NPL securitization also is gaining traction. Orient engaged Galaxy Securities Co. to
advise in an RMB 8 billion (U.S. $992 million) NPL securitization, and is awaiting
approval from regulators. Cinda is also considering an RMB 20 billion (U.S. $2.5
billion) securitization of NPLs with the help of the Asian Development Bank. The
transaction could move ahead as early as 2006 if it wins the necessary approvals.
New Challenges
While AMCs have made strong progress in disposing of NPLs, they face new chal-
lenges going forward. They are under a mandate to complete liquidation of assets
estimated to be more than U.S. $230 billion and transform themselves into commer-
cial enterprises after 2006. And they may face competition from the banks, which
are seeking more powers from the government, including the power to resolve NPLs
on their own. Following the success of CCB’s first settled asset (loan collateral
foreclosed upon or taken over by the bank; typically real estate assets) portfolio sale
in 2004, CCB and other banks plan to increase their use of auctions to dispose of ad-
ditional settled assets, received in the settlement of bad loans.
The relationships of AMCs and banks that have gone public could change. If CCB
were to require another bailout in the future, this would include an undesirable bailout
of foreign investors. As a result, government infusions of capital into CCB and other
listed banks and transfers of NPLs from listed banks to AMCs may be more difficult in
the future. With future NPL sales, CCB and other listed banks may need to adhere to
a more market-based, commercial pricing and transaction structure that eliminates the
AMCs as middlemen. The AMCs also face the problem of issuing bonds to the banks
at face values much higher than the value of their NPL recoveries.
13
Unresolved NPLs
Obtaining accurate information about the NPLs in the loan portfolios of Chinese
banks is difficult, among other reasons because of the banks’ inconsistent application
of loan classification systems, a banking culture that resists openness and accountabil-
ity, the inherent decentralized operating environment, and regulations that limit banks
in resolving problem loans that result in a loss of principal. But recent studies by UBS,
McKinsey & Co., and Ernst & Young illustrate the significant dimensions of the finan-
cial institutions’ NPL problems.
Banks
In retrospect, in 1998, China’s four state-owned banks had an estimated
U.S. $620 billion of legacy loans on their books, including some loans dating
back to the early 1980s. Recognizing the need to reform and strengthen China’s
banking system, the government in 1998 reportedly transferred U.S. $170 billion
of these legacy NPLs to four newly created state-owned AMCs.
From 2000 to 2005, in order to try and clean up their balance sheets in preparation for
future IPO listings, the banks transferred an additional $160 billion of NPLs to the
AMCs and aggressively wrote off U.S. $157 billion of NPLs against current earnings.
Because of the lack of transparency and other problems, these figures may not provide
a complete picture of NPL disposition activity since 1998. Regardless, the official
NPLs of the big four banks, after these transfers and write-offs, as of
December 31, 2005 were reported to be U.S. $133 billion.
However, according to a research report by UBS, the banks’ aggressive lending from
2002 to 2004 has resulted in a potential new wave of NPLs, which eventually could
be as high as U.S. $225 billion. These undisclosed loans may include an estimated
U.S. $65 billion in real estate loans that we, in an earlier analysis, suggested may be
buried in the “special mention” loan category that is not included in computing a bank’s
NPL ratios.
 A s i a : C h i na

Other NPLs
All told, the big four banks may have created an estimated U.S. $845 billion in bad Apart from the banks and the four AMCs, there are still significant NPLs elsewhere
loans over the past 15 years. Of this amount, about U.S. $225 billion is still in the big in the financial system, totaling U.S. $323 billion (i.e., in Huida Asset Management
four banks and not presently classified as NPLs. Stated differently, after all the trans- Company, the so-called “fifth AMC” established in 2005; state-owned investment
fers and recapitalizations, the big four banks could still have to address NPLs totaling holding companies; city commercial banks; and rural credit co-operatives).
approximately U.S. $358 billion, or more than two times official estimates.
NPLs in China’s Financial System (U.S. $ Billions)
China NPL Overview (Big Four Banks and AMCs) (U.S. $ Billions) Financial Entity NPLs
Big Four Banks 358
BANKS AMCs
AMCs 230
+/(-) Balance +/(-) Balance
Year Event Other System-Wide NPLs 323
($Billion) ($Billion) ($Billion) ($Billion)
Total Exposure 911
Before 98 Build-up prior to 98 — 620 — —
Source: Ernst & Young
99 Initial transfer to AMCs (170) 450 170 170
Conservatively, we estimate China’s NPL liability from all sources including the
Additional transfer to AMCs (160) 160
Write-offs/resolution of NPLs (157)* (100)
banks, AMCs, investment companies, and credit co-operatives at more than
00 to 05
Potential future NPLs 225 358 — 230 U.S. $900 billion, an amount that exceeds its massive foreign exchange reserves.
* Write-off plus newly generated NPLs during 2000 to 2005 This is a large amount of distressed assets considering our 2002 NPL report pegged
Source: Ernst & Young
China’s NPLs at U.S. $480 billion. There are several reasons for the increase. First,
better (but still incomplete) information about the dimension of China’s NPL problem
Existing AMCs is now available. Second, the problem is not limited to the largest banks and AMCs
Of the U.S. $330 billion transferred to the AMCs as of the end of 2005, the AMCs have but also extends to other banks, AMCs, state investment companies, credit
disposed of only about U.S. $100 billion, and about U.S. $230 billion still remains on cooperatives, and other entities. Third, as noted, the banks are believed to have
their books. made more bad loans in recent years that have or will turn into future NPLs.

Outlook
China’s banks are at a crossroads in addressing their NPL problems. The opening of
the banking system to foreign competition in 2007, the investments by strategic inves-
tors, and the banks’ IPOs will expose them to the challenges of global competition and
the opportunities in partnering with global banks. After a slow start, China’s banks
have made significant progress in disposing of their bad loans through transfers to the
AMCs and, increasingly, portfolio sales and auctions. The quality of the banks’ NPL
portfolios is improving: there are more Category 4 loans that are backed by assets in

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 14
better condition and in better locations than Category 5 collateral. Furthermore, many
of the Category 4 loans were to companies that were restructured and are now viable
operating businesses; by contrast, many Category 5 loans were to underperforming or
defunct state companies. Category 5 loans have generally traded from 5% to 10% of
outstanding principal balance while Category 4 loans are trading from 25% to 45%.
The guarantees behind Category 4 loans are stronger, backed by power companies and
other large corporations.
Banks generally have transferred NPLs to the AMCs for 50% to as much as 100%
of book value, with the AMCs issuing promissory notes and bonds to the banks. By
realizing relatively high values for these assets, the banks were able to reduce their
loan losses as they prepared to attract strategic investors and for IPOs. For the AMCs,
however, the transfers have not been such a good deal. The AMCs generally have
recovered only about 25% of the value of the NPLs they acquired from the banks, but
they issued the bonds at face values that far exceeded the actual recoveries.
Now, one of the biggest issues facing strategic investors, banking analysts, rating
agencies and accounting firms is how to value the AMC bonds on the balance sheets
of the big four banks. Sources believe the AMCs would be technically insolvent if the
bonds were not implicitly guaranteed by the Ministry of Finance. Uncertainty about
the Ministry’s backing for the bonds and whether the banks could redeem them at face
value has complicated the due diligence process for investors and analysts. As far back
as 2002, the Bank of International Settlements (the agency responsible for determin-
ing international capital adequacy standards) described the Chinese government’s
approach to guaranteeing the bonds as “constructive ambiguity.”
China’s legal system, while far from perfect, has shown that it is capable of support-
ing NPL recoveries. But gray areas remain, including defective documentation and
inadequate due diligence information. Because of the lack of transparency and the
general reluctance of sellers to provide representations and warranties, prospective
15
investors are deeply discounting NPLs that banks and AMCs put up for sale. The
AMCs have pushed back, insisting that they should receive close to full value for the
NPLs because the quality of the collateral has improved. Some deals have fallen apart
because the parties could not agree on terms. Some strategic investors who have been
in the China market for several years are beginning to find opportunities elsewhere,
such as direct investments in real estate; others have moved on to other markets, such
as Germany. NPL sales that used to attract 20 or more registered investors a few years
ago are now attracting 5 to 10 investors. And, as noted, more bad loans may loom on
the horizon.
Under these circumstances, China cannot afford to be complacent. As regulators and
bank executives are well aware, the banks need to keep pushing forward with resolving
bad loans through actual sales at market clearing prices, rather than simply transfer-
ring them to the AMCs. Banks need to continue to attract strategic investors in NPL
portfolios. Regulators need to keep pushing through bank reform. This is a restructur-
ing process that is designed to strengthen the banks in further preparation for China’s
opening its market to foreign investors in 2007. Meanwhile, China can continue to
move forward with developing a capital structure that includes investment banks,
REITs, private equity markets, and a wide array of financial products and services.
This process will help China to attract investment capital, create markets, and stimu-
late economic growth. China is making progress, but much remains to be done.
 Asia: India

India: Nonperforming Loan Market Report

A t the time of our last
report, we had expect-
ed India to see several NPL
transactions attracting sig-
nificant capital and spurring economic growth from under-
utilized assets. With new rulings aimed at creating more
liquidity in the NPL market, the distressed assets market wit-
nessed several portfolio transactions as well as single asset
turnaround investments since January 2005. We expect that
this trend will continue and anticipate significant activity in
this space in the coming year.

Economy
The Indian economy maintains its position among the fastest-growing economies in the
world with GDP growth pegged at 8.1% for the period April-September 2005; India’s
GDP at current market prices was close to U.S. $700 billion for the fiscal year ended
(FYE) March 2005.
Strong corporate performances across industry and service sectors, coupled with posi-
tive investor sentiment saw the Sensex breach 9300 points on December 14, 2005,
increasing by 47% year by year. Market capitalization was up from U.S. $375 billion
in December 2004 to more than U.S. $510 billion in December 2005.

The Indian corporate sector registered a 20% growth in sales and more than 35%
growth in profits in FY2005 over the previous year. A robust consumption cycle,
fuelled by recovery of commodity and stock markets and emphasis on infrastructure
led to improved performances from key industries – automobile, pharmaceutical, steel,
and cement. The Indian industrial sector grew at 8% in FYE2005.
In a recent AT Kearney report, India was ranked second after China as the most at-
tractive destination for foreign direct investment in 2005. In the first nine months of
FY2006, foreign direct and portfolio investment (Indian securities and stock invest-
ments) totalled more than U.S. $9 billion, growing 600%, in comparison to the same
period for FY2005.

As India emerges as a favoured destination for outsourcing of back-office and IT ser-
vices, the Indian services sector also grew at more than 8% during FYE2005. A recent
McKinsey report on the prospects of the Indian business process outsourcing (BPO)
and information technology (IT) industry puts the potential growth rate of the industry
at 25% per annum with the sector having the inherent strength of capturing more than
50% of the global outsourcing opportunity of U.S. $300 billion by 2010.
The boom in the economy heightened transaction activity – during the calendar year
2005, India has witnessed deals worth U.S. $18 billion, with close to 700 pure M&A
transactions, as compared to only U.S. $6.1 billion in the previous calendar year. The
real estate sector was opened up to foreign investment; the sector has since seen high
 The Sensex is a value-weighted index composed of 30 companies with the base April 1979 = 100, comprising the 30 largest and most
actively traded stocks, representative of various sectors, on the Bombay Stock Exchange (BSE). These companies account for around
one-fifth of the market capitalization of the BSE.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 16
 activity with significant investments underway. Across sectors, transaction markets
deepened and matured, encouraged by reform-oriented policy measures of the govern-
ment and India’s alignment to the global economy.
Indian Banking
As of March 2005, the Indian financial sector had total financial assets of
U.S. $600 billion, primarily held by 88 scheduled commercial banks (SCBs), 8 all-
India financial institutions (FIs) and 3 large investment corporations (ICs) and their
subsidiaries.
Indian banking has been witnessing a period of sustained growth, with high capital
expenditure and a consumer finance boom driving a more than 25% growth in credit
off-take since March 2004. The acceleration has been driven by a pickup in corpo-
rate and retail demand and increasing investments in urban and social infrastructure.
According to the Indian Finance Minister, P.A Chidambaram, the sector is targeting
a loan-GDP ratio of 50% by 2010 (from current levels of about 35%) and improving
credit coverage in urban as well as rural sectors.
Performance of Banking Stocks vis-à-vis Sensex
Despite concerns of hardening interest rates, the profitability of Indian banks has
soared with core net interest earnings of the SCBs reaching U.S. $15 billion in
FYE2005, a 17% increase compared to the previous year. The sector has been one of
the top performers on the stock markets, outperforming sectors like FMCG and Public
Sector Units. For the six-month period ending September 2005, the BSE Bankex rose
by 33%, buoyed by a 28% increase for FYE2004.
Balance-sheet quality received greater focus, due to the approach of Basel II in 2007.
Higher profits were used by banks to increase provisioning cover – over the last two
years, SCBs and FIs have provided more than U.S. $15 billion towards bad assets,
increasing the loan to loss coverage to 60% at end March 2005 as compared to 48% at
end March 2003. Proactive NPL reduction strategies have led to improvement in the
NPL ratios – the gross NPL ratio for the sector was at 5.2% as of March 2005, declin-
ing from 8.8% as of March 2003.
India boasts of having one of the most stringent NPL identification, classification, and
provisioning regulations in the world today. The Reserve Bank of India (RBI) proposes
to further tighten the same by stipulating 100% provisioning for all NPLs that remain
doubtful for more than three years, irrespective of the collateral cover.

The Securitization and Reconstruction of Financial Assets and Enforcement of Secu-

400
350 rity Interest (SRFAESI) Act, passed in 2002, had provided a framework for creation
300 of asset reconstruction companies (ARCs), and gave powers to secured lenders to
250
200 simplify and expedite liquidation proceedings against defaulting borrowers. The regu-
150 lators further introduced new policies between April and November 2005, to clarify
100
50
ambiguities in the SRFAESI Act and also create a framework enabling foreign invest-
0 ment transactions in the ARC and NPL market space (these are discussed in detail in
Jan 2004

Jan 2005
Jun 2003
Jul 2003

Jun 2004
Jul 2004

Jun 2005
Jul 2005
Feb 2004

Feb 2005
May 2003

Nov 2003

May 2004

Nov 2004

May 2005
Mar 2003

Mar 2004

Mar 2005
Aug 2003

Oct 2003

Aug 2004

Oct 2004

Aug 2005
Apr 2003

Sep 2003

Apr 2004

Sep 2004

Apr 2005

Sep 2005
Dec 2003

Dec 2004

the sidebar on recent regulatory developments on page 18).

BSE Sensex BSE Bankers In the face of rising credit demand, capital-starved banks have increasingly accessed
the capital markets – in the last 18 months ending November 2005, 10 banks and FIs
Source: Reserve Bank of India have tapped the capital market through equity and ADR routes, raising close to
 Financial assets include loans, investments (in securities and stocks), cash and deposits with the Reserve Bank of India.  Net NPLs: Gross NPLs less Provisions against NPLs.
 Asset reconstruction companies are special purpose vehicles (as allowed by the SRFAESI Act) to act as NPL resolution agencies.

17
 Asia: India
U.S. $2.4 billion; more issues are in the pipeline aiming to raise further funds exceed-
ing U.S. $2 billion. It is expected that the banking sector would need large doses of
additional capital to achieve the loan to GDP target of 50%.
With the need for more capital to fund credit growth and progressively tightening
prudential norms, the Indian banking sector today is more committed to proactively
resolve legacy NPL issues.
Indian NPL Review
The NPL stock in the financial system is estimated to be around U.S. $30 billion, with
more than 70% held by the SCBs, FIs, and ICs. In addition, there is another large pool
of stressed corporate assets under restructuring and turnaround.
NPLs continue to be predominantly from corporate exposures. These loans are mainly
secured by fixed assets (plant and machinery, land and buildings) or by stocks and
book debts (usually in the case of working- capital exposures), along with additional
collateral like personal guarantees and personal assets of promoters. NPLs in real es-
tate, capital, and commodity markets remain low, primarily because Indian banks have
been conservative in lending to these sensitive sectors – loan exposure to these sectors
comprise only 3.5% of total bank credit. With rapid expansion of retail credit, the NPL
in the retail loans segment has also grown to more than U.S. $1 billion.
The Indian banking system had witnessed significant increase in the NPL levels in the
late 90s. While the approach towards NPL resolution was changing, it was in 2002,
when the NPL levels were the highest, that a concerted focus from regulators and
lenders in addressing the NPL problem was initiated.
Traditional NPL resolution strategies of Indian lenders in the 1990s suffered from
drawbacks – the provisioning levels were inadequate to allow lenders to accept dis-
counts; lenders themselves had issues with respect to the best strategy; legal recovery
and bankruptcy proceedings routes were lengthy and often ineffective. However, over
the years the regulators put in place several policy measures that have created a condu-
cive environment for debt recovery and turnaround.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
Encouraged by the RBI, lenders established the Corporate Debt Restructuring (CDR) cell
– a lenders forum which ensures joint decision-making on borrower restructuring propos-
als. More than 120 cases (representing an aggregate U.S. $16 billion) have been restruc-
tured under this forum’s guidance; several such cases are performing well, thanks also to
the buoyant economy. In a few cases, lenders also opted for proceedings under
Section 391 (a provision of the Companies Act in India, which allows corporate and finan-
cial restructuring under the aegis of the judiciary) – significant cases in point are BPL Ltd
and Core Healthcare Ltd, where multiple lender issues are being resolved in this way.
A watershed event in the development of the NPL market was the SRFAESI legisla-
tion in 2002. Armed with powers under the SRFAESI Act and amendments to debt
recovery laws (see sidebar on recent regulatory developments below), lenders have
aggressively pursued legal action against the borrowers. In many cases, action under
the SRFASEI Act has forced borrowers to negotiate out-of-court settlements. The
legal process was also streamlined with greater powers for Debt Recovery Tribunals
(DRTs). Superior powers granted to DRT officials as compared to civil courts expe-
dited liquidation and recovery proceedings for institutional creditors.
Recent Regulatory Developments
The SRFAESI Act has been amended in April 2004 to fur-
ther strengthen creditor rights, besides being upheld by the
Supreme Court. Notable changes include:
 It will now be possible to consolidate multiple debt recovery tribunal proceed-
ings; this change is expected to hasten the legal recovery process considerably.
 Lenders have been given additional powers in relation to possession and
transfer or sale of the assets of the defaulting borrowers.
 Timelines to DRTs for adjudication of counter-suits and stay applications with
respect to the SRFAESI Act set at 60 days, extendable to a maximum of 120 days.
 Borrower appeals to higher jurisdictions would now require deposit of at least
50% of the dues claimed.
 Special Judiciaries for adjudication of debt recovery of banks, FIs, and NBFCs.
18

Guidelines for Sale/Purchase of Nonperforming Assets, July 2005
 Only assets classified as nonperforming for more than two years are
eligible for sale.
 Sale is on a cash and non-recourse basis.
 Resale by purchasing banks, FIs, and NBFCs are not allowed for 15 months
after sale.
 NPLs may be treated as standard assets for 90 days in the books of the
acquirer. Subsequent classification is based on actual recovery vis-à-vis esti-
mated cash flows; at least 5% recovery required every quarter.
 Assets are to be written off within three years.
Guidelines for Foreign Investment in Asset Reconstruction stamp duty regimes; special duty exemptions on NPL transactions have been allowed
Companies, November 2005
 Foreign direct investment in equity share capital of ARCs permitted up to
49%; board to be broad-based.
 Foreign institutional investment (FII) investment in instruments issued by
ARCs is permitted; overall ceiling of FII in security receipts is 49%, with
individual FII cap of 10%.
The SRFAESI Act also provided a new resolution strategy for lenders – block sale
and resolution of NPLs through ARCs. Approximately U.S. $10 billion of NPLs have
already been decoupled from the Indian banking system and are now under specialized
resolution teams:
. NPLs aggregating U.S. $3.67 billion acquired by Asset Reconstruction
Company of India Ltd (ARCIL) – India’s first ARC
2. NPLs transferred to Stressed Asset Stabilization Fund (SASF)
of IDBI –U.S. $2 billion
. Assets of IFCI (formerly Industrial Finance Corporation of India – one of the
eight FIs) approximately U.S. $1.5 billion–U.S. $2 billion
4. ASREC (India’s second ARC approved by the Reserve Bank) about to
commence operations on assets of U.S. $1.5 billion
19
With the recent rulings on purchase and sale of NPL portfolios, several cash-based
NPL portfolio transactions have been underway since January 2005. The permission
to FIIs to invest in the security receipts may well be the first step towards developing a
secondary market for these security receipts and providing more liquidity in this mar-
ket. These measures are likely to create a junk bond/mezzanine financing market and
support a market for corporate debt restructuring and NPL resolution. The individual
FII cap of 10% though is a deterrent to effective restructuring/sale of NPLs out of the
banking system by a single investor, forcing potential distressed-debt investors to col-
laborate, which may prove to be difficult.
State governments have also attempted to encourage NPL portfolio transactions by
reducing statutory transaction costs. Various state governments have amended the
for ARCs in certain states like Andhra Pradesh, Tamil Nadu, Madhya Pradesh, Uttar
Pradesh, Rajasthan, Karnataka, and Orissa.
While steps have been taken in the right direction, some aspects may still require
attention. Higher foreign investment caps over and above the current level of 49% as
well as income tax and stamp duty exemptions for ARCs may have further invigorated
the market. Also, the foreclosure laws could be tightened further, especially with
regard to expediting liquidation proceedings through DRTs and courts.
Market Activity
Portfolio Sales – With the RBI paving the way for cash-based NPL transactions,
several banks – notably ICICI Bank, State Bank of India (SBI), Punjab National Bank
(PNB) and HSBC – have put up NPL portfolios for sale.
 Duty charged on signature of legal deeds concerning sale / assignment / conveyance / securitization transactions, may range from a
fixed U.S. $ 2100 to ad valorem rates up to 10%
 Asia: India

Cash-Based NPL Portfolio Transactions (Jan 05 - Apr. 06) Notable Investments by Foreign Investors in Single Credits
Bank Size Status – Apr. 2006 Investor Company Size
ICICI Bank U.S. $320 million Closed GE Capital / Spinnaker / Deutsche Bank Sanghi Cements U.S. $160 million
SBI (tranches) U.S. $220 million Closed ADM Capital India Cements U.S. $148 million
HSBC U.S. $48 million Closed JPMorgan Chase Binani Cement U.S. $57 million
Indian private sector bank U.S. $47 million Pipeline Citigroup Rain Commodities U.S. $30 million
ARCIL PNB U.S. $20 million Closed Spinnaker IG Petrochemicals U.S. $28 million
Indian private sector bank U.S. $12 million Pipeline Clearwater Capital Partners Kopran U.S. $20 million
Source: Ernst & Young Reliance Capital / Standard Chartered Bank Kinetic Engineering U.S. $26 million
Citigroup Shetron U.S. $10 million
Estimated principal dues of over U.S. $650 million have been on offer to a small Source: Ernst & Young
but growing foreign investor and bank community with players like Deutsche Bank,
JP Morgan Chase, Standard Chartered Bank, Barclays Bank, Bank of America and Typically, investors have used hybrid debt and equity investment structures to facilitate
Actis; Kotak Mahindra Bank and ARCIL have been the local players. debt restructuring/takeout (generally with sacrifices from existing lenders) and fund-
ing for future working capital and capital expenditure needs. The innovative structures
ARCIL continued to play an important role in market development and in removal of have allowed balance sheet correction and stock market re-rating for the stressed com-
NPLs from the financial system. ARCIL’s buyout of nonperforming assets amount- pany, ensuring fixed returns through debt and an upside through the capital markets.
ing to U.S. $3.67 billion has led to about 13% reduction in NPLs from the financial
system. ARCIL has announced that it has resolved 35 out of the 108 large cases with Foreign investors like Citigroup, Clearwater, Asia Debt Management, JPMorgan
an average upside of 17%. With the new policy framework in place, more competi- Chase, and Credit Suisse have already pumped in more than U.S. $500 million over
tion is expected in the ARC space – a few foreign distressed debt players are actively the past 12 months in 10 to 15 stressed corporate transactions – these investors are
considering options of setting up ARCs, in strategic alliances with Indian banks. expecting yields of more than 20% in such takeout financing deals.

Single Credit Deals – Investment in single assets has also increased, given the
industrial recovery and strong performance of the stock markets.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 20
Outlook
NPL portfolio transactions – On the immediate horizon, transaction activity in the
portfolio space is building up – SBI, the flagship of public-sector banking, in a groun-
breaking step, has begun putting its written-down assets on the block. Other public-
sector banks, which have been up until now on the sidelines, are likely to follow suit
soon. ARCIL, in its role as market-maker, has been working closely with investors
and originators offering the investors a ready servicing platform. With the new norms
for FII participation in security receipts, ARCIL now is aggressively proposing to
monetize security receipts by offering them to FII investors and also involving foreign
distressed debt investors at the stage of buying new portfolios from lenders. Indian
banks are also considering playing a more active role in the market, not only as sellers
but also as investors and servicers.

Single-asset transactions – With corporate and capital market performance reaching

new highs, several more single credit takeout and special situation transactions are in
the offing. Investment structures are also evolving with new routes like mezzanine
and junk bonds becoming available to stressed corporates. Areas of opportunity may
include opportunities in the assets restructured under CDR, where lenders have ac-
cepted extended payment schedules and may even be amenable to accept immediate
discounted pay-offs. The large cases acquired by ARCIL and SASF are in a stage of
re-rating and may be offered to investors.

Given the market development, we expect that about U.S. $1.5 billion to
U.S. $2 billion may be invested in the Indian distressed and special situations debt
market, between NPL portfolio and single-credit opportunities by March 2007.

The stage is now set for sustained transaction activity – several regulatory hurdles
have been removed, pricing benchmarks are evolving, and investor interest continues
to rise. With this backdrop, we believe that India will continue to offer significant
and attractive investment opportunities in the area of NPLs in 2006 continuing
into 2007.

21
 Asia: Indonesia

Indonesia: Nonperforming Loan Market Report

I n September 2004, Indone-
sia’s first direct presidential
election resulted in Susilo
Bambang Yudhoyono becom-
ing Indonesia’s sixth president. It is understood that one of his
main goals is to tackle corruption, and this has been well-received
by the business community.

In 2004, the domestic economy began to gain momentum with a 5.1% growth rate.
However, after reaching a 6.12% rate in the first quarter of 2005, GDP growth slowed
to 5.34% in the third quarter of 2005. The slowdown was attributed to high oil prices
and rising interest rates, which dampened exports and investments. Consumption, one Its efforts have been further challenged by the tsunami in late 2004 and the recent out-
of the main drivers of economic growth, also stalled under rising inflation. break of bird flu.

Indonesia GDP Growth As stated in the Fitch report,
8 the new government has set a
minimum GDP annual growth
7
target of 6% during its five-year
term (2005-2010). This is the
6
minimum rate at which it is
5
anticipated that unemployment
rates can be reduced. However, a
4 political compromise involving
ministerial positions has created
3
some public skepticism about
01
Indonesia’s most recent fuel subsidy cuts on October 1, 2005  have increased con-
sumers’ fuel costs and inflation pressures. The annual inflation rate reached 17.11%
in 2005 compared with 6.1% in 2004. Bank Indonesia (BI) pushed up interest rates,
from 7.43% as of December 22, 2004 to 12.75% as of December 14, 2005, to curb
inflation and to defend the rupiah exchange rates. The rupiah exchange rate weakened
against other foreign currencies in 2005, from IDR 9,290/USD at the end of 2004 to
IDR 9, 830/USD at the end of December 2005. The central bank has also intervened in
the foreign exchange markets to control the rupiah’s depreciation.
Banking Environment
Since Indonesia’s 1998 financial crisis, rehabilitation of its banking industry has been

02

03

5
00

00

00

00

00

00

00
20

20

20

-2

-2

-2

-2

-2

-2

-2
Q1

Q2

Q3

Q4

Q1

Q2

Q3

Real GDP growth (% change)
Source: Moody’s Investors Service, Analysis on Indonesia, February 2005.
Source: Bisnis Indonesia, “Laju Ekonomi Terus Melambat,” 22 November 2005.
 The Jakarta Post, “Economy Slows Down in Q3, for 3rd Quarter in a Row,” November 22, 2005.
 FitchRatings, “The Indonesian Banking System,” July 15, 2005, p. 2.
the government’s efforts to
achieve these growth targets and
to continue battling corruption.
a long-term process. The Indonesian Bank Restructuring Agency (IBRA), a special-
purpose institution established by the government in 1998, was liquidated in
February 2004 after completing the mandate to restructure and rehabilitate the bank-
ing industry. IBRA was comprised of Asset Management Credit (AMC) and Asset
 Bisnis Indonesia, December 29, 2005, “Prospek Perbankan 2006.”
 <www.detik.com>, January 3, 2006, “Inflasi 17.11%, What’s Next?”

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 22
Management Investment (AMI). AMC was responsible for handling NPLs of the Ownership Changes Among Major Banks in Indonesia
closed or taken-over banks by the government, while AMI was responsible for taking Total Assets
Status
care of the pledged or given-up assets related to the NPLs. During these years, IBRA (2004) IDR trn
Bank Panin 23.9 ANZ acquired 29% Stake back in 1998-99. Still Controlled by the Gunawan family (42%)
recovered an estimated 28% of its approximately IDR 600 trillion (U.S. $61 billion)
Bank Mandiri 248.2 Divested30% to the Public in Mid-2002
nonperforming loan portfolio. During 2002-2004, foreign investors also participated
Bank Central Asia # 149.2 Divested 51% to Farindo Investment in 2002
in this rehabilitation process by acquiring controlling stakes in certain major private
Bank Niagi # 30.8 Divested 52% to Commerce Asset-Holding Berhad in late-2002
banks such as Bank Danamon, Bank Niaga, and Bank International Indonesia (BII).
Bank Danamon # 58.8 Divested 51% to Asia Financial Holdings in late-2003
These foreign banks are seen as better-equipped strategic investors, who can meet any
Bank Rakyat Indonesia # 107.0 Divested 40% to the Public in Late-2003
additional capital requirements, competitive pressures, and the need for international
Bank International Indonesia # 36.1 Divested 51% to Sorak financial Holdings in late-2003
banking experience, including risk management practice. To prepare the state banks
Bank Lippo # 27.8 Divested 52% to SwissAsia Global in Early 2004
as anchor banks and to privatize them, the government publicly listed Bank Mandiri in
Bank Permata # 31.6 Divested 51% Stake to a Consortium Comprising SCB and Astra in late-2004
2002 and Bank Rakyat Indonesia in 2003 on the Jakarta Stock Exchange.
Bank Negara Indonesia * 136.5 Planned Additional Sale to the Public in 2005

After IBRA was liquidated, its remaining unsold assets were transferred to the state
asset management company (Perusahaan Pengelola Aset/PPA), which was established
under the control of the Ministry of Finance. Under PPA, further divestments
to foreign investors are to continue.
The following table shows the divestments made by IBRA and PPA from 2002 until
2004 and also divestment by private shareholders.
Bank NISP 17.9 OCBC Acquired 22.5% in Mar-2004 and Raised to 51% in Mar-2005 and 70.6% from end-May 2005
Bank Buana 23.9 UOB Aquired from Various Private Shareholders, 53% as at July 2005
* State-owned
# Recapitalized and nationalized by the government during the financial crisis
Source: Fitch Ratings
Furthermore, in 2005 PPA divested 5.22% of government held shares in Bank Niaga,
15.25% in BII, and the remaining 10.5% shares in Bank Danamon. In late 2005, PPA
disposed of one the main assets related to the NPL (i.e., PT Dipasena Citra Darmaja, an
asset submitted to IBRA/PPA to settle the debt of the closed-down Bank Dagang Negara
Indonesia, to a third party). The scheme will require the new investor to provide financ-
ing and will be followed by a debt–to-equity conversion. Within the first 1.5 years the
new investor will provide funds of IDR 9 billion (U.S. $91.6 million).

In order to reduce its NPLs, Bank Mandiri planned to execute the loan collaterals
through an auction at the Direktorat Jendral Piutang dan Lelang Negara (DJPLN), the
Directorate General of Debtors and Auction. In the first stage, the auction will be held
for 140 debtors covering 380 land/building certificates. In addition, Bank Mandiri
also plans to set up a special purpose vehicle (SPV) aiming at rescuing credits

 Website PT Perusahaan Pengelola Aset (Persero), <www.ptppa.com>

 <www.bisnis.com>, “Perombakan Dipasena Tunggu Kredit Recapital Advisors,” December 23, 2005.
 Website PT Bank Mandiri (Persero) Tbk.

 FitchRatings, “The Indonesian Banking System,” July 15, 2005, p. 4.

23
 Asia: Indonesia

Multi-Finance Companies
by separating strong banks and ailing banks based on the best practice, transparency, In the four years ended in 2004, loans extended by finance companies grew significantly
and accountability principles, and in accordance with the prevailing rules and provi- from IDR 38 trillion (U.S. $3.8 billion) in 200311 to IDR 65 trillion (U.S. $6.6 billion) as
sions. The maximum at July 2005.12 Most of the growth was contributed by consumer financing loans.
IDR 3 trillion (U.S.
Loan Composition of Multifinance in Indonesia
$305 million) of NPL As stated in the Fitch report,13 as of September 2004 there were 238 finance
100% will be transferred to companies operating in Indonesia with total assets of approximately IDR 79 trillion
80% the SPV. This plan, (U.S. $8 billion). The strong recovery in domestic consumption has increased demand
however, still needs for consumer loans, particularly motor vehicles and motorcycle financing. As a result,
60%
to be approved by the most finance companies have shifted their business from corporate leasing and factor-
40%
government and regu- ing to consumer financing.14 As shown in the chart to the left, consumer financing
latory bodies, among contributed more than 60% of the finance companies’ loans as of September 2004.
20%
others, the Ministry of
0%
Finance and BI.10 The government’s decision to cut fuel subsidies and increase interest rates has had a
negative impact on the multi-finance business and the banking industry by reducing
01

02

03

04

5
00
20

20

20

20

-2
Q7

Leasing The banking industry
Factoring
Consumer Financing
Credit Cards
has taken a cautious
Others
approach toward lend-
ing since the 1998
Source: FitchRatings, “The Indonesian Banking System,” July 15, 2005, p. 10 (for 2001-2003
figures); Kompas Daily News, “Musim Gugur Multifinance,” December
financial crisis. Banks
are holding a large por-
tion of their productive assets in government bonds and similar financial instruments.
Perceiving corporate lending as too risky, they have focused on consumer financing
through a channeling agency format, with various financial services institutions such
as leasing and other multi-finance companies as indicated below. Under this scheme,
a bank would enter into a consumer credit channeling agreement with a multi-finance
company. The bank would finance certain specific loans in the multi-finance compa-
ny’s consumer finance portfolio which are considered good credit risks and which had
built up on the company’s books. In fact, certain banks have acquired multi-finance
companies in an effort to become major players in the consumer segment, for exam-
ple, Bank Danamon acquired PT Adira Dinamika Multi Finance in January 2004 and
BII acquired PT Wahana Ottomitra Multiartha (WOM) Finance in May 2005.
 <www.indoexchange.com>, “Indonesia’s Bank Mandiri Mulls Setting up SPV to Reduce NPL,” November 29, 2005.
10 <www.republika.co.id>, “Kredit Macet Rp3 Trilliun ke SPV Mandiri,” December 22, 2005.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
consumer purchasing power and creating challenges with loan collectibility.
The recent collectibility rate trend in the consumer finance sector has not been encour-
aging because many more customers are lagging behind in their loan repayments. The
multi-finance asset growth was only 7.4% from 2004 to July 2005, which is far behind
the growth of 67% during calendar year 2004.15 The competitive pressures also led many
competitors to enter into cut-throat competition by offering a U.S. $50 down payment to
get a new motor vehicle lease of U.S. $1,000–U.S. $1500. Customers who are in default
with one finance company can easily get new credit with another finance company as
long as they have this U.S. $50 as a down payment. The lenders’ honeymoon period of
easy motor vehicle and motorcycle financing seems to be over because of collectibility
issues and consequently a lack of funding support from the banking industry.
Regulatory Overview
The Indonesian Banking Architecture law (Arsitektur Perbankan Indonesia/API) as
designed and regulated by the Indonesian Central Bank (Bank Indonesia) was enacted
in January 2004. Under the framework of API, the merger and consolidation of anchor
11 FitchRatings, “The Indonesian Banking System,” July 15, 2005, p. 10.
12 Kompas Daily News, “Musim Gugur Multifinance,” December 23, 2005, p. 21.
13 FitchRatings, “The Indonesian Banking System,” July 15, 2005, p. 10.
14 Those numbers are excluding loan channeling (arrangements made by banks to provide funds for finance companies which in turn
are the financing agents).
15 Kompas Daily News, “Musim Gugur Multifinance,” December 23, 2005, p. 21.
24
 Nonperforming Loans
banks is expected to continue, resulting in a decline in the number of banks from more From 2001 to the third quar-
than 130 in 2005 to approximately 60 by 2010. The criteria to be classified as an ter of 2005, the assets of the
anchor bank are, among others: (i) a minimum tier-one capital of over IDR100 billion; banking industry grew from Indonesian Banking Indicators
(ii) an NPL ratio of less than 5%; (iii) a Capital Adequacy Ratio of 12%; (iv) Return IDR 1,099.7 trillion in 2001
on Assets of at least 1.5%; (v) an annual credit growth of 22% or a Loan to Deposit (U.S. $112 billion) to IDR
1,500
Ratio of more than 51% ; and (vi) should be publicly listed or planning to go public 1,347 trillion in the

IDR trn
in the near future. The concept of anchor banks echoes the banking industry structure third quarter of 2005
1,000
in Malaysia and Thailand, although in these neighboring countries the consolidation (U.S. $137 billion). The total
process took place through market forces rather than by regulatory intervention.16 loan amount also grew in this 500

period from IDR 359 trillion

The following diagram illustrates the envisioned structure and capital requirement of (U.S. $36.5 billion) in 2001 0

01

02

03

04

5
00
the banking industry under API. to IDR 702 trillion

20

20

20

20

-2
Q3
(U.S. $71 billion) in the third Total Assets
Envisioned Structure of Banking System Loans
BI’s more stringent quarter of 2005. The total
requirements, particu- LDR as of the third quarter of
Source: Bank Indonesia
Capital larly concerning minimum 2005 rose to 67% from 62%
(IDRtm) International
Banks capital and the restriction in the fourth quarter of 2004.
50
on the scope of activities,
National
Banks is expected to lead to a The recent increases in oil
10
stronger and more transpar- price and interest rates are
Specialised Banks
Indonesian Banking-NPL (%)
Regional Corporate Retail Others
ent banking industry with expected to have a nega-
0.1
Rural Banking Banks with Limited a reduced number of NPLs tive implication for credit 14
Scope of Business
in the future. expansion, as it reduces 12
0
the debtors’ capabilities in 10

Source: Bank Indonesia

A new regulation in servicing and settling their 8

NPL (%)
earning assets classification, known as PBI No. 7/2/05, was introduced by BI in Janu- loans, which in turn causes 6

4
ary 2005 and focuses on the one debtor-one obligor concept. This requires all banks banks to be more cautious
2
to adopt more stringent measures for loans to debtors who have borrowed from more in their lending activities.
0
than one bank.17 This ruling is aimed at preventing debtors from borrowing from one

05
0

0
20

20

20

20

20
bank to cover payment of a nonperforming loan with another bank. As of the third quarter

-
Q3
of 2005 the banks’ gross NPL (%)

NPLs had reached

Source: BI Statistic Perbankan Indonesia
16 Retail Banker International, “Asia-Pacific Consolidation: Indonesia Seeks Safety in Small Numbers,” August 12, 2005.
IDR 110 trillion
17 GK Goh, Banking Sector Update, June 6, 2005, p. 2. (U.S. $12 billion) or 8.9%,

25
 Asia: Indonesia

an increase from IDR 50 trillion (U.S. $5 billion) or 5.8% in 2004.18 This increase in
NPLs in 2005 can be attributed to the implementation of the more stringent new BI rul-
ing about “the one debtor-one obligor” concept, the fuel subsidy cuts, and the recent in-
crease in interest rates. BI’s governor indicated that the financial sector will face heavy
challenges in 2006 as a consequence of these factors.19 Therefore, these increases might
put further pressures on the financial services industry in dealing with the collectibility
of their outstanding loans.
The analysis of NPLs as of the third quarter of 2005 by sector is presented in the chart
below. The industrial sector has the highest level of NPL compared to other sectors.
The most recent example is Bank Mandiri, Indonesia’s largest in terms of its assets.
NPLs in Bank Mandiri hit a record high in mid-2005 after the bank was rocked by a
multi-million-dollar bad-debt case, which in turn led to the dismissal of the bank’s
CEO. Corporate borrowers contributed 71.5% of Mandiri’s IDR 25.2 trillion (U.S.
$2.6 billion) in NPLs portfolio as of June 2005, while commercial borrowers and con-
sumers comprised 27.6% and 0.9%, respectively.20 Bank Mandiri stated that the fall
in its first quarter 2005 profit of 70% (year over year) was partly because of tighter BI
regulation.21 Bank Negara Indonesia, another state-owned bank, predicted that its NPL
ratio will significantly increase from 0.6% in the first quarter of 2005 to 6% when the
bank implements the ruling.

Outlook
NPLs by Sector The Indonesian government faces bigger challenges than it may have anticipated in
achieving its growth targets for the economy and creating a stronger banking and
4.01%
financial services industry. The government has taken steps such as enactment of the
5.95% Indonesian Banking Architecture law and adopting the more stringent one debtor-one
Agriculture, Hunting & Agriculture Facilities
Mining obligor concept in order to strengthen the industry and address banks’ NPL problems.
16.06% Manufacturing Through such steps, Indonesia can lay the foundation for a healthy financial services
Construction
sector that is imperative for the rebuilding of the economy as a whole.
49.45% Trade, restaurants & hotel
Business services
5.79% Others

13.78%
4.96%

Source: BI Statistic Perbankan Indonesia

18 BI Statistik Perbankan Indonesia Vol. 3 No.10, September 2005, Table 1.41-1.47 20 Reuter News, “Interview: Indonesia Bank Mandiri Bad Loans to Halve in ’06,” September 16, 2005.
19 <www.indoexchange.com>, “Indonesian Financial Sector to Face Tough Challenges in 2006: BI,” November 17, 2005. 21 AFX Asia, “Bank Indonesia Resists Pressure to Revise Bank Asset Ruling” (report), June 2, 2005.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 26
27
 A s i a : J a pa n

Japan: Nonperforming Loan Market Report

A fter a painful restruc-
turing of its economy
and banking system that has
stretched over more than a
decade, Japan has finally recovered from the collapse of its
bubble economy. Today Japan’s economy is growing, bank
profits are improving, merger and acquisition activity is pick-
ing up, and property markets are rebounding. Over the past
five years Japan has reduced its NPLs by 50%. It is attract-
ing more investment from global investors, who are shifting
their focus from NPLs and other distressed assets to invest-
ments in hard assets, as well as mergers and acquisitions • Exports and imports are showing moderate growth
• Since hitting bottom (¥7,600 ) in April 2003, the Nikkei Stock Average has been
and other corporate transactions.
recovering along with the economy
• The yen recently has strengthened against the dollar
After years of stagnation, Japan’s economy finally has begun to recover; GDP in-
creased 1.9% in 2003, 2.1% in 2004 and an estimated 1.6% in 2005. The economy However, Japan has been struggling to reduce its public debt, which reached an esti-
has been improving for a number of reasons, including: mated ¥774 trillion (U.S. $6.6 trillion) in 2005. This is equal to about 150% of GDP,
the highest deficit-to-GDP ratio of any advanced nation. The government has been
• Businesses have trimmed their labor forces and costs and focused on better man- considering various measures to control public spending and reduce the deficit.
aging capital spending and reducing debt
• Household incomes are improving as more people retire and collect retirement Real Estate Market
pay and social security Japan’s bubble economy of the late 1980s was a tide that lifted all boats: property val-
• Consumer spending has been gradually increasing ues generally soared in Tokyo and the country’s other leading real estate markets. Now
• The overall unemployment rate has been declining, although unemployment Japan’s economy is again recovering, but this time the country’s real estate markets
among 15 to 24 year-olds remains comparatively high are responding differently. Well-located properties with strong tenants, healthy cash
• Demand for goods and services has been increasing flows, and profitable operating results are commanding higher prices, while values of
• Business profits are picking up, enabling businesses to increase capital spending marginal properties have remained flat or are continuing to decline. The gap between

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 28
the values of strong and weak properties is widening. In Tokyo, commercial property Most of Japan’s major banks have nearly completed their dispositions of NPLs.
values are beginning to rebound after 15 years of continuous decline, and property In the process they have reduced their NPL ratios from an average 8.4% in the
values in other cities are showing moderate improvement. Demand for office space, 2002-2003 period to about 2.4% in 2005-2006. By comparison, the NPL ratio for
particularly in newer buildings, is growing as Japan’s corporations and businesses ex- regional banks dropped from 8.0% in 2002-2003 to 5.2% in 2005-2006. The banks
pand. With commercial property markets improving and demand strong, some owners accomplished this through bulk sales to the Resolution and Collection Corporation
are taking the opportunity to implement exit strategies and take their gains by selling (RCC) as well as traditional bulk sales; sales to private equity funds; and sales to the
selected assets or portfolios of properties to Japanese REITs (J-REITs), private funds, Industrial Revitalization Corporation of Japan (IRCJ) under the Financial Revitaliza-
or other buyers by securitizing or refinancing assets. Banks also have benefited by be- tion Program. Under this program, announced in October 2002, major banks received
ing able to move NPLs off their books through sales or other dispositions. support for NPL reductions through an injection of public funds and an extraordinary
low-interest-rate policy. By the end of the fiscal year in March 2005, the RCC had
NPL Market acquired about ¥4 trillion of NPLs. The RCC has kept most of these NPLs with the
By September 2005, the NPL balances of Japanese banks had fallen to about ¥15.9 intention of working out the loans with the borrowers. It has disposed of the rest via
trillion (U.S. $134 billion) from ¥23.7 trillion (U.S. $201 billion) in September 2004 the secondary market.
and ¥43.2 trillion (U.S. $367 billion) in March 2002. During this period (March 2002
to September 2005), some loans were moved into a higher risk classification, resulting IRCJ has also contributed to the banks’ resolution of NPL problems by allowing them
in an increase in NPLs; however, this was more than offset by other loans being moved to move NPLs from their balance sheets to IRCJ. Between April 2003 and March
into a lower risk category as well as through NPL sales. The result was a net decrease 2005, when it completed its sponsorship program, the ICRJ approved 41 restructuring
in NPLs from March 2002 to September 2005. plans submitted by borrowers who have chosen or have been forced to request the as-
sistance of IRCJ due to their poor financial condition. By unloading their NPLs, many
As of September 2005, the following was the banks’ total NPL balance, by classification: Japanese companies have dramatically improved their balance sheets, become more
“Bankrupt or De Facto Bankrupt” NPLs were ¥2.8 trillion (U.S. $23 billion) or 17.6%; efficient and productive, and significantly improved their return on equity.
“Doubtful” were ¥8.0 trillion (U.S. $67 billion) or 50.3%; and “Special Attention” were
¥5.1 trillion (U.S. $43 billion) or 32.1%. Investment Activities
Japan’s strong economic recovery, and the ready availability of investment capital on a
The Transition of NPLs for all Banks (¥ Trillion) global basis, is attracting more investment money to Japan. More of the global oppor-
Category Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sept-05 tunity, buy-out and turnaround funds such as KKR and Carlyle have announced plans
NPL’s Total to enter the Japanese markets or to increase their investments in Japan over the next
All Banks 32.9 33.6 36.8 43.2 40.2 35.3 31.6 26.7 23.8 17.9 15.9 few years. Investors are shifting their investment focus from NPLs and other distressed
Bankruptcy or De
8.6 7.7 7.4 7.4 7.0 5.7 5.6 4.4 4.1 3.2 2.8 products to investments in hard assets, M&As, and other corporate related transac-
Facto Bankrupt
tions. Global investors currently active in Japan include: Aetos Japan, Cerberus Japan,
Doubtful 15.3 15.0 15.9 19.3 16.4 13.0 12.3 11.2 12.7 8.8 8.0
Colony Capital Asia Pacific, Credit Suisse, Deutsche Bank, GE Commercial Finance,
Special Attention 9.0 10.9 13.5 16.5 16.8 16.6 13.7 11.1 7.0 5.9 5.1
GMAC Commercial Mortgage Japan, Goldman Sachs (Japan) Ltd., JPMorgan Chase,
NPL Ratio
Lehman Brothers, Lone Star Japan, Merrill Lynch, Morgan Stanley, Ripplewood Hold-
All Banks 6.2% 6.3% 7.0% 8.4% 8.3% 7.4% 6.8% 5.8% 5.3% 4.0% 3.5%
ings, Secured Capital, and Shinsei Bank Ltd. In addition, an increasing number of
Major Banks 5.1% 5.3% 6.2% 8.4% 8.1% 7.2% 6.5% 5.2% 4.7% 2.9% 2.4%
domestic funds are becoming active in the market place, including Kennedix, Pacific
Regional Banks 7.1% 7.3% 7.7% 8.0% 8.3% 7.8% 7.5% 6.9% 6.3% 5.5% 5.2%
Management Corporation, and Da Vinci.
Source: Financial Services Agency

 The borrower has filed for bankruptcy, or the borrower has not filed but is effectively bankrupt.
 Recovery of the loan from the borrower is doubtful.
 The loan requires monitoring because of the borrower’s poor performance.
29
 A s i a : J a pa n
Some of the major investment activities in 2004 and 2005 (some are still ongoing) included:
• Aetos’ acquisition of a ¥15 billion (U.S. $127 million) stake in Matsushita Invest-
ment & Development Co., an affiliate of Matsushita Electric Industrial Co.
• Cerberus Group and Nikko Principal Investments Japan Ltd., a merchant banking
unit of Nikko Cordial Corp., are expected to contribute ¥90 billion (U.S. $763
million) and ¥50 billion (U.S. $424 million), respectively, to Kokudo Corp’s plan
to raise up to ¥160 billion (U.S. $1.4 million) for the revival of the Seibu Railway
Co. group
• Starwood Capital and Morgan Stanley’s acquisition of the Westin Tokyo hotel for
¥50.1 billion (U.S. $425 million)
• Shinsei Bank’s acquisition of Aplus, a consumer credit company for about ¥100
billion (U.S. $848 million)
• Cerberus Group’s acquisition of the controlling shares of Aozora Bank from Soft-
bank for about ¥100 billion (U.S. $848 million)
Asset Sales
We estimate that the total sales of the distressed assets in the major markets including
Japan, Germany, Taiwan, and China were approximately U.S. $20 billion to U.S. $22
billion in 2004, of which Japan accounted for U.S. $13.6 billion to U.S. $14.96 billion.
In 2005, we estimate that Japan’s distressed asset sales increased to U.S. $22 billion,
of which 64% were real estate-related transactions, followed by major corporate bank-
ruptcies.
Some of the investors who were among the first to enter the distressed asset market
in the late 1990s have started to cash in and realize their gains through asset sales to
third-party investors and IPOs.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
Such transactions include:
• Ripplewood Holdings LLC sold part of its shareholdings in Shinsei Bank (the
former Long-Term Credit Bank of Japan) through an IPO
• Lone Star’s sale of First Credit Corp., which specializes in lending to small and
mid-size businesses and was once affiliated with the former Long-Term Credit
Bank of Japan, to Sumitomo Trust & Banking Co. for ¥130 billion
• Lone Star Group sold part of its shareholdings in the Tokyo Star Bank Ltd. (the
former Tokyo Sowa Bank) through an IPO
• Lone Star Group, through Pacific Golf Management, one of its affiliates, became
Japan’s largest golf course operator by buying 95 courses (Lone Star sold a por-
tion of its shareholdings in Pacific Golf Management through the IPO)
• According to Nihon Keizai Shimbun, Accordia Golf Co., a golf course manage-
ment firm owned by Goldman Sachs, is preparing to list itself on the Tokyo Stock
Exchange sometime in 2006
J-REITs
At the end of 2005, there were 26 J-REITs with a total market capitalization of ap-
proximately ¥2.7 trillion listed on Japan’s stock exchanges, and four more J-REITs
were expected to be listed by the end of March 2006. The J-REITs’ average annual
return was around 5% and the spread between the J-REIT return and the 10-year bond
was about 3.5%. The average annual return declined to below 4% in 2005 and the
bond spread to less than 2.5%. By market capitalization, diversified properties account
for about 40% of J-REIT investments; office, 40%; retail, 10%; and residential and
distribution centers, 10%. The sponsors of J-REITs are real estate companies, major
trading companies and (recently) venture-type real estate companies such as
Darwin, Kenedix, Asset Mangers, FC REIT, and Da Vinci. Investors are 60% financial
institutions (banks, life insurance companies, etc); 20% individual; 10% domestic
corporations; and 10% foreign investors. Traditionally, Japanese individuals have only
invested in debt products, mainly postal savings. However, more individual investors
are starting to invest in J-REITs, although they still represent only a small percentage
of total investors.
30
Japanese Banks
According to the Financing Services Agency (FSA), Japan’s 11 major banks reported
aggregate net earnings of ¥600 billion for the year ended in March 2005, up from
¥400 billion the previous year. They also reported a surplus for the first time in the
past four years. Their capital adequacy ratios improved to 11.6% in March 2005 from
11.1% the previous year. Their cost of NPL resolutions has dropped. In the year ended
March 2002, the overall cost of the major banks’ NPL resolutions exceeded
¥7 trillion (U.S. $59 billion); by March 2005, it had dropped to ¥2 trillion.
Banks also have achieved significant cost savings by reducing the number of
employees. In addition, rating agencies have upgraded the ratings of Japanese banks.
Mergers and Acquisitions
Both Japanese and foreign investment companies are playing a dominant role in merg-
ers and acquisitions through management buyouts, buyout funds, and restructuring.
In addition, there has been an increase in corporate takeover bids, especially hostile
bids. M&A activities in Japan are expected to show continuous growth through 2006.
Financially sound corporations will expand through M&A and the disposition of non-
profitable business lines. In addition, with M&A, mid-size corporations can become
more competitive in the market.
Outlook
More than a decade ago, Japan was the first in Asia to experience the painful reper-
cussions of the NPL morass. Now, Japan’s painful and at times seemingly endless
process of living with and resolving NPL problems is finally coming to an end, but at
a heavy cost. Not only borrowers but property owners, corporations, banks, and the
public were devastated by an alarming rate of corporate and personal bankruptcies,
reductions in income, loss of properties (including homes), and the end of what had
been a world-renowned lifetime employment concept and seniority system in Japan’s
workplace. Such a heavy toll left many Japanese fearful of the future, and, worst of
all, suffering a loss of pride.
The lessons learned from this ordeal vary. For the property owners, the myth that
“Japanese real estate never depreciates” was proven to be just that: a myth. Invest-
ment decisions are now being made based on the expected profitability of real estate
ownership. Corporations are now evaluating whether real estate ownership truly fits
their business models. Banks are more thoroughly assessing their risks and exposures
amid heightened scrutiny by government agencies. The people of Japan are more alert
and actively participating in the decision-making process at all levels, rather than just
following “others,” a trap this homogeneous country has fallen into in the past.
This experience has prepared Japan for growth. Through great sacrifices, the nation is
on its way to regaining its global competitiveness, and re-emerging as one of the true
global economic leaders. Finally the sun is rising again.
The Nikkei Weekly notes that a second wave of foreign buyout funds is coming ashore.
In contrast to the foreign investors who arrived in the late 1990s and who focused on
the distressed products, the newcomers are likely to seek opportunities in mergers and
acquisitions and restructuring active businesses. Despite the diminishing distressed
asset market, Japan will continue to represent an attractive market for global investors
where they can realize acceptable returns in a stable business and investment environ-
ment with established rules of law.

31
 Asia: Korea

Korea: Nonperforming Loan Market Report

D uring the 1997-1998
Asian financial crisis,
thousands of Korean com-
panies went bankrupt, leav-
ing banks with huge portfolios of nonperforming loans. The
Korean government moved aggressively to deal with the
problem; among other steps, it closed, merged, or sold
scores of banks and financial institutions, required banks to
raise their capital adequacy ratios, strengthened asset clas-
sification standards for banks, and required banks to provi-
sion adequately for nonperforming loans. It also activated
the Korean Asset Management Corporation (KAMCO) to ac-
quire and dispose of the banks’ NPLs. Following the collapse
of the debt-laden Daewoo Group in 1999, the government
also instituted reforms to increase corporate accountability
and transparency.
been buying corporate NPLs generally shunned consumer NPLs, choosing instead to
target M&A deals and a diminishing number of corporate NPL opportunities. With
Korea’s NPL market peaked in 2000 and a few large-volume NPL sales to investors the continuing disposition of their NPL portfolios, financial institutions have managed
were closed in 2001. While banks were reducing their portfolios of corporate NPLs, to improve their asset quality, which has resulted in a more stable banking system. In
their consumer NPLs began to increase as overextended consumers defaulted on their 2005, Korean banks posted record earnings and a record low NPL ratio.
credit card debt. In 2002, banks began to dispose of their consumer NPLs, and when
Korea’s credit bubble burst in early 2003, they shifted their focus from corporate loans Meanwhile, restructuring and reform is continuing in Korea’s corporate sector. As once-
to write-offs and sales of portfolios of consumer NPLs. The change in NPL pools ailing companies have been restored to health, they are being sold or merged to get relief
from corporate to predominantly consumer loans also led to changes in the makeup of from heavy debt burdens. (The merger of companies under a restructuring plan usually
NPL buyers, with domestic investors such as savings and loans, mid-sized corporate requires a creditor agreement as well as a guarantee of repayment, even if there is some
restructuring companies (CRCs), and collection agents forming investment groups to debt forgiveness.) Companies also are being sold or merged by shareholders who want
acquire consumer NPLs. Foreign investment banks and private equity funds that had to sell their stakes and take their profits. Shareholders are mostly financial institutions

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 32
that helped to bail out these companies by exchanging debt for equity stakes. Mergers The S&P and Fitch upgrades are still below their “AA–” ratings before the Asian
and acquisitions of these restructured companies are expected to peak in 2006 and 2007. Financial Crisis.

Economy Korea Rating History

When the consumer credit bubble burst in 2003, consumer spending slowed and GDP
growth fell to 3.1% that year from 7.0% in 2002. Helped by strong exports, GDP growth AA-
increased to 4.6% in 2004. Growth might have been stronger; however, weak consumer Before Crisis

sentiment, contraction of the construction industry, and high oil prices acted as drags on A+
the economy. It is estimated that GPD grew by around 4% in 2005, with exports gaining A Oct-05

momentum, consumer sentiment improving, and the service industry picking up. BBB+ Jun-02

BBB Mar-00

BBB- Jun-99

GDP is ex- BB+ jan-99

Korea GDP Growth 2000-2005 pected to grow Feb-98

around 4.5%
in 2006, driven
B-
800 9.0%
Crisis
8.0%
by increases
700
in exports,
7.0%
600 consumer Source: Fitch Ratings
U.S. $ in billions

6.0%
spending, and
GDP Growth

500
a continued Improved corporate earnings, increased investment in stocks of public companies, and
GDP

5.0%
400
4.00% recovery in favorable international financial market conditions pushed the Korea Composite Stock
300
3.0%
the service Price Index (KOSPI) to 1,142.99 on September 7, 2005, an 11-year high. The market
200
sector. Service continued to gain, closing at 1,379.37 on the last trading day of 2005. The market has
2.0%
output growth, benefited from record low interest rates, which have prompted investors to switch from
100 1.0%
supported by bank deposits to mutual savings funds that invest in stocks and universal insurance
0 0.0% rising sales products (which include stock market investments). In addition, strict controls on real
00

01

02

03

04

in the retail estate speculation have resulted in a shift of capital from real estate to stocks. An anti-
(e
20

20

20

20

20

05
20

and financial
Source: Fitch Ratings
services sec-
tors, has eased concerns about a slump in domestic demand. A bullish stock market has
helped to boost consumer sentiment. However, there is concern that unstable oil prices
and a slump in construction spending might weigh on the economy. Furthermore, cor-
porate spending on facilities has not shown tangible signs of recovery.
In 2005, Korea’s sovereign rating was upgraded to “A” from “A-” by S&P in July and
to “A+” from “A” by Fitch in October. One of the reasons for Fitch’s upgrade was the
eased nuclear threat from North Korea, whose agreement in the six-party talks to scrap
its nuclear weapons program has eased tensions on the Korean peninsula. While there
are some disputes over implementation, achieving an agreement ensures North Korea
remains as a participant in the six-party talks for further negotiation toward a treaty.
speculation measure, which became effective in 2006, is intended to stabilize housing
prices through heavy taxation of the ownership of more than two homes or expensive
houses (value above U.S. $600,000). The measure also stipulates stricter regulations and
taxation on overall transactions in the real estate sector. The stock market is expected to
maintain its momentum in 2006.
KAMCO and KDIC
KAMCO and Korea Depositary Insurance Corporation (KDIC) have earned interna-
tional recognition for their contribution to the timely resolutions of NPLs, which enabled
Korea’s financial system to recover sooner than anticipated and set an example for other
Asian countries hurt by the 1997-1998 financial crisis.

33
 Asia: Korea

From 1997 to November 2002, KAMCO paid a total of U.S. $38.1 billion to acquire As of August 2005, KDIC had injected public funds of U.S. $106.9 billion into 517
NPLs with an outstanding principal balance of U.S. $106.4 billion. It also resolved troubled companies and collected U.S. $32.7 billion through sales of NPLs or equity
U.S. $73.1 billion through 13 portfolio sales to international investors and 7 asset- shares as well as from the liquidations of failed companies. Together with creditors,
backed securities (ABS) issuances using NPLs as underlying assets as well as other KDIC, as a fund provider, monitors workouts of troubled companies under memoranda
methods. KAMCO stopped the acquisition process in November 2002 and currently of understanding (MOU). (An MOU is an agreement between the workout company and
focuses on resolution and collection. As presented below, loans of U.S. $36.3 billion the creditors.) In addition, KDIC prescribes the operation and profit targets that must be
had not been resolved as of November 2005. It is expected that the loans of Daewoo met, and the debt restructuring plan, capital support plan, etc. that must be implemented
Companies and borrowers under workout plans will be mostly recovered through the for workout companies to graduate from the workout plan. Finally, it exercises influence
merger and acquisition (M&A) process. on MOU to improve the equity value of the companies, which would lead to a higher
rate of recovery on the funds provided to these companies.
NPL Acquisition by Year
(U.S. $ in Billions) Bailout and Collection by Type
1997 1998 1999 2000 2001 2002 Total (U.S. $ in Billions)
*OPB 10.7 31.5 17.6 31.7 5.8 9.2 106.4 Insurance Asset
Equity Investment Contribution Loans Total
Acquisition Price 6.8 11.8 4.3 12.4 1.9 0.9 38.1 Payment Acquisition
Bailout 47.0 17.2 29.1 11.5 2.1 106.9
* Outstanding principle balance (OBP)
Source: KAMCO Collection 10.8 2.7 12.3 5.6 1.3 32.7
Collection ratio 23.1% 15.6% 42.2% 48.3% 63.6% 30.6%
NPL Acquisition by Seller Type
Source: KDIC
(U.S. $ in Billions)
Merchant Guarantee
Bank *ITMC Other Total
Bank Insurance Bailout by Institution
OPB 59.6 3.4 6.8 21.5 15.1 106.4 (U.S. $ in Billions)
Acquisition Price 23.7 1.4 1.7 8.1 3.2 38.1 Merchant Savings &
Bank Insurance Securities Other Total
* Investment Trust Management Company (ITMC) Bank Loans
Source: KAMCO
44.2 18.6 9.5 21.9 8.2 4.5 106.9
Source: KDIC
Composition of NPLs Unresolved as of November 2005
OBP %
Daewoo Companies 28.5 78.6% Consumer NPLs
Workout Loan 1.5 4.1% Delinquent consumer and household loans have hampered the economy since the
*Special Asset 2.0 5.4% credit bubble burst in late 2002 and early 2003. The government has implemented
Regular Asset 2.0 5.4% credit recovery programs including a consumer workout program, which was cre-
Total 36.3 100.0% ated in 2002. In another program, Hanmaum Bad Bank was created for consumer
* Special asset: NPLs of borrowers under composition or court receivership debt rescheduling. During part of 2004 it accepted applications from consumers to
Source: KAMCO
reschedule their debts with new loan terms of up to eight years. In a third program,

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 34
Heemang Moa, a special purpose company (SPC), was established in January 2005 for Korea’s banking industry is facing another “big bang.” The first was the liquidation of
credit recovery and efficient collection. Thirty financial institutions sold their NPLs to failed financial institutions after the Asian financial crisis. The second was the mergers
Heemang Moa, which issued asset backed securities (ABS) backed by the consumer of Korean banks between 2001 and 2004: Kookmin Bank and Housing and Commer-
NPLs purchased from the institutions. Under the Heemang Moa program, the debts of cial Banks; Hana Bank and Seoul Bank; and Shinhan Bank and Chohung Bank.
the multi-defaulters –consumers who defaulted on loans from multiple financial in-
stitutions – have been rescheduled in an extended repayment program. Of 3.7 million The third is expected with the takeover opportunities of Korea Exchange Bank and
consumers who defaulted, the credit of 675,000 was restored by these programs. How- LG Card in early 2006. These deals are large enough to change the current positions
ever, 10% of the consumers who had entered into workouts under the consumer work among the banks. Korea Exchange Bank, the fifth largest lender, has U.S. $71 billion
program and 17% of the consumers in the Hanmaum Bad Bank program had defaulted in assets with strength in corporate banking and foreign currency transactions and
as of October 2005. There is controversy over the effectiveness of these programs, LG Card has the largest credit card holder base. The acquirers of these targets could
which did not allow loan forgiveness but just extended the repayment period. strengthen their position in the industry through the specialties of the targets and
extended customer base. Major banks and financial holding companies have expressed
Banks interest in acquisitions that, if they were completed, would change the landscape of the
Through aggressive disposition of their NPLs and more efficient credit management, Korean banking sector.
Korea’s 19 banks as of the end of June 2005 had succeeded in reducing their NPLs to
U.S. $11.9 billion and their NPL ratio to a record low of 1.63%. In addition, corpo- Korean banks plan in 2007 to implement Basel II, which requires banks to strengthen
rate borrowers who were in restructuring plans saw an improvement in their business their credit risk management systems. Korea’s Financial Supervisory Service is ex-
operations, which contributed to an improvement in banks’ financial health and a surge pected to tighten its rules on loan ratings.
in bank earnings. Banks were also able to reduce loan loss reserve as the borrowers’
financial conditions improved. Furthermore, banks benefited from the rise in the prices Credit Card Industry
of stocks obtained through debt and equity swaps with corporate borrowers under re- The government began to deregulate Korea’s credit card industry in 1999 as part of its
structuring plans. In the first nine months of 2005, six major commercial banks (Kook- policy to stimulate growth in consumer consumption. Credit card transaction volume
min Bank, Woori Bank, Shinhan Bank, Hana Bank, Choheung Bank, Korea Exchange rapidly increased from U.S. $100 billion in 1999 to U.S. $400 billion in 2001 because
Bank) had generated a record high net income of U.S. $5.9 billion, a 77.4% increase of intensified competition among service providers for assets (i.e., cash advances and
year over year, mainly attributable to an increase in nonoperating income. Profits from loans). These assets, however, turned out to be of poor quality when the credit bubble
banks’ core operations did not significantly contribute to their substantial income burst. The government introduced remedies, such as allowing credit card companies
growth; however, core profits are expected to improve slightly in 2006. to access more capital to relieve a liquidity crunch, extending maturities of credit card
companies’ bonds, and establishing a fund to service the debt on those bonds and help
(U.S. $ in Billions) to absorb the negative impact of credit card defaults on the financial market. To re-
Year Total Assets Total Loans NPL NPL ratio solve their problems, credit card companies started to strictly manage their credit risks
2000 780.8 505.4 40.4 8.00% while focusing on the settlement business. All of the six independent (i.e., non-bank)
2001 764.3 529.2 18.0 3.41% credit card companies went into the black in the second quarter of 2005 after having
2002 906.9 622.4 14.5 2.33% been in the red since the second quarter of 2001.
2003 1,047.1 680.8 17.9 2.63%
2004 1,096.6 704.8 13.4 1.90%
Source: Financial Supervisory Service. Data for 19 banks as of Dec. 2004.

35
A s i a : P h i l i pp i n e s

Philippines: Nonperforming Loan Market Report

B uffeted by political un-
certainty, higher energy
prices, and slower growth in
farm output, the Philippines
economy slowed to a 4.7% growth rate in the first half of
2005 from 6% in the same period a year earlier. But because
of a rebound in the agricultural sector and an increase in
personal consumption, the economy grew at an estimated
rate of nearly 6% for all of 2005. Foreign investment has
increased, and the public-sector deficit has been reduced.
An expanded value-added tax (EVAT) has been implemented,
and should provide stronger tax revenues in 2006. In the
banking sector, the NPL ratio returned to single digits for
The Philippine Nonperforming Asset (NPA)
the first time in seven years, the result of continued bank re- In our Global Nonperforming Loan Report 2004: Asia and The Philippines we noted
structuring and an increase in consumer lending. The budget that global nonperforming asset (NPA) investors had allocated approximately U.S.
deficit for the eight months ended in August 2005 stood at $20 billion in 2004 to invest in the NPA market. Increasingly, investors are acquiring
portfolios of performing loans, real estate, and other types of assets and investments
PHP 80.82 billion (U.S. $1.5 million), or approximately 55%
as well. A country’s NPL market can also act as a catalyst for foreign investments,
of estimated deficits budgeted to September 30, 2005, in- attracting investors to other sectors in the economy. Local telecoms and industries that
dicating therefore that the government has a reasonable support them appear to be benefiting from the rehabilitation of sick telecoms by the
chance at meeting budgeted deficit numbers. The cash bud- purchase of their debts at discounts and the subsequent additional investments added
get surplus for August was PHP 1.75 billion (U.S. $33 mil- after control of the finances of the telecoms are established. We noted that 2004 would
be a pivotal year for the Philippines for substantial NPA dispositions that would take
lion) and represents a potential substantial turnaround for
advantage of the SPV Act of 2002 (see sidebar).
government finances.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 36
NPA Market Developments
The 2005 second quarter NPL and NPA/Total Assets ratio of the banking system
The SPV Act of 2002
dropped 9.87% and 6.85% to 9.92% and 10.15% respectively since 2002 as banks The Philippine Government sought to were SPAVs set up by the banks them-
continued to make progress in disposing of their bad assets (see chart below). assist the NPA market – composed of selves with the goal of selling both the
nonperforming loans (NPLs) and real SPAV entity along with the NPAs to
After the SPV Law and other properties owned and acquired distressed asset investors.
of 2002 expired in (ROPOA) – through the passing of
Philippine Historical Nonperforming Asset Ratios*
April 2005, the Republic Act 9812: The Special Purpose The SPV Act of 2002 originally required
25% Philippine NPA Vehicle Act of 2002. The key objective that all NPA sales under the law be
market grew some- of the law was to develop and maintain completed by April 12, 2005, but the law
20%
what quiet. The law a sound financial sector for the country subsequently was extended. (See NPA
15%
subsequently was and improve the liquidity of the financial Market Developments, left) This meant
amended to extend system by addressing the NPA problems that the transfer of NPLs or ROPOAs by
10% the deadline for of the financial sector. The incentives the financial institution to an SPV should
the sale of non- provided by the law encouraged private be completed by the above date in order
5%
performing assets sector investments in NPA and elimi- to avail of tax incentives provided by
0 to SPVs by two nated existing barriers in the acquisition the law. Further, banks had until May
years. The exten- of NPAs by way of tax savings. 12, 2005 to submit their applications for
02

03

04

05
20

20

20

20
2Q

2Q

2Q

2Q

sion is expected to Certificates of Eligibility (COEs) to the

NPL Ratio NPL / Total Assets take effect by the The law provides for the establishment of Bangko Sentral ng Pilipinas (BSP or the
end of April 2006; Special Purpose Asset Vehicles (SPAVs), Central Bank). COEs are issued by the
however, new rules which are corporations organized for the BSP to certify that the assets sold are
* NPA are nonperforming assets that are inclusive of NPLs and real and other properties owned or
acquired (ROPOA). NPL and NPA ratios are representative of only Philippine domestic banks. implementing the special purpose of acquiring the nonper- indeed nonperforming and comply with
Source: Business World
extension must first forming assets of financial institutions. the requirements of the law. The COEs
be approved and published. These changes have given financial institutions (FIs) It is essentially an asset management are required for the SPAV to take advan-
more time to use the tax perks provided by the law . The BSP reported that the NPL company (AMC) set out to perform three tage of tax incentives from the respective
ratio of the banking industry may go down further to 7.5% now that Congress has key functions: asset acquisition, asset governing bodies such as the Bureau of
approved the two-year extension of the SPV Act. The BSP has indicated that the mo- management, and asset disposal. As of Internal Revenue and the Registry of
mentum for further decline in the ratio is building up, as approximately PHP 45 billion September 2004, 36 corporations were Deeds.
worth of bad assets were sold after April 12, 2005, without the use of the SPV Act and established under the SPV Act of 2002,
its benefits. The BSP is confident that banks will sell an additional PHP 100 billion indicating an interest in the purchase
worth of bad assets in 2006. of NPAs. Of the 36 corporations, some

 The SPV Act of 2002 grants the same incentives to financial institutions that are defined by the law as credit-granting institutions,
including banks, financing companies, investment houses, and government financial institutions. The latter institutions includes the
Philippine Deposit Insurance Corporation, and the government owned or controlled corporations (GOCCs), including the Social
Security System (SSS), the Government Service Insurance System (GSIS), the National Housing Authority (NHA), and the Home
Development Mutual Fund .

37
 A s i a : P h i l i pp i n e s

With the extension of the SPV Law FIs can contribute to the continued success of the Status of the Philippine NPA Inventory
NPA market and successfully compete against other markets for investment capital by: The BSP estimated that Philippine banks held approximately PHP 500 billion
(U.S. $9 billion) worth of NPAs at the onset of 2002. With the transactions from 2004
1. Announcing plans to sell NPL and ROPOA assets and following through through April 12, 2005 totaling approximately PHP 100 billion, (U.S. $1.9 billion)
on those plans; Philippine banks still hold a sizeable portfolio of NPAs. As of the second quarter 2005,
2. Pursuing open or limited competitive sales processes; the top local commercial banks hold approximately PHP 312 billion (U.S. $5.9 billion)
3. Making realistic assessments of the risks and returns expected from NPL and in NPAs (see chart below).
ROPOA assets; and
4. When possible, being positive and vocal about improvements in economic NPA Ratio of Top Commercial Philippine Banks (Ranked in Terms of Total Assets)
conditions and the recovery of real estate and equity markets. (PHP billions)
NPAs as
Total As- ROPOA/ % of Total
Bank sets (TA) (NPLs) (A) NPL Ratio ROPOA (B) Total Loans NPAs (A+B) Assets
Distressed Assets in the Philippines as a Percentage of Total Loans (by Central Bank Measure) Metropolitan Bank & Trust Co. 550.29 34.28 12.78% 32.94 12.72% 67.22 12.21%
Bank of the Philippine Islands 471.91 10.71 4.72% 15.65 7.45% 26.36 5.59%
Equitable PCI Bank 325.83 11.14 7.01% 16.57 12.51% 27.71 8.50%
40
Land Bank of the Philippines 307.64 11.13 7.00% 14.05 12.19% 25.18 21.84%
35
Philippine National Bank 217.1 26.4 26.00% 26.28 50.65% 52.68 34.18%
30
25 25.52 Rizal Commercial Banking 199.45 11.06 12.74% 12.69 15.17% 23.75 11.90%
Corporation
20
15
Banco de Oro 195.92 4.52 5.34% 5.63 8.57% 10.15 5.18%
9.70 Development Bank of the 183.02 9.13 8.75% 4.3 6.17% 13.43 7.34%
10 9.54
6.28
Philippines
5
0 Allied Banking Corporation 151.59 5.46 9.81% 4.26 7.90% 9.72 6.41%
Mar-99

Mar-00

Mar-01

Mar-02

Mar-03

Mar-04

Mar-05
Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05
Sep-99

Sep-00

Sep-01

Sep-02

Sep-03

Sep-04
Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

China Banking Corporation 126.66 7.47 10.93% 4.87 10.60% 12.34 9.74%
Union Bank of the Philippines 110.19 4.19 6.07% 5.87 41.49% 10.06 9.13%
NPLs ROPOA Restructured Total distressed
United Coconut Planters Bank 108.42 5.91 17.30% 22.86 73.21% 28.77 26.53%
Security Bank Corporation 102.41 2.31 4.72% 2.45 6.79% 4.76 4.64%
Source: Various sources compiled by Ernst & Young
TOTALS 143.71 168.42 312.13
Source: BusinessWorld

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 38
 NPAs in the Philippines: Progress Has Been Made but More Is Needed Per the BSP, as of the end of April 2005, PHP 52 billion (U.S. $983 million) in bad
Philippine banks had to hurdle several obstacles to gain access to global NPA investor loans were sold to SPVs where 193 COEs have been granted by the BSP. Applications
funds. First, the Philippine NPA market of approximately U.S. $9 billion competes for COEs (as of April 2005) that were approved by the BSP were approximately
with larger markets such as China with an NPA market size of approximately PHP 93.3 billion (U.S. $1.8 billion).
U.S. $480 billion. Larger market transactions are more attractive to investors as they
bring certain economies to scale. Second, the Philippine banks’ sale timetable had to One will note that the ROPOA portfolios that have come to market in the past year
beat the SPV Act of 2002 deadline of April 12, 2005. Given these two major hurdles, did not trade despite the fact that investors placed competitive bids on these portfo-
12 Philippine financial institutions sold approximately PHP 93 billion lios. One of the main reasons for the failed bids was a gap in the perception of value
(U.S. $1.8 billion) in NPAs in 2004 and through July 2005 (see chart below). of these investors and those expected by the FIs. As FIs often point out, ROPOAs are
tangible assets that are easily appraised and valued as opposed to loans. ROPOAs,
NPA Sales by Financial Institutions as of July 2005* however, often have a long-term resolution process. In many cases properties require
ESTIMATED additional funds in order to be completed or rebuilt to attract potential buyers. This
GROSS BOOK
VALUE (PHP
process involves higher risks perceived by investors, which translate into to lower bids.
BANK ASSETS METHOD OF SALE Billions) Last, investors (mostly international investment firms) must partner locally in order to
National Housing Mortgage Finance Corporation (NHMFC) Nonper- Sealed Bid Auction 15.0 own land, as Philippine law requires that ownership of land is limited to Filipinos or
forming
residential
firms that are 60% owned by Filipinos. Therefore, investors must find local partners
mortgages with whom they feel comfortable making an investment commitment that requires
Land Bank of the Philippines NPLs Sealed Bid Auction 14.0 time to develop and establish. Despite these obstacles, we believe that as inves-
United Coconut Planters Bank (UCPB) ROPOA Failed Auction (Portfolio did not trade) 14.0 tors gain experience in the resolution of their NPL portfolios and conduct business
UCPB NPLs Sealed Bid Auction 12.0 dealings in the country, there will be both a need and an appetite to invest in ROPOA
Philippine Bank of Communications (PBCOM) NPAs Negotiated Sale (Failed Auction) 11.0 portfolios in the future.
Bank of the Philippine Islands (BPI) NPLs Negotiated Sale 8.6
BPI ROPOA Failed Auction (Portfolio did not trade) 8.0 Distressed Assets Growth
Equitable PCI Bank (EPCIB) NPLs Negotiated Sale 8.0 Not included in the definition of NPA are restructured loans. The picture of total
EPCIB NPA Negotiated Sale 5.3 distressed assets as a percentage of total assets is shown below.
Philippine National Bank (PNB) NPLs Limited Auction 5.0
Rizal Commercial Banking Corp (RCBC) NPLs Negotiated Sale 4.0
BPI NPLs Negotiated Sale 2.5 % Y/Y Distressed Assets Growth
120
Metropolitan Bank & Trust Co. (MBTC) NPLs Auction 2.2
100
RCBC NPLs Limited Auction 2.0
80
Bank of Commerce NPLs Negotiated Sale 1.6
60
Asiatrust NPLs Negotiated Sale 1.0
40
International Commercial Bank of China- Branch NPAs Sealed Bid Auction 1.0
20
TOTAL 115.2 0 4.8
-14.6
* Not all transactions listed were eligible for SPV benefits. This list is generally representative of bulk sales brought to market from -20 -16.9
2004 through July 2005 and does not include single asset sales that may be eligible for SPV benefits. -28.5
Source: Ernst & Young -40

Sep-04
Sep-00

Sep-01

Sep-02

Sep-03
Dec-00

Dec-01

Dec-02
Mar-00

Dec-03
Mar-01

Dec-04
Dec-99

Mar-02

Mar-03

Mar-04
Jun-00

Mar-05
Jun-01

Jun-02

Jun-03

Jun-04

Jun-05
NPLs growth ROPOA growth
Restructured loan growth Distressed assets growth

Source: Various sources compiled by Ernst & Young

39
 A s i a : P h i l i pp i n e s
IAS 39: A Compelling Reason for Banks to Dispose of Bad Assets
Despite the extension of the SPV Act, another compelling reason for banks to consider
in the sale of their NPAs is International Accounting Standards 39 (IAS 39). The BSP
has required all banking institutions to implement International Accounting Standards
in their financial reporting by year-end 2005. These include IAS 39 “Financial Instru-
ments: Recognition and Measurement,” which establishes principles for recognizing,
measuring, and disclosing information about financial assets and financial liabilities.
The impact on banks lies in the testing for impairment of assets. At each reporting
date, banks and their auditors must assess the existence of objective evidence indicat-
ing that the financial assets may be impaired. If it is probable that the amounts due
(i.e., principal and interest) are not collectible in accordance with the contractual terms
of the loan, then the financial asset is impaired and the bank must recognize an impair-
ment loss during the period which the financial asset is considered impaired. Impair-
ment loss refers to the difference between the financial asset’s carrying amount and
the present value of expected future cash flows discounted at the financial instrument’s
original effective interest rate. Given that most banking institutions will have to con-
sider large loss-provisioning once IAS 39 is implemented, banks should consider the
sale of such assets that will have the same effect in loss-provisioning. However, in the
case of a sale, banks can realize up-front cash on the sale of such assets, assuming an
all-cash transaction.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
Banking institutions will be allowed by the BSP to amortize the regulatory loss from
the sale over a 10-year period. The schedule for amortization of losses are 5% per an-
num for years 1–3, 10% per annum for years 4–6, and 15% per annum for years 7–10.
This provides adequate time for the financial institution to absorb such regulatory
losses in conjunction with its capital adequacy ratios. Further the BSP allows for the
reallocation of existing provisions on NPLs sold to unsold NPLs. It should be noted
that the loss amortization incentive provided by the BSP is regulatory in nature. Such
amortization of losses is not permissible by Philippine GAAP. A bank may have its
financial statements qualified if it tries to amortize the loss in its books.
Outlook
Despite competing markets in the region, investor interest in the Philippine NPAs
continues to be high. Investors will continue to be interested in pursuing the
Philippine NPAs should the local market offer the following:
. A continued and steady supply of NPL and ROPOA assets for sale
2. A transparent and fair selling process
. A tax-favorable ownership structure that limits taxes to around
10% to 15% of income
4. A judicial system that advocates reasonable creditor rights
5. An economy with good recovery potential
40
With several portfolios that have successfully traded in the market, and investor inter-
est still keen, there is an opportunity for FIs to address the vast majority of their prob-
lem loans over the next two to three years. Further, investors are keen on hiring asset
management companies (AMCs) or developing their own AMCs to service and man-
age the nonperforming loans purchased. Therefore, over the next year it is expected
that several AMCs will surface to compete for this new line of business. In addition,
investors who have made sizable investments in NPL portfolios and are now familiar
with the Philippine market may decide, after their initial investments are resolved, to
stay to invest in ROPOA portfolios and to continue with new lines of business.

41
 Asia: Singapore

Singapore: Nonperforming Loan Market Report

S ingapore enjoys fairly
strong economic funda-
mentals. In the third quarter
of 2005, the economy grew
7% compared with the same period of 2004 and was broad-
based, reflecting strong external and domestic demand. The
manufacturing sector was boosted by a surge in biomedical
output and the financial services sector by stronger activity
in the stock brokering and fund management segments. In
light of the economy’s stronger-than-expected performance,
the growth forecast for 2005 was revised to around 5% from
the earlier announced forecast of 3.5%–4.5%. GDP growth
for 2006 is expected to be around 3%–5%.
In 1999, the Monetary Authority of Singapore (MAS), Singapore’s financial regulator
and de facto central bank, announced a five-year plan to liberalize the banking sector
Real GDP Growth (YOY % change) and remove regulatory barriers, such as restrictions on opening branches that had
2003 2004 1Q 2005 2Q 2005 3Q 2005 2005 Forecasted 2006 Forecasted constrained foreign institutions from competing on an even playing field with local
Singapore 1.4% 8.4% 2.7% 5.4% 7.0% 4.6% 4.8% players. Encouraged by the government and faced with the need to achieve econo-
Source: Monetary Authority of Singapore (MAS) mies of scale, the five local banking groups merged into three groups in 2001. Keppel
TatLee, itself the product of a merger, was taken over by Oversea-Chinese Banking
Banking Environment Corp. (OCBC). Meanwhile, United Overseas Bank (UOB) acquired Overseas Union
Compared to other Asian markets, Singapore emerged fairly unscathed from the Bank (OUB), leaving rival bidder Development Bank of Singapore (DBS) short. These
1997 Asian crisis. Banks were well-capitalized before the crisis – and still are, due to three banking groups are now among the highest-rated institutions in the Asia-Pacific
prudent government policies and a robust economy. Characterized by sound liquidity, region, reflecting their conservative balance sheet structures, strong franchise posi-
stable earnings, and above-average capitalization, the Singapore banking system is tions, and stringent supervisory and regulatory framework.
perhaps one of the most liberal and least risky in Asia. These advantages are, however,
partially counterbalanced by the small home market, heightened industry competition, Singapore banks are now presented with an ongoing set of challenges including
and the lack of revenue diversity. managing the post-merger integration process and achieving economies of scale in

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 42
 Asset Quality
an operating environment characterized by lower profit margins. Competing against Nonperforming loans peaked for most banks in 1999 following the Asian financial cri-
the three local universal banks – DBS, UOB, and OCBC – are many foreign play- sis. The NPL ratio for all banks (including multi-nationals with branches in Singapore)
ers operating freely in commercial, corporate, and investment banking. By the end was 4.3% in 2005, down from 8.3% in 2001.
of 2002, the MAS had issued Qualifying Full Banking (QFB) licenses to six foreign
banks – ABN AMRO Bank, BNP Paribas, Citibank, HSBC, Standard Chartered Bank, NPL Ratio (as % of commercial bank loans)
and Maybank. (Another 16 foreign banks have regular full banking licenses that carry   2001 2002 2003 2004 Mar-05 Jun-05 Sep-05
some limitations, such as on the number of branches and ATMs, and 33 have restricted Singapore* 8.3 7.7 6.7 5 4.6 4.2 4.3
licensing arrangements.) QFB licenses allow foreign operators to compete against
DBS** 5.7 6.1 5.2 2.5 2.4 2.2 2.0
local banks, with few restrictions. Foreign banks, for example, cannot use the shared
domestic ATM networks, but with the QFB license, they can set up one of their own. UOB** 9.3 9.0 8.1 7.6 6.9 6.7 6.2
They also cannot open more than 15 branches. The three local banks have strong do- OCBC** 9.7 8.1 6.9 5.0 4.8 4.3 4.2
mestic market shares, but these are likely to diminish as increasing deregulation opens Sources: * MAS; ** Annual reports
up further opportunities for foreign banks – in particular in the area of retail banking.
As a consequence, Singapore’s local banks are looking to expand into the Asia-Pacific Thanks to a much improved credit environment and more proactive NPL manage-
region, which has the potential to raise their risk profiles. Local bank management ment, all three local banks – DBS, UOB and OCBC – reported a decline in their NPLs
teams have yet to prove their ability to handle regional operating risks. As such, good through the third quarter of 2005. The decline in the NPLs of DBS and OCBC can
management will likely become a key distinguishing factor. Singapore is turning into be attributed to the fact that upgrades and write-offs far exceeded new NPLs classi-
an exciting yet unpredictable banking market as competitive forces and liberalization fied during 2005. DBS’s NPL ratio declined to 2.0% in the third quarter of 2005 and
fuel consolidation and expansion. OCBC’s ratio to 4.2%.

The banking sector has remained sound because of continued expansion in economic
activity and the continued financial health of the household and corporate sectors.
Commercial bank lending accelerated in the third quarter of 2005 to reach 8.5% year
over year. The renewed strength in credit demand was due to strong activity in non-
bank lending in the Asian Dollar Market (ADM) and overall interbank lending. In con-
trast, domestic and non-bank loans saw slower growth. Banks have sufficient reserves
of liquid assets to cover their short-term cash outflows, suggesting low liquidity risk in
the banking system. Profits of all three local banking groups have grown, their balance
sheets are strong, their NPL ratios have declined, and their capital positions are above
the regulatory requirement.
UOB also has actively been managing a reduction in its NPLs, from 7.6% in 2004 to
6.2% in the third quarter of 2005, excluding the impact of the acquisition of Thailand’s
Bank of Asia (BOA), which would have resulted in a lower NPL ratio for UOB. How-
ever, the relative share of “loss” NPLs in total NPLs continues to be relatively higher
for UOB (26%) than for DBS (18%) and OCBC (14.5%), largely due to its less proac-
tive write-off policy.

43
 Asia: Singapore
Singapore banks’ good asset quality is partly attributable to their portfolio mix. By
value, about one-third of their loan portfolios are residential mortgages. In addition,
while the banks continue their overseas expansion, about half of their loans are still
originated in Singapore. Significant regional exposures are in Malaysia, Thailand, and
Indonesia, where the banks have a long operating history. Additionally, Singapore’s
conservative regulatory definition of problem loans means that loans classified as im-
paired have a higher probability of recovery than in many other markets. Consequent-
ly, the aggregate expected loss on such loans is low. Finally, asset quality is bolstered
by generous loan loss coverage – loan loss reserves cover more than 65% of the banks’
problem loans. Banks are able to absorb losses without a material impact on their bal-
ance sheets. Supported by a recovering economy, banks should see their loan collateral
values improve, especially property-related ones. As housing and property develop-
ment loans are a significant proportion of local banks’ loan portfolios, recovery in the
residential property sector should enhance collateral values.
Going forward, improving regional economies will continue to improve banks’ asset
quality. Businesses are showing signs of expansion, which should slowly fuel demand
for corporate lending. Moreover, banks are also refining their risk management strate-
gies, among other reasons to improve their credit risk underwriting. (Singapore has set
up a centralized credit bureau to help achieve this goal.) Subtle changes in regulations
also reflect the proactive attitude regulators have in guiding credit risk management
at the banks. Apart from possible regional instability, Singapore has many credit
strengths, including consistently large current account surpluses, the strong financial
position of its public sector (including substantial financial assets), an advanced infra-
structure that is attractive to multinational corporations, and political stability.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
High domestic savings, due in large part to government-sponsored programs, have
financed first-rate development of public infrastructure and facilitated private invest-
ment that has kept external debt to a minimum. Most of the external liabilities (short-
and long-term capital costs) of the private sector appear to be either inter-company
debt or transactions related to the country’s role as a regional financial center. Over
the long run, keeping this strong position will depend on maintaining competitiveness
as other countries undergo reform and economic transformation. The government has
attempted to address this challenge through a number of measures related to develop-
ing entrepreneurship, widening the array of financial services, and maintaining tax
and regulatory structures that continue to attract investment. Despite the more difficult
economic situation of the past few years, the financial position of the Singapore gov-
ernment remains strong.
Outlook
Singapore is deepening its role as the financial center for Southeast Asia and banking
hub for Asia because of its strong economic fundamentals, adjustable wage system,
and flexible exchange rate system that protects against any currency attacks. The
island republic represents a tremendous platform for financial institutions operating
in Asia because of its good government, business-favorable regulations, and access
to surrounding markets and talent that are only matched by Hong Kong. Its banks are
quickly emerging as key players in international financial markets. An effective regu-
latory framework and a moderately leveraged corporate sector support a sound and
stable financial system. The banks’ resilience and financial resources are adequate to
withstand external shocks like high and rising fuel prices, rapid interest rate increases,
or declining asset prices. All in all, Singapore is both a promising market that of-
fers attractive opportunities for banks operating domestically and a powerful hub for
regional businesses, such as private banking and asset management.
44
45
 A s i a : T a i wa n

Taiwan: Nonperforming Loan Market Report

B etween 2002 and 2005,
Taiwan was Asia’s most
active NPL market outside
of Japan as the government
pushed banks to improve loan asset quality and strengthen
balance sheets. In 2003, NPL transactions exceeded a record
NT $192.5 billion (U.S. $6.0 billion). However, transaction ac-
tivity, especially deals with international distressed-debt buy-
ers, waned in 2004 (at least NT $155 billion or U.S. $4.8 billion
sold) as banks issued new loans and their NPL ratios improved.
By 2005, banks had become reluctant to auction NPLs to in-
ternational investors; they could earn higher recoveries by in 2005, among other reasons, because of higher raw materials and oil prices and
slower export growth.
disposing of assets to related entities. Late in 2005, however,
banks recognized consumer loan defaults were increasing and As the world economy continues to expand, Taiwan’s GDP growth is expected to increase
they began to readdress their NPL problems by disposing of slightly to about 4.3% in 2006. Long term, we believe that the island’s future will be heav-
consumer NPL portfolios. ily influenced by ties with mainland China, which is Taiwan’s No. 1 trading partner.

Although the rate of NPL cleanup among Taiwan’s banks has varied greatly, the govern-
ment’s financial system reforms have succeeded in reducing the banks’ nonperforming
loan exposure (current NPL ratio is about 2.2%) and improving the health of the banking
sector. As reform efforts continue, local and global investors will have opportunities to
invest in financial institutions, NPLs, corporate restructuring, and real estate.
Taiwan’s Economy
Taiwan’s economy grew by 6.1% in 2004, its fastest pace in four years, due to in-
creased foreign trade and manufacturing output. However, GDP growth fell to 4.1%
Banking Environment
In the mid-1980s, efforts to open Taiwan’s tightly regulated financial sector resulted in
the establishment of many new banks, securities firms, and insurance companies. This
liberalization trend continued in the early 1990s, as state-owned banks attempted a se-
ries of privatization reforms. Unfortunately, those deregulation efforts have resulted in
today’s highly fragmented banking system. Since Taiwan has only 23 million residents,
many creditors had to loosen their lending standards to attract new clients and, not
surprisingly, the result has been a plethora of loan defaults.
So far, the ability of Taiwan’s banks to compete against regional banks in Asia or
against global banks has been undermined by their NPLs and inefficient management

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 46
practices. Furthermore, the state still controls more than half of all banking assets,
which total almost NT $26.9 trillion (U.S. $840 billion).
Regulatory Overview
In spite of its current state, Taiwanese leaders have expressed a desire to transform the
island into a regional financial center like Hong Kong and Singapore. Although the suc-
cess or failure of this daunting goal might not be known for years to come, the efforts
to date have been positive. NPL problems have been recognized and managed under the
“2-5-8 Plan.” Begining in 2002, financial institutions were to have two years to reduce
their NPL ratios below 5% and increase their capitalization to greater than 8% or face
penalties, fines, and business restrictions.
is anticipated to limit the growth of financial institutions overexposed to consumer debt.
Recent M&A Progress May Stall
In an effort to create a more competitive, market-driven banking system, the
government publicly announced its near-term M&A desires:
• Reduce by half the number of state-owned banks by the end of 2005
• Cut the number of financial holding companies to 7 from 14 by 2006
• Encourage at least one bank to be managed and operated by a foreign investor or
to be listed in overseas exchanges
• At least three banks should have market share of at least 10% each.

Other NPL related laws and regulations include: The FSC adapted its policies to both provide an incentive and pressure banks into meet-
ing these stated goals; so far the results have been promising. M&A activity increased
1. New NPL Definition and Asset Classification System. To conform to interna- substantially in 2005 as no fewer than 26 financial services firms changed ownership, ac-
tional best practices, Taiwan adopted a new NPL definition and stricter asset classifica- cording to data from Dealogic. Announced transactions totaled U.S. $7.4 billion in 2005,
tion standards for banks in mid-2005, with five categories replacing the previous four. up from U.S. $1.9 billion in 2004. However, some analysts say the deals are superficial
The categories now range from “Normal,” which does not require any provisioning in that bank operations have not been streamlined out of fear that layoffs might incite
allowance for bad debts, to “Overdue Loan Assets with No Chance of Recovery,” labor unrest. Other market observers note that small, private banks owned by wealthy
which requires a 100% provision against the full loan amount. While it is possible families (or otherwise controlled by a few shareholders) might not be willing to relin-
that these new standards will increase the NPL ratios and required provisioning levels quish ownership due to pride, prestige, or other personal reasons.
of financial institutions, the Financial Supervisory Commission (FSC) believes better
risk management and greater consistency in defining and reporting asset quality across Selection of Recent M&A Activity
the industry will ensue and provide banks with the tools to consider credit investments Transaction Size
Bank/Acquirer Seller/Target (U.S. $ Millions) Transaction Date
with more precision and less ambiguity.
E.Sun Commercial Bank Kaohsiung Business 417.7 2004 May
Bank
2. Renewed Financial Restructuring Fund (FRF). The government has extended Polars Securities Bank of Overseas 21.6 2004 December
the life of Taiwan’s FRF to 2010. The fund, modeled after the U.S. Resolution Trust Chinese

Corporation, was established in July 2001 to bail out debt-ridden banks. Fuhwa Commercial Bank Tainan Seventh Credit 9.0 2005 January
Cooperative Association
Union Bank of Taiwan Chung Shing Bank 222.2 2005 March
3. Increased Transparency for NPL Transactions. As a result of some questionable
Jihsun Securities Taiwan Development 187.5 2005 May
NPL portfolio sales involving banks and their self-established asset management com- & Trust Corp. (Trust
Division)
panies in 2004 and 2005 (See “Taiwan NPL Market,” page 48). the Financial Supervi-
Fuhwa Commercial Bank Tainan Sixth Credit Co- 17.0 2005 August
sory Commission (FSC), which oversees the implementation of bank reforms, issued operative Association
regulations to increase the transparency of NPL transactions. Shinkong Financial Holding Co., Ltd Macoto Bank 221.5 2005 October
Bank of Taiwans Central Trust of China 548.7 2005 November
4. Stricter Benchmark for Credit and Cash Card Issuances. A proposed law would ICBC (Mega Holding) Bank of Communica- 839.1 2006 January
tions (Mega Holding)
prevent credit card issuers from supplying new cards if their card-related NPL ratios
Source: Various sources compiled by Ernst & Young
were over 2.5% compared with 8% currently. If approved by the FSC, this new measure

47
 A s i a : T a i wa n

Foreign Investors’ Interest in Taiwan Financial Industry Taiwan NPL Market

In recent years the government has taken a series of steps to attract global invest- The sale of First Commercial Bank’s NPL portfolio in March 2002 marked the be-
ment, such as relaxing restrictions on foreign investment in securities of local com- ginning of an aggressive effort by banks to move NPLs off their books. Since then
panies. Despite some early successes in attracting foreign investment, the results to Taiwan’s banks have held more than 147 public and limited auctions to dispose of
date have been mixed. Some proposed investment transactions were not completed; NPLs with a face value in excess of NT $728.7 billion (U.S. $22.8 billion).
one was completed but subsequently dissolved, in part because of differences in the
expectations of foreign investors and local financial institutions. Industry analysts Overview of Taiwanese NPL Auctions
also speculate that it will be a challenge for the government to attract foreign or
No. of NPL NPLs Disposed NPLs Disposed
private investment, since local banks are prohibited from setting up full operations in Year
Transactions (NT$ Billions) (U.S. $ Billions)
mainland China. Despite such challenges, Taiwan, as Asia’s fourth largest consumer
2002 16 160.8 5.0
banking market, is still considered attractive to foreign investors based on various risk 2003 20 192.5 6.0
and reward metrics. Since February 2004, there have been seven private placement 2004 26 155.0 4.8
transactions totaling U.S. $1.4 billion. 2005 85 220.4 6.9
Total 147 728.7 22.8
Source: Ernst & Young
Recent Banking Sector Investments by Foreigners
Transaction Comparatively low due diligence costs, strong creditor rights, and, most importantly,
% of Owner-
Domestic Bank Foreign Investor Size Transaction Date strong deal flows between 2002 and 2004 caused the world’s most active distressed-
ship
(U.S. $ Millions)
debt buyers to flock to Taiwan. During that time, banks held public auctions to dispose
E. Sun Bank Prudential Financial 84.8 5.0% 2004 February of NPL portfolios containing corporate, small and medium-sized enterprise (SME),
Bowa Bank GMAC 47.1 15.5% 2004 April and mortgage borrowers secured with collateral and personal guarantees. While early
Bank of Overseas portfolios sold for less than 15% for industrial or land assets (and about 40% for resi-
New York Life 18.8 5.0% 2005 September
Chinese dential-backed assets), increased competition, decreased deal flow, overall economic
Enterprise Bank Nassau Inn recovery, and comfort in Taiwan’s methodical foreclosure system has caused steep
31.4 44.7% 2005 November
of Hualien Investment Ltd. price appreciation. Now, NPL purchasers offering anything less than 30% or 40 % for
2006 January industrial or land assets (and about 60% for residential-backed assets) are likely to be
Cosmos Bank GE Capital Taiwan 281.6 24.9%
(announced) unsuccessful.
Taishin Holdings Newbridge Capital 843.8 18.5% 2006 February
Nomura Holdings Some market observers argue that some NPL transactions have been tainted by deals
Taishin Holdings 124.6 2.7% 2006 February
Inc.
involving related parties. They point to a period in late 2004 and early 2005 when
Source: Various sources compiled by Ernst & Young
many local banks and financial holding companies established 100% owned AMCs
in order to acquire NPLs – namely those to be sold by their own parent bank. Market
transparency was potentially compromised, since some of these “market auctions”
were rumored to have been announced in obscure publications and/or on Websites,
and the buyer due diligence period was limited to only a few days. These questionable

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 48
types of transactions, whether intentional or not, all but guaranteed a competition-free
auction so the parent company could minimize any write-down for the loss on an NPL
sale. Fortunately, the FSC has recognized the potential for abuse and has since further
defined its minimum rules for conducting NPL auctions.

So far, Taiwan’s NPL market seems to be tracking closely with Korea, which
managed its corporate debts first and then resolved credit cards and other consumer
loans. With fewer opportunities to acquire NPL portfolios and only NT $371 billion
(U.S. $11.6 billion) of NPLs remaining, several global investors have exited the market.

Credit and Cash Card NPLs Emerge

To gain a competitive edge, generate fee-related income, and increase loan interest
spreads, banks have aggressively expanded their consumer loan (i.e., credit and cash
cards) and wealth management businesses. In 2001, there were 24.1 million credit
cards while as of November 2005 there were more than 49.1 million credit and cash
cards (combined). Analysts have not noted any other econometric trends (i.e., popula-
tion, employment, salary, or GDP growth) to justify this credit expansion.

According to government statistics, as of December 2005, NPLs accounted for about

U.S. $548 million of the U.S. $25 billion issued by Taiwan’s 31 cash card and 50 credit
card issuers, or an average NPL ratio of 2.19%. Despite a surge in credit and cash
card NPLs, most market observers believe that Taiwan’s consumer loan problem will
be significantly less than Korea’s (where – at peak – more than 40% of all cash cards
were reportedly in default). They point to Taiwan’s sophisticated credit bureau and
oversight by the FSC as effective in countering the new NPL threat.

Outlook
To comply with government policies related to NPLs, banks have aggressively dis-
posed of bad credits, improved management strengths, and lowered default ratios.
But challenges still remain for Taiwan’s financial industry: banks are still exposed to
unsecured loans and credit and cash card problems and further consolidation in the
banking sector is necessary to meet the government’s reform goals.

49
 Asia: Thailand

Thailand: Nonperforming Loan Market Report

T hailand experienced a mod-
erate economic slowdown
in 2005 as a result of higher oil
prices, slower export growth,
and reduced tourist arrivals in the aftermath of the tsunami. Infla-
tion was 4.5% in 2005. Interest rates are being adjusted upwards
as the central bank tightens monetary policy to curb inflation. In
the fiscal year 2005 ended September 30, Thailand had its first
budget surplus since its 1997 financial crisis. The government is
determined to maintain fiscal discipline by running a balanced
budget and limiting public debt to less than 50% of GDP (and the
current account deficit to less than 2.5%). Exports for the first the Finance Ministry became banks, while those failing to obtain licenses or submit
plans eventually will become credit companies without the formal status of a financial
10 months of 2005 totaled $91.5 billion, up 15%, compared with
institution. Under the plan, there are now four segments of banks: universal banks (or
a 27% rise in imports to $99.2 billion. Following seven consecu- full-service commercial banks), retail banks, branches of foreign banks, and non-banks
tive years of surpluses until the first quarter of 2005, Thailand that provide specialized financial services. To date the Finance Ministry has approved
was expected to have a current account deficit of approximately the upgrade to universal bank status of three finance firms (Tisco Finance Plc, Kiatnakin
Finance Plc, and Asia Credit Plc) and approved four finance firms’ applications to oper-
U.S. $4 billion in 2005. GDP growth is estimated at 4.75% in 2005,
ate as retail banks (GE Money Finance, AIG Finance, Thai Keha Credit Foncier, and
or less than the 6.1% growth in 2004; however, the rate of growth Land & Houses Credit Foncier). In September 2004 TMB Bank completed its merger
is expected to improve to 5% in 2006. with DBS Thai Danu Bank and the Industrial Finance Corporation of Thailand. In May
2004 Singapore’s United Overseas Bank took over Bank of Asia through a U.S. $554
Banking Environment million acquisition. It subsequently merged Bank of Asia with UOB Radanasin Bank to
Banks have continued to improve their financial positions. Expansion in bank credit to create United Overseas Bank (Thai) in November 2005. As of year-end 2005 there were
the private sector and wider margins have helped banks to boost profitability, increase 16 commercial banks, 18 foreign bank branches, 5 international banking facilities, 14
their capital base, and achieve greater stability in terms of loan-loss provisions. finance and credit foncier companies, 10 specialized financial institutions, and 15 asset
The Financial Sector Master Plan, which was introduced by the Bank of Thailand in management companies in Thailand. Total loans in financial institutions amounted to
2003, paves the way for consolidation of financial institutions. Those finance com- approximately Baht 5.8 trillion (U.S. $141.6 billion) as of September 30, 2005.
panies and credit fonciers that received approval from the Bank of Thailand and
 The term “credit fonciers” means 1) the business of lending money on the security of mortgage of immovable property in the
ordinary course of business; 2) the business of buying immovable property under contract of sale with a right of redemption in the
ordinary course of business; and 3) other types of business concerning immovable property as prescribed in ministerial regulations.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 50
Regulatory Overview
Recent financial reforms in Thailand include measures to move towards Basel II
(an international standard for minimum capital requirements for banks), progress
on consolidation of financial institutions, and strengthened bank supervision on risk
management. In preparation for full implementation of Basel II, the Bank of Thailand
has developed measures for the three pillars: minimum capital requirements, supervi-
sory review, and market discipline. Basel II will require banks to focus more on capital
management in order to align risk with regulatory capital requirements.
Basel II also helps promote prudent banking and governance that will enhance
financial system stability and increase trust in the market. Thai banks are currently
preparing for liberalization of the banking sector that will follow the conclusion of
negotiations under the Thailand-U.S. Free Trade Agreement framework. (Negotiations
are expected to conclude in 2006.) The top item on the agenda is liberalization of
financial services, with free market access to investment and trade in financial ser-
vices, especially in the insurance and mutual fund industries, as well as free transfer
of capital. Despite an improving economy and low interest rates, progress on nonper-
forming loan (NPL) resolution has been relatively slow for the last two years. This has
put pressure on regulatory bodies to introduce new measures, including tighter loan
provisioning and bad-debt reclassification rules, to accelerate restructuring. The new
rules impose a qualitative assessment on borrowers’ repayment ability based on future
cash flows. This is in addition to the existing quantitative assessment based on the ag-
ing criteria (i.e., the length of the overdue period) and increased restrictions on the use
of collateral to offset NPL provisioning requirements.
NPL Market
Preliminary data for September 30, 2005 show that the total NPLs of Thailand’s finan-
cial institutions amount to Baht 576.9 billion (U.S. $14 billion), or 9.9% of outstand-
ing credit, down from a peak in the NPL ratio of 47.7% in May 1999. The continuing
decline in the NPL ratio is attributed to credit expansion, prevailing low interest rates,
transfer of NPLs from banks’ balance sheets to the asset management companies of
private banks, speeding up of debt restructuring through the introduction of collateral-
value reductions, allowing state-owned asset management companies to buy NPLs
from banks, and accelerating the process of asset sales by the Legal Execution Depart-
 To accelerate the resolution of nonperforming loans, the Bank of Thailand revised asset classification and provisioning regulations
by requiring that the collateralized portion of loans classified as “doubtful of loss” be subject to incremental rate of provisioning
based on the length of overdue period, unless the loans have been restructured or legal actions taken by financial institutions against
the debtors.
51
ment. Although new and re-entry NPLs (i.e., performing loans that have relapsed into
NPLs) increased in second and fourth quarters of 2004 and the second quarter of 2005
following the enforcement of the previously mentioned new rules on loan reclassifica-
tion, (in “Regulatory Overview,” left) banks are now ready to cut their NPLs, due to
the previously described (in “Banking Environment,” p. 50) rise in operating profits,
and strong loan loss coverage and capital positions. However, the weakening economic
environment and rising interest rates may see some pressure on loan delinquencies,
given the still high level of restructured loans in the system.
The Thai Asset Management Corporation (TAMC) after four years has largely suc-
ceeded in NPL resolution. As of the second quarter of 2005, the TAMC has managed
NPLs to resolution of an approximate book value of Baht 772.4 billion
(U.S. $18.8 billion) from an approximate book value of Baht 778.1 billion
(U.S. $19 billion) or 99.3% of book value of the NPLs transferred to TAMC.
The NPLs managed to resolution through debt restructuring or rehabilitation in the
Central Bankruptcy Court account for 74.3% of the total book value of NPLs managed
to resolution. TAMC has projected an expected recovery rate from the debt repayment
plans of debtors having achieved resolution by debt restructuring or rehabilitation in
the Central Bankruptcy Court at approximately 48.2% of the book value of NPLs.
These NPLs were approved for resolution by debt restructuring or rehabilitation in
the Central Bankruptcy Court, not considering conversion of debt to equity, risks from
future non-compliance of the debtors and the depreciation of assets received from
the transfer of assets for debt repayment. The Finance Ministry, state banks, and the
TAMC reportedly plan to jointly establish a new asset management firm in preparation
for cleaning up NPLs at state-owned financial institutions.
With the new laws facilitating fast-track sales of foreclosed assets, the Legal Execu-
tion Department estimated disposal of around Baht 140 billion (U.S. $3.4 billion) of
Baht 215 billion (U.S. $5.2 billion) of foreclosed assets in fiscal 2005, with a return of
70% on their value. This followed the disposal in fiscal 2004 of Baht 190 billion
(U.S. $4.65 billion) of foreclosed assets.
 The Legal Execution Department is an administrative body whose principal mission involves the execution of civil judgments, bankruptcy
administration, business reorganization, deposit of property (in lieu of performance), and liquidation. Its main objective is to help propel
Thailand’s recovery from the economic crisis and to help adjust the country’s judicial enforcement in correspondence with the dynamism of
modern Thai society.
 Asia: Thailand

The Bank of Thailand expects NPLs to decline to 2% of total lending by 2007 from
9.9% as of the third quarter of 2005. However, more time may be needed to achieve
this. The Finance Ministry announced in September 2005 that banks will not be
allowed to pass off their NPLs to the state-owned Asset Management Corporation
(AMC). In December 2005 the Bank of Thailand revealed that the government plans to
allow the AMC to merge with state-owned Bangkok Commercial Asset Management
(BAM) to buy nonperforming assets in the banking system. In the meantime, the cen-
tral bank is encouraging banks to sell NPLs to BAM and state-owned Sukhumvit Asset
Management (SAM) to help resolve/reduce NPLs in the system.
For example, in November 2005 BAM acquired NPLs of Baht 7.8 billion
(U.S. $190 million) from the Government Housing Bank at 61.6% of book value.
This enabled the Government Housing Bank to improve its financial statements in
preparation for issuing securitized bonds and mortgage-backed securities. In late 2005
BankThai also sold approximately Baht 7.5 billion (U.S. $183 million) of NPLs to
BAM, SAM, and two other asset management companies (namely Sathon Asset Man-
agement and Tawee Asset Management). Commercial banks have also been moving
ahead with NPL sales by auction with a recent transaction being the sale of Baht 2.5
billion (U.S. $61 million) of NPLs by Siam Commercial Bank, as part of its plan to
auction off 1,800 restructured-NPL accounts with face value of Baht 10 billion
(U.S. $244 million).
Asset securitization is likely to increase due to increasing interest among investors in
asset-backed securities and among institutions in using securitization to raise funds
(e.g., banks could raise additional funds to support the strong growth of their mort-
gage and retail loan portfolios). The Securities and Exchange Commission is revising
the Securitization Act to make it easier for issuers and to provide greater protection for
investors, with the revised law expected to help financial institutions securitize loans
and to provide flexibility for property registration when mortgages are transferred to
special purpose vehicles.
The country’s NPL ratio can be expected to decline further in 2006 and 2007, with
transfers to asset management companies and auction sales continuing. However,
whether all of the restructured loans excluded from this reported number can stay per-
manently in performing status remains to be seen, especially those restructured loans
with large balloon payments of deferred interest due in the future.

Outlook
Financial liberalization will maintain momentum as financial services are gradually
liberalized in line with free trade agreements and moves by the Bank of Thailand to
encourage consolidation in the sector. While this sector has focused on debt restructur-
ing in the past, it will concentrate on merger and acquisition activity over the next few
years, with the number of financial institutions expected to be significantly reduced
from around 80 currently. Mergers will help to strengthen the competitiveness of
financial institutions by building up their branch coverage and assets and drawing ad-
ditional capital to boost capability and efficiency.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 52
53
E u ro p e : G e r m a n y

Germany: Nonperforming Loan Market Report

I n late 2003, the Ger-
man NPL market was
practically dormant, and
German banks were hold-
ing more than €300 billion of NPLs. Market analysts gener-
ally agreed that Germany’s banking system – the largest in
Europe and the third largest in the world – had serious NPL
problems. Despite the gravity of the situation, banks had
made little effort to address their problems, and few NPL
transactions had taken place.

In contrast, Germany today has an active and dynamic NPL market, one that is fi-
nally living up to its potential. In the past 24 months, no fewer than 12 experienced
international NPL investors established offices in Germany and have participated
in German NPL transactions or are looking for investment oppportunities. As of
February 28, 2006, international investors have pursued at least 32 transactions, of
which 25 have closed, with total sales volume of approximately €24 billion (U.S.
$28.4 billion) in face value. Of the remaining seven, three are in progress and four
have been cancelled.
Unlike its NPL market, Germany’s economy has continued to drift between near
stagnation and recession. Since hitting a low of 0.1% in 2002, Germany’s GDP
growth has not been strong enough to sustain an economic recovery. Unemploy-
ment remains high, and recent federal elections have created uncertainty about the
government’s ability to implement tough economic reforms.
Banking Environment
In recent years Germany has made little progress toward creating a more efficient
and competitive banking system. Germany is still over-banked compared to its
European neighbors, with approximately 2,100 banks serving Germany’s 83 million
people. While the system remains Europe’s largest, with total assets of almost
€7 trillion (U.S. $8.3 trillion as of November 2005), it is still quite fragmented.
Germany’s largest banks (Deutsche Bank; Dresdner Bank; HVB Group, which was
purchased by Italy’s Unicredito in late 2005; Commerzbank; and Deutsche Postbank)
have total assets of approximately €1.2 trillion (U.S. $1.42 trillion). This represents
only 18% of total banking assets, according to statistics published by Deutsche
Bundesbank. Despite some recent bank mergers or planned mergers, large-scale con-
solidation of Germany’s banking sector has yet to materialize. Nonetheless, it is still
viewed as inevitable, even as larger banks struggle to remain independent.
Historically, German banks have provided specialized services that meet the particular
needs and requirements of private citizens or public local, state, and federal institu-
tions. This contrasts with the one-stop-shopping model of some other countries in
which national or super-regional banks provide a range of services to a variety of
banking customers. Germany’s “niche” model has led to the development of the fol-
lowing banking sectors:

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 54
• Commercial banks of the guarantees in 2005 has largely turned out to be a non-event. This was due, in
• Landesbanks (regional state banks) part, to the ability of the public sector banks to plan for the phase-out by shoring up
• Sparkassen (savings banks) their capital and liquidity and developing new products. Additionally there is a period
• Regional banks where the guarantee for the old liabilities is grandfathered.
• Credit cooperatives
• Mortgage banks Basel II
• Building and loan associations A more potentially significant change is the adoption in 2007 of Basel II. Begin-
• Special-purpose banks ning that year, international banks – including German banks with business beyond
Germany – will have to comply with Basel II’s more stringent framework for capital
These sectors are generally grouped into what are known as the “three pillars”: pri- measurement and capital standards. Bank capital requirements will be closely aligned
vately owned commercial banks, anchored by Germany’s big four banks (Deutsche with the bank’s reserves against impaired loans. If not adequately reserved when
Bank, Dresdner Bank, HVB Group, and Commerzbank); public sector banks where Basel II is effective, a bank will be required to take a large charge to capital. This is
ownership is by a state or municipality or other institutions (Landesbanks, Sparkas- not a pleasant prospect for a bank’s management, and it would only worsen if a bank’s
sen, and development banks); and the cooperative sector where ownership shares are capital were to fall below the minimum standards required by government regulators
mostly held by depositors and creditors (led by DZ Bank). There is little to suggest and international banking standards. In any event, management has a clear incentive to
that these pillars will not continue to co-exist going forward. dispose of or otherwise reduce exposure to impaired loans prior to 2007.

Merger Activity
Percentage of Total Banking Assets by Sector In contrast with expectations of significant merger activity in Germany’s banking
November 2005 sector in 2005, only a few noteworthy transactions actually occurred. Three stand out:
Unicredito Italiano SpA’s announced takeover of HVB in October 2005 in the largest
10%
Commercial Banks cross-border merger in Europe, which created the fourth largest bank in the Eurozone;
3% 28% Landesbanks Commerzbank’s November 2005 pending purchase of the mortgage bank Eurohypo,
Sparkassen which will make Commerzbank one of Europe’s biggest mortgage lenders and the
13%
Regional Credit Coops second largest bank in Germany; and Lone Star’s pending take over of the troubled
Credit Cooperatives AHBR, one of Germany’s largest mortgage banks.
8% Mortgage Banks
Building and Loan Associations With consolidation comes the opportunity to rid the “new” bank of past troubles,
3%
20% Special Purpose Banks including NPLs – and there is no shortage of global investors willing to assist consoli-
14% dating banks in disposing of their impaired loans. Thus, consolidation often triggers
increased NPL disposition activity, either just before or following the merger. True
Source: Deutsche Bundesbank Banking Statistics January 2006
to form, prior to being acquired, HVB was busy resolving its NPL problems: first, by
spinning off its real estate mortgage lending activities into a new entity (Hypo Real
Estate); and second, by auctioning off in excess of €4.5 billion (U.S. $5.3 billion) in
Expiration of State Guarantees NPLs and subperforming loans in two transactions. Commerzbank took a significant
In 2002 Germany reached an agreement with the European Commission on the charge in 2004 to clean up its balance sheet, helping in part to pave the way for its
expiration of certain state guarantees of the country’s public sector banks, which had Eurohypo deal. With limited consolidation activity occurring, the Federal Financial
provided a competitive advantage to the Landesbanks and Sparkassen. The expiration Supervisory Authority, commonly known as BaFin, Germany’s banking regulator, has

55
 E u ro p e : G e r m a n y
suggested that if German banks don’t take the lead in consolidating, foreign competi-
tors certainly will by buying and consolidating German banks.
Regulatory Overview
The German banking regulatory environment has its roots in legislation passed in
1931 that created a uniform system of state supervision covering all banks and led to
the adoption of the Banking Act in 1934. The post-World War II era brought decen-
tralization to Germany’s banking supervision, pushing regulatory powers to Germany’s
individual states, consistent with the revamping of Germany’s political system. Over
the years a variety of amendments to the Banking Act finally resulted in the creation
in April 2002 of the Federal Financial Supervisory Authority, commonly known as
BaFin, which now stands as the single federal regulator supervising banks, financial
services institutions and insurance companies.
Germany’s central bank, known as the Bundesbank, plays a key role in the functioning
of the nation’s banking system. It was established in 1957 to preserve the value of the
German currency and support the government’s economic policies. The Bundesbank
is widely recognized as one of the world’s most respected and politically autonomous
central banks and a key contributor to the economic and political stability of Germany
and Europe. It is an integral part of the European System of Central Banks (ESCB)
and the Eurosystem and plays a role with BaFin in the monitoring and supervision
of Germany’s banking system. As the central bank, it is responsible for financing,
clearing and collection and also functions as lender of last resort and keeper of the
country’s monetary reserves.
NPL Market
While much has been written about the size of Germany’s NPL market, the govern-
ment has not officially defined an NPL – in fact, BaFin has not publicly acknowledged
the NPL problem. But German banks tend to take a broad view of what defines an
NPL by including subperforming loans (past due, but sporadic payments are being
made) whereas a narrower, by-the-book definition would typically be that an NPL is
defined by contractual payments that are past due more than 90 days.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
Our initial estimate pegged the magnitude of Germany’s NPL problem at
€300 billion (U.S. $356 billion) while other estimates have the figure at around
€160 billion (U.S. $189.5 billion). Because the central bank does not publish NPL
statistics (partly due to the lack of definition), the size of the market is left up to those
who worry about such things. But one thing is certain: the market is big enough to
keep a handful of large investors busy for at least the next 18 to 24 months, maybe
much longer. And busy they are. With at least 32 transactions having come to market
since the fall of 2003, the German NPL market is the most active market in the world,
eclipsing even China (where the volume of NPLs may be larger but where investors
have been frustrated with limited sales activity to date). To attract global investment,
German banks have put together a mix of NPLs, as well as sub-performing loans and
performing loans (the latter are often referred to as “non-core assets”). A tried and
true legal system, clear protocols for resolving bad loans, a preference (so far) towards
loans secured by real estate, a hoped-for upturn in the economic fortunes of the
country, and an anticipated rise in Germany’s real estate values have all contributed
to strong investor interest. Germany’s NPL market is attracting investors who were
previously focused on Asian opportunities. With Basel II around the corner and the
expected consolidation of the banking industry, banks have strong incentives to
properly provision against their bad loan exposure and dispose of NPLs. Thus, the
interests of both buyers and sellers are in alignment.
This has not always been the case. In new NPL markets like Germany’s in 2003,
global investors have tended to be viewed as opportunists who because of their
international experience and keen pricing knowledge have the upper hand in NPL
transactions. One leading German politician went so far as to describe international
investors as “locusts” descending upon Germany. But attitudes, and more importantly
circumstances, have changed in Germany. With a sale of a €500 million (U.S. $ 592.2
million) portfolio by HRE to Lone Star in the fall of 2003, the NPL market started in
earnest. Since then, approximately €24 billion (U.S. $28.4 billion) in face value of
German NPLs, sub-performing and non-core assets have been sold to no fewer than
nine investors. German bankers early on realized that an influx of international inves-
tors had created a seller’s market, but it might not last forever, and they should take
advantage of the opportunity to dispose of NPLs while they could. Curiously, regula-
tors have generally taken a hands-off approach, but banks nevertheless have seen a
56
need to act because of the confluence of shareholder pressure, rating agency influence,
the need to improve financial performance to stay competitive, looming international
banking standards, and the simple recognition that bad debts were starting to pile
up faster than the banks’ work-out departments could deal with them. If transaction
volume is an indicator, German banks and international investors have learned to work
together; bankers are more amenable about talking with the investors and bringing as-
sets to the market, and investors are more willing to meet the price demands of sellers.
Distressed Debt Transactions in Germany*
Completed and In-Progress
loan arrangements, collateral, and guarantor to each prospective investor and, after
a period of due diligence, the investor submits a sealed bid in competition with a
handful of other investors. These auctions have generally gone well, are considered
efficient for both buyers and sellers, are internationally accepted, and, if properly
structured, provide a heightened level of competition to help assure the selling bank
of achieving true market price for the portfolio. Limited negotiated deals, where
one or two investors have secured an exclusive right to negotiate with the seller, also
have taken place in Germany. However, by their nature such deals are done quietly,
so information about them is not readily available. However, in comparison to auc-
tions, negotiated transactions tend to take much longer to complete and there is a
greater degree of uncertainty in completing a transaction.

¤ 4,000
• Deal sizes. Over the 24 months ended December 31, 2005 deal sizes have been
¤ 3,500 quite large on average, due in part to some mega-deals. The largest was HRE’s
¤ 3,000 €3.6 billion (U.S. $4.3 billion) portfolio sale. A total of five more transactions
¤ 2,500 with portfolios of more than €2.0 billion (U.S. $2.4 billion) also were completed.
Millions

¤ 2,000 Each was quite large by international measures, and it was extraordinary to have
¤ 1,500 six transactions above €2.0 billion in such a short time span. The trend, however,
is toward smaller transaction sizes of €300 million to €500 million (approximately
¤ 1,000
U.S. $350 million to $600 million) as transactions move from the very large
¤ 500 banks to more regional institutions. Negotiated deals tend to be much smaller
¤0 – in the range of €100 million (U.S. $118 million) or less.
4
4

6
5

5
3

5
-0
-0

p-0

-0

n-0

r-0
y-0

-0
-0

c-0
v
b

ne

• Transaction structure. All but two of the transactions we have tracked have
g

No

Ma
Fe

Se

Ma

Ja
Au

De
Au

Ju

* Amounts include NPLs, sub-performing and non-core asset loan sales
Source: Ernst & Young
What has emerged is a robust seller’s market where, done properly, sales transactions
can be efficiently completed at prices attractive to sellers. To date, key attributes of
the German NPL market include the following:
• Transaction format. Most transactions reported to date have followed the invita-
tion-only, sealed-bid auction format in which sellers invite bids from investors who
meet certain qualification criteria and who have an expressed interest in the type of
loans in the portfolio. The seller provides relevant information on the borrowers,
been outright cash sale transactions, where investors pay the full purchase price
at closing in return for full ownership and control of the portfolio of loans. One
twist is when German banking secrecy laws come into play. By law, German
banks must notify a debtor and receive permission by that debtor to transfer the
debtor’s loan to another institution. This requirement is waived if the bank has
“terminated” the loan (due to the debtor’s not making any payments in the prior
90 days), thereby allowing the bank to pursue full collection of all principal, inter-
est, and penalties. Once terminated, the generally accepted view is that the loan is
not subject to the banking secrecy laws and can be sold outright. But if it cannot
be terminated (which is the case for sub-performing and performing loans), the
secrecy laws still apply, complicating the bank’s ability to cleanly transfer the loan
to the investor. The bank can overcome this through proper transaction

57
 E u ro p e : G e r m a n y
structuring (by the use of subparticipation agreements, for example), and buyers
and sellers consider such transfers to be outright sale transactions.
The other two transactions that we have tracked have been structured as joint ven-
tures, with the selling bank taking an interest with the investor in a newly created
venture. (No publicly reported transactions have used a synthetic structure, due
mainly to their complexity.)
• Selling institutions. The German and international press have actively reported
on Germany’s NPL transactions, and general information about these deals is
relatively widespread, notwithstanding certain sellers and buyers wishing to keep
transactions quiet. From October 2003, when the HRE transaction marked what
is considered the opening of the NPL market in Germany, through December
2005, approximately 17 banks and 1 insurance company have sold portfolios of
distressed loans. The most notable sellers have been Dresdner Bank (through
its Institutional Restructure Unit), HRE, HVB, Eurohypo, DG HYP, and Aareal
Bank with other regional banks, public sector banks, and cooperative banks also
participating.
• Investors. Few international investors have been left behind in the lively German
NPL market. At least 12 investors have participated in one or more of the auctions
and/or negotiated transactions. Most have experience acquiring impaired loans in
other regions of the world, and some have invested heavily in pursuing transac-
tions in Germany, including the establishment of servicing platforms or forming
strategic relationships with existing servicers. Most loans sold at auction have
gone to a single purchaser, although it is not uncommon for investors to pair up
when pursuing particularly large transactions. The most prolific investors to date
have been Lone Star and Goldman Sachs, followed by a handful of other investors
such as Merrill Lynch, Credit Suisse, Lehman Brothers, Shinsei Bank, Morgan
Stanley, JPMorgan Chase, Deutsche Bank, Citigroup, and Cerberus.
• Asset type. Transactions to-date have been quite varied, with portfolios often
including a mix of NPL, sub-performing, and performing loans. Within those cat-
egories, the favored loan type has been real estate collateralized loans, with
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
corporate (unsecured) loans sometimes part of the mix. Real estate loans appeal
to investors and sellers because they tend to be the easiest on which to perform due
diligence and to price and often result in the highest and most efficient resolution.
These loans range from single-family, owner-occupied properties to income-pro-
ducing commercial real estate to corporate premises. Borrowers are everywhere in
Germany, although slightly more are in the former East German states.
• Price. Germany’s NPL market has developed with surprising speed, considering
that German regulators have not put much pressure on banks to sell assets. A key
reason is price, the great equalizer. Investors have met the price expectations
of sellers, and sellers have provided investors with a steady flow of assets. The
large deal sizes have helped sellers to attract global investors, thereby fostering
the competition that contributes to strong pricing. While the exact prices paid by
investors are hard to determine, they have ranged from 20% of total claim to as
much as 75% of total claim, although 45% to 70% is more typical. As might be
expected, sub-performing and performing loans command higher prices, while
stale and worked-over assets go for less. Because price is a relative concept, it is
difficult to compare prices across global regions. For various reasons, prices paid
by investors in China tend to be lower than those paid by investors in Germany.
But the common sentiment of investors in Germany is that the competitive envi-
ronment is putting pressure on investor returns. This has fueled complaints by
investors that the prices they are paying are too high, although few if any have
closed up shop and abandoned the market. Competition continues to be fierce, so
price levels have held up with little sign of softening.
• Resolution strategies. In pricing NPL portfolios, investors typically consider a
variety of resolution options. Common strategies include negotiating with the bor-
rower for a discounted payoff, restructuring the loan terms, initiating court action
such as foreclosure, and working with the borrower to effect a sale of the collateral
for forgiveness of the remaining indebtedness. In Germany, it is still too early
to gauge the success of investors in working out their portfolios, in part because
investors don’t like to talk about such things, and in part because the market is still
relatively young and widespread meaningful results have yet to be achieved.
58
• Servicing. Perhaps the most overlooked but significant influence on investor
returns is the loan servicer. It is the servicer who sets up the information technol-
ogy infrastructure to provide accurate reporting to the investor. It is the servicer
who must receive the assets transferred from the selling institution as quickly and
as efficiently as possible. It is the servicer who must promptly initiate collec-
tion efforts once the transaction is closed. In short, in the German market, it is
the servicer that can make the difference in whether the investor meets its return
requirements, because the competitively driven, tight profit margins leave little
room for inefficiencies and delays.
Outlook
Germany is well on its way to resolving its NPL problems. Whereas regulatory
pressures have driven NPL disposition activity in many other countries, the flurry
of activity in Germany over the past 24 months has been driven mainly by market forces.
HRE jump started the market with its October 2003 transaction. When Dresdner
followed with its Project Phoenix deal in early 2004, market activity was ignited and
has continued relatively unabated as other institutions have jumped in to take advan-
tage of opportunities to dispose of NPLs.
While some investors are far more selective in pursuing opportunities or have decided
to pull out of the market altogether, and while it is likely the large transactions that ini-
tially defined the market are mostly over, there are signs that the market will continue
its frenetic pace throughout 2006 and into 2007. The first quarter of 2006 has brought
at least three auctions totaling more than €750 million (U.S. $888 million), with other
transactions in the works. We expect to see the following trends in 2006 and beyond:
• Consolidation of international investors. Intense investor competition for NPL
assets will drive out those investors unwilling or unable to compete, leaving a
core group of international investors, perhaps four to six, who will have numerous
investment opportunities.
• Invasion of smaller and local investors. With deal sizes dropping, smaller and
local investors can more easily participate, in some cases by venturing with
established international investors. Equally likely, though, is that these smaller
investors, including some without prior experience in German NPLs, will look for
opportunities to invest on their own.
59
• Securitization. No NPL securitizations have taken place in Germany yet. But
with Lone Star amassing a portfolio of over €8 billion (U.S. $9.5 billion) and
Goldman Sachs not far behind, it is only a matter of time before we see Germa-
ny’s first NPL securitization.
• Smaller deal sizes. As previously noted, the days of the mega-auctions are likely
over. This is partly because Germany’s biggest banks have dealt with the most
troublesome parts of their loan portfolios, and partly because only a limited num-
ber of investors have the resources to pursue large transactions. Going forward,
auction sizes will likely be in the €300 million to €500 million (approximately
U.S. $350 million to $600 million) range with limited chances for mega-deals in
the billion-plus euro range we have seen so far, although non-auction deal sizes
could be significantly smaller.
• Improvement in quality of portfolio information. Banks for the most part have
come to recognize that there is a direct relationship between the quality of the
information they provide to investors and the prices investors are willing to pay.
Providing properly organized, timely, accurate, and complete information is the
best way for sellers to stay competitive in the market, manage an efficient transac-
tion process, and meet internal pricing expectations.
• Servicing scramble. Many investors rushed into the German NPL market
without establishing either a robust servicing platform or relationships with local
servicers. Now some investors are scrambling to get their servicing arrangements
up and running in time to absorb the portfolios they are purchasing, while fac-
ing competition from other investors in developing exclusive relationships with
capable local servicers or acquiring such servicers. Those investors that secure
advantageous servicing arrangements will have the upper hand in the German
NPL market in 2006 and heading into 2007.
 E u ro p e : P o l a n d

Poland: Nonperforming Loan Market Report

F ollowing a slowdown
in 2002 and 2003, the
Polish economy has experi-
enced strong growth – gross
domestic product (GDP) increased 5.3% in 2004 and an
estimated 3.2% in 2005. For the next few years analysts
predict steady growth of 3%–5% a year.
Poland GDP
6.00% 350

5.00% 300

250
Nominal GDP in EUR

4.00%
Real GDP growth

200
Since 2004 the PLN has seen a steady and firm appreciation against all major foreign
3.00% currencies.
150

2.00%
100
Strong exports and an increase in internal demand were key reasons for the improve-
ment of the financial results of Polish companies in 2004 and 2005. From a low of
1.00%
50
1040 points in June 2003, the blue-chip WIG20 stock index has been rising and at the
0 end of 2005 had reached 2655 points.
00

01

02

03
04

20 (F)
20 (F)

20 F)

20 F)

20 F)
(F)
(

(
20

20

20

20
20

05
06
07

08

09

10
20

Real GDP growth GDP in EUR With export growth expected to slow, companies’ investment expenditures will be a
key contributor to sustained economic growth. Analysts expect such expenditures to
Source: National Bank of Poland, Central Statistics Office.
increase about 10% yearly.
Domestic consumption and exports are key factors of growth. Since 2002 Polish exports
have been growing at an average of 15% per year despite the strengthening of the na- Since 2000 Poland’s unemployment rate has exceeded 15%, and at the end of 2005 it
tional currency, the zloty
600 (PLN), which has increased relative export prices. Additionally, reached 17.6%, the highest level in the EU. Despite the economy’s stronger economic
Poland’s accession into the European Union (EU) on May 1, 2004 has increased its cred- growth, Poland has found that reducing unemployment is a complicated and long-
ibility with foreign investors
500 and given an additional boost to its economy and companies.

400
ts in EUR/PLN bln

300

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 60
200
 6.00% 350

5.00% 300

250

Nominal GDP in EUR

4.00%

Real GDP growth

200
3.00%

150

term process, mainly because of the structural character of the unemployment and the versus 280%2.00%
in EU-15). The growth rate of loan volume in Poland for the next 10
100
relatively low mobility of labor force. years is estimated at 14% per annum.
1.00%
50
As a member of the EU, Poland is preparing to enter the European Monetary System and, The Polish banking system is dominated by commercial banks, whose share of total
as of year-end 2005, had met three of five Maastricht conditions. Those conditions are: bank assets exceeds 90%. All major banks (except for PKO BP and BGK, which are
0
still state-owned) are controlled by foreign financial institutions like UniCredito,

00

01

02

03

20 4
20 F)
20 (F)

20 F)

20 F)

20 F)
(F)
0

(
20

20

20

20
20

05
06
07

08

09

10
• Inflation limit: no more than 1.5% above the average inflation rate of the three HVB, KBC, or AIB. These foreign-controlled banks account for 80% of total bank
EU countries with the lowest inflation rates capital and 60% of bank Realassets.
GDP growth Furthermore,
GDP in EUR33% of the market is controlled by two

• Interest rate limit: the long-term rate should be no more than 2% above the
average of the three EU countries with the lowest inflation rates
• Maximum annual deficit equal to 3% of GDP
• Public debt of no more than 60% of GDP
• The so-called collar rule (i.e., exchange rate is to move within +/-15% during
the “trial” time)
key players in the banking business – PKO BP (state-owned) and Pekao S.A.
(UniCredito group). However, an expected merger of BPH (the third position)
and Pekao may create a new leader in the Polish banking market.
Bank Assets in Poland
600

At present, Poland does not meet the collar rule and the 3% of GDP requirement. In
addition to the 3% target, the most important challenge in debt management policy is 500

keeping total debt below 60% of GDP. National debt exceeded PLN 461 billion
(U.S. $144 billion), and was approximately 50% of GDP in 2005. In 2006-2007, debt 400

Nominal Assets in EUR/PLN bln

in relation to GDP is expected to reach 55%, after which it is expected to decline (as-
suming steady growth of the economy).
300

There is much speculation as to just when Poland might be ready to join the Euro
zone; the best “guesstimates” put the entry date somewhere between 2009 and 2012. 200

EU monetary accession will lead to a more stable and competitive Polish economy,
partly by reducing currency risk for Polish companies and banks. 100

Banking Environment
0
According to National Bank of Poland, at the end of September 2005 there were 68 00

01

02

03

04

05
20

20

20

20

20

20
commercial and 594 cooperative banks. The five largest banks in Poland account for
approximately 50% of total banking assets [as of December 31, 2005 the total banking Nominal Banking Assets in PLN
Nominal Banking Assets in EUR
assets amounted to PLN 587 billion (U.S. $183 billion)]. Although banks in Poland
have experienced 30% asset growth since 2000, the level of banking intermediation or
Source: National Bank of Poland
assets in relation to GDP is still much lower than in EU-15 countries (61% in Poland

61
 E u ro p e : P o l a n d
In 2005, Polish banks achieved their best financial results ever. Aggregated profits for 2005
exceeded PLN 9 billion (U.S. $2.9 billion). High profitability of banks was a result of
higher interest and commission revenues and lower loan loss reserves. In comparison with
EU countries, Polish banks are characterized by higher efficiency measured by return on
equity or ROE (20.8%) and return on assets or ROA (1.6%); however, cost controls are still
in need of improvement (Cost/Income ratio is over 60%).
Regulatory Overview
The Polish banking system is regulated by the Banking Law Act (1997 and 2002),
which was amended in 2004, with the changes resulting from the EU accession by
Poland. The new act includes prudent regulations regarding banks’ own funds, capital
adequacy rules, and exposure concentration limits.
The new framework also regulates outsourcing in the Polish banking system, which
should help banks to maximize profitability, while ensuring the security of deposits placed
with the banks. The changes have also focused on strengthening banks’ internal controls.
Another important change to the Banking Law was the implementation in 2004 of the
legal framework for assets securitization. This likely will be a key factor in the devel-
opment of Poland’s NPL market and an improvement in banks’ credit quality ratios.
Among all financial institutions, only banks are permitted under the law to carry out
securitization with specialized securitization funds or capital companies (SPV).
According to Poland’s Ministry of Finance Decree on banks’ provisioning rules (amend-
ed at the end of 2003), a five-tier asset quality classification system is used by the banks
in Poland: normal, watch, substandard, doubtful, and loss. For corporate exposures,
repayment delinquencies exceeding 90 days are, apart from a borrower’s financial stand-
ing assessment, a criterion for downgrading the loan to substandard. If the delinquency
exceeds 12 months, the loan should be classified as loss. In the corporate exposures clas-
sification assessment, qualifying collateral is considered (i.e., guarantees).
In consumer lending, a two-tier classification is used: normal and loss. The latter is ap-
plied for exposures which are over six months in arrears. These classification regulations
 Banks may outsource certain banking activities to other parties. The most common functions likely to be ousourced are certain IT
and financial intermediation services.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
have been in force since the beginning of 2004 and are similar to the previous regula-
tions; however, they are less stringent as far as the period of delinquency in repayment
and the ability to classify exposures based on qualifying collateral are concerned.
Moreover, following the relevant EU Directives implementation, starting from 2005 certain
qualifying banks (i.e., quoted on Warsaw Stock Exchange subsidiaries of the quoted com-
panies) elected to use International Financial Reporting Standards (IFRS) as a basis for
their financial statements preparation. Furthermore, all banks in holding company groups
in Poland are obliged to prepare their consolidated financial statements in accordance with
IFRS. The implemented changes have an influence on a number of definitions including
methodologies of assets and liabilities valuation, and profit and loss measurement. Nev-
ertheless, based on initial observations as to the effect of the IFRS implementation on the
banks’ financial statements in 2005, the introduced changes did not have a very significant
impact on those financial statements. This is mainly due to the fact that under local GAAP,
the banks were required to use accounting regulations which were, to a significant degree,
already compliant with IFRS (especially in the area of IAS 39).
NPL Market
In the late 1990s, Polish banks experienced a deterioration in credit quality and an in-
crease in their NPLs to about 22% of gross loans. This was mainly attributable to poor
credit risk management of consumer and corporate loans originated after Poland’s
transition to a market economy. Following changes in Poland’s Investment Funds Act
in 2004 and subsequent changes in tax regulations for banks, banks have new oppor-
tunities to dispose of nonperforming loans. The act’s new legal framework introduced,
among others, the institution of securitization funds (FS), which are managed by asset
management companies (TFI) under Polish Securities and Exchanges Commission
(KPWiG) supervision. The NPL portfolios of banks can now be transferred to FS
either through true sale or subparticipation agreements (in which a bank still remains
owner of the legal title of the receivable and all proceeds from the receivable are
transferred to the FS). The true sale transaction has a clear advantage due to the fact
that the bank disposes of the receivable and obtains cash and benefits from the associ-
ated tax relief. The subparticipation is likely to be used in cases where the legal status
of the collateral may contribute to problems with foreclosure action by a new owner,
especially in cases when bankruptcy proceedings had been initiated against the bor-
rower. With sub-participation, the bank is not able to take advantage of the immediate
62
tax relief; however, the tax benefit can be obtained once the proceeds from the receiv-
able recovery are transferred to the FS.
By the end of 2005 KPWiG had granted approval to four FSs while one FS application
was awaiting approval. (The market indicates that setting-up of an FS may take three
to five months.) The existing TFIs managing already established FSs are owned usu-
ally by investors (among others: Credit Suisse, Copernicus Capital TFI).
In 2004, a small NPL transaction completed between Deutsche Bank PBC (seller) and
Reform Capital (investor), with the face value amounting to about PLN 160 million
(U.S. $49 million). In 2005, PKO BP (the biggest retail bank in Poland) announced a
sale of a retail receivables portfolio amounting to approximately PLN 670 million (U.S.
$205.7 million). The auction was won by a syndicate consisting of PRESCO (servicing
company), Reform Capital and Credit Suisse London (investors).
Outlook
Until recently, banks have had little incentive to dispose of NPLs; among other reasons,
because they have not experienced liquidity problems and the more stringent capital
requirements of Basel II do not become effective until 2007. As a result, there
has been little activity, with the PKO BP sale the only significant transaction completed
as of year-end 2005. However, PKO BP already has started preparations for another sale
of a corporate portfolio of NPLs with approximate face value of PLN 750 million
(U.S. $230 million), which is scheduled to be completed in 2006. Other banks in Poland,
including Pekao (Unicredito), BPH (HVB), BZ WBK (AIB), and BGZ (Rabobank) have
also initiated actions by offering portfolios for sale which are likely to be in a range
€150 million–300 million each (U.S. $178 million – U.S. $355 million). Other big banks
in Poland (i.e., Kredyt Bank [KBC], Bank Handlowy [Citibank], BRE [Commerzbank])
are likely to be preparing for the process of disposing of NPLs or at least considering
NPL disposal options.
63
The first planned NPL transactions in 2006 likely will include relatively old loans to
corporate and small-medium enterprises. Initial transactions prices are very likely
to be low, a reflection of the age of these loans, poor collateral quality, and bankrupt
borrowers. Following this first wave of transactions, the banks are likely to dispose of
more NPLs to free up capital, free up human resources tied up in managing and re-
structuring NPL portfolios, and focus on core businesses. This should result in a more
favorable environment for securitization, with banks using securitization of sub-per-
forming and nonperforming loans as another tool to raise capital. However, it should
be emphasized that so far a limited use of sell-side advisors by the banks and the poor
quality of banks’ loan data has contributed to a considerable degree of uncertainty
in the processing of NPL information, which could result in delays in completion of
some transactions.
The NPL market potential in Poland looks promising. According to the Polish Central
Bank, as of the end of December 2005 the value of nonperforming loans (defined as
substandard, doubtful, and loss) on the banks’ balance sheets amounted to
PLN 29.0 billion (U.S. $8.8 billion) including PLN 21.1 billion (U.S. $6.4 billion)
classified as loss. However no official statistics are available as to the full amount of
loans written off by the banks and transferred off-balance sheet. It is estimated that
in the period from 2003 till 2005 loans written off by the banks amounted to over
PLN3 billion (U.S. $920 million). The banks’ NPL to gross loans percentage
decreased from nearly 21.86% in 2003 to 11.00% as of the end of December 2005.
This change is partly due to write-offs, favorable changes in banks’ loan classifica-
tion framework, and benefits from the economic boost resulting from the Poland’s
accession to EU in 2004. Even so, banks still hold a substantial amount of NPLs in
their loan portfolios, accumulated over the last 15 years, and they have a significant
opportunity to develop an NPL market for interested investors. Recent changes in
legal framework opened the door for banks in Poland to take robust action in resolving
their NPLs, clean up their balance sheets and free up capital for new loan originations.
This should definitely provide attractive opportunities for investors looking to invest
in Central and Eastern Europe. Investors have been actively visiting banks and seeking
NPL opportunities in Poland, setting the stage for a lively 2006.
 E u r o p e : H o t sp o t s

Europe: Other Potential NPL Hotspots

J ust as in Asia, countries
in Europe are at various
stages in resolving their
NPL problems — some, like
Poland, are just beginning, a few, like Germany, are nearing
the apex of NPL disposals, and others are well along. Among
those that have made reasonable progress are:

Italy
Italy was among the first European countries to acknowledge an NPL problem. In 1999
it created a law that laid the foundation for banks to securitize NPLs. Through 2001,
securitizations of bad loans were especially popular, since originators could spread over
five years any loss generated by a securitization carried out before May 2001. This
popularity was evidenced in that NPLs comprised about 18% or €5.4 billion
(U.S. $6.4 billion) of Italy’s total securitized volume in 2001. However, overly complex like BNL, MPS, Sanpaolo, BPU/Centrobanca, Intesa, and others struggle with regula-
structuring (i.e., synthetic transactions, which failed to fully transfer risk off originators’ tory and accounting changes that are forcing them to reevaluate their balance sheets.
balance sheets) caused some deals to be downgraded by rating agencies, prompting reg-
ulators to require originators to put several deals back on their balance sheets and amend Selection of Recent NPL Transactions
the banks’ disclosure policies to include all the risks retained and financial implications. Seller Portfolio Size (in millions of EURO) Approximate Date Purchaser
Nonetheless, with enactment of the 1999 law, the keystone for resolving NPLs had been BNL 430 2004—December Morgan Stanley & Pirelli RE
set; and today, Italy continues its pursuit of resolving between €50 and €60 billion BNL 177 2005—February Goldman Sachs
(U.S. $59 billion and $71 billion) in NPLs. BPU/Centrobanca 107 2005—April Teriscore SPV
Sanpaolo 270 2005—May ABN Amro
The period between late 2004 and most of 2005 was marked by numerous NPL transac- Intesa 9,000 2005—June Merrill Lynch & Fortress
tions between Italian banks and international and U.S.-based investment banks. The MPS 197 2005—September Lehman Brothers
wave of global investment comes as the Bank of Italy undertakes measures to align the Sources: Press releases and various news agencies

definition of impaired loans with the standard 90-day past due criteria and Italian banks Specifically, compliance with the new International Accounting Standards (IAS) will
force banks to create specific provisions against nonperforming and problem loans.
 Law 130/99.
While an NPL sale might be considered as an admission of weakness, clearly the
 A provision in Law 130/99 permitted the originator to spread over five years any loss generated by the transfer of the securitized
assets to the issuing vehicle carried out before May 2001. The loss, which is generated by the difference between an asset pool’s net
book value and the sale price, is deducted from the issuer’s equity reserves and amortized over five years.
long-term benefits outweigh the pain of short-term write-offs, for example:

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 64
 Czech Republic
• Analysts praised Intesa’s new “clean” balance sheet while investors pushed As the Czech Republic emerged from its planned economy, the banking sector devel-
up its share price oped very rapidly, with the number of banks increasing from 5 in 1990 to 55 in 1995.
• Fitch Ratings upgraded BNL’s individual rating, long-term rating, and short-term However, lenient licensing and regulatory oversight, as well as political intervention in
credit grade – all a direct result of the bank’s NPL transactions in 2004 and 2005 the lending practices and management appointments of the state-owned banks, result-
ed in careless lending and questionable business practices. By 1997, the financial sec-
Italy’s medium-term outlook for resolving problem loans remains relatively encourag- tor had deteriorated further in a recession and banks’ NPLs jumped 62% from 1990.
ing based on a strong market fundamentals for NPL sales (e.g., defined foreclosure The banks’ NPL troubles led to the establishment of a government sponsored work-out
process). So far, the Italian banking sector has not been affected by the negative and consolidation agency, the Ceska Konsolidacni Agentura (CKA), in June 2001, to
economic conditions. However, new NPLs might evolve depending on the macro-eco- help bail out troubled banks and companies in the post-Communist transformation.
nomic environment as well as stiff competition among lenders that has reduced profit
margins and pressured them to pursue higher-risk loans. In early NPL transactions, CKA received relatively low prices, a reflection of limited
information about old loans, poor collateral quality, and bankrupt borrowers. Since
Italy Strengths and Weaknesses then, CKA has been somewhat more successful in providing investors with complete
Metric Strengths Weaknesses and accurate information about NPLs in its portfolio, thus decreasing investment
Italy’s economy, Europe’s fourth 2005’s zero GDP growth was a drop risk and transaction costs; in addition, it has grouped loans with like characteristics,
GDP largest, will likely expand 1.3 % from an already sluggish 1.1 % growth thereby enabling investors to better match their risk profiles with Czech NPL portfo-
in 2006 and 1.4 % in 2007. A in 2004. As a result, the country’s lios. The CKA expects these steps to help broaden the competition among investors to
number of recently approved public deficit (as a % of GDP) grew to
acquire NPLs, thereby facilitating the completion of NPL transactions at fairer prices.
reforms – including bankruptcy 4.1 % from 3.4 % in 2004, in breach of
and civil procedures and a “savings Eurozone guidelines. Italy’s relatively low
law” that enhances corporate levels of productivity and competitive- To date, NPL reform efforts, regardless of the CKA’s recovery rates, have been favor-
governance, disclosure, and coordi- ness could deteriorate with continued able:
nation among regulators – have set inflation differentials compared with
the stage for further progress. other EU members. • Smaller banks that couldn’t compete have been forced to either consolidate or
cease operations; and as of 2004, only 35 registered banks remain of the original
Unemployment Country-wide unemployment Unemployment in the South is high at 55 (26 of which are either fully or partially foreign-owned).
remains just below its historical av- 15% to 20%. Participation rates of • Since 2004, the CKA has disposed of about 15 portfolios with a total face value
erage of 8% due to low unemploy- women and older males are lower than of more than €2.47 billion (U.S $2.9 billion).
ment in the North. the EU average.
• Czech NPL transactions have continued to attract the interest of potential pur-
chasers, as evidenced by the 19 buyers (9 domestic and 10 foreign) who have
Loan Growth Loan growth accelerated in 2005 Italian banks have been focusing on
by about 7.5%, posting its best long-term loans for retail and SME bor- expressed interest in a CKA U.S. $1 billion portfolio of bankrupt and doubtful
performance since 2000 with rowers. Increased competition might obligors to be auctioned in early 2006.
demand mainly supported by the hurt profit margins.
household segment, which now
represents 31.6% of total loans The outlook for NPLs in the Czech Republic remains cautiously optimistic, since the
outstanding versus 26.9% in 2001 country’s economic and banking industry fundamentals are improving but still need to
according to Credit Suisse. be closely monitored through tighter risk management and IT controls. The CKA will
NPLs NPLs in the South, which account In our experience, loan growth coupled continue to administer bad loans left over from the time of reformation but its mandate
for just over 10% of the total, with lower banking margins could cause will expire in 2007. As a result, banks and credit institutions must independently deal
continue to decrease, lowering loan underwriting standards to soften,
the average gross NPL ratio to its thereby provoking further NPL problems. with bad loans by selling portfolios to improve their balance sheets.
all-time-low at just under 5%, ac-
cording to selected sources.

65
 E u r o p e : H o t sp o t s

Czech Republic Strengths and Weaknesses to restructure state banks both financially and operationally through privatization,
Metric Strengths Weaknesses promoting competition, and improving the regulatory and supervisory framework.
GDP Accession into the European Union Without pension and healthcare reform, Consolidation and closures have knocked the weakest banks out of the market and to-
should enable the Czech Republic social welfare will continue to impede day there are a total of 47 Turkish banks versus 81 in 1999. From these failed or weak
to enjoy solid economic growth and long-term fiscal sustainability. banks, the state’s Savings Deposit and Insurance Fund (SDIF), in coordination with
low inflation.
the BRSA, has assumed nearly U.S. $50 billion in total liabilities and has attempted
to recapitalize, sell, or liquidate 21 financial institutions. Another significant change
Unemployment Unemployment is around 10%. If Payroll taxes at 47.5% of gross wages are
parliament addresses tax, pension, among the highest in Europe and are a in the post-crisis period is the banks’ income source. Past revenues were driven by
and healthcare reforms, then em- major impediment to lowering unemploy- treasury bill securities, but today, New Turkish Lira-denominated loans, along with
ployment could be stimulated. ment. their interest income, fees, and commissions, are more profitable and offer a more bal-
anced income stream. As a result, loans for 2005 increased almost 60% from U.S. $64
Loan Growth Bank of Tokyo-Mitsubishi (a key Rapid growth in retail lending, espe- billion in 2004, resulting in total banking assets of no less than U.S. $271 billion.
unit of the world’s largest bank, cially with sub-prime rates offered to a
Mitsubishi UFJ Group) plans to relatively impoverished population base,
open a branch in Prague to handle is a source of risk for banks’ balance Perhaps Turkey’s NPL reform efforts have been overshadowed by the large volume of
loans, deposits, and foreign ex- sheets. Sharp drops in mortgage rates portfolio sales recently offered by EU member countries like Germany and Italy, but
change deals in anticipation of fu- will continue to put pressure on banks’
progress has been evident:
ture economic growth and to step profit margins.
up lending to Japanese companies • The government is planning to transfer certain outstanding bad debts in the
operating there. amount of about U.S. $1.8 billion from the state banks (like Ziraatbank, Vakibank,
NPLs The secondary market for bad debt As Czech law makers have proposed a and Halkbank) to the SDIF. The SDIF has prepared and published a sales strategy
is strengthening (as evidenced bill which will raise U.S. $2.55 billion in whereby the bulk of these delinquent receivables will reportedly be resolved by
through CKA’s planned disposition of government bonds to cover past CKA
U.S. $4.8 billion before it closes op- losses (as required by law), taxpayers will
the end of 2007.
erations in 2007), and other positive foot the ultimate bill for past NPL woes. • All Turkish banks continue to protect themselves by embracing high provision
changes are anticipated in conjunc- amounts (5.6% of total loans in 2004 and just under 5% in 2005) against their
tion with a new bankruptcy law. problem loans. By themselves, the top four banks (generally regarded as Akbank,
Despite Europe’s past (and recent) successes, there are a host of potential NPL “hot Isbank, Garanti, and Yapi Kredi) have loss reserves Equal to 85% of their NPLs.
spots” such as Turkey, Russia, and other locales. • In late 2005, Lehman Brothers won a government controlled NPL portfolio of
U.S. $1 billion in a competitive auction of numerous high-quality and experienced
Turkey global bidders.
In 2001, when Turkey’s currency collapsed, banks closed, and the country entered a
deep economic recession, NPLs as a percentage of banks’ total gross loans reached Barring any unforeseen events like a sharp loss of investor and consumer
nearly 21%. Since then, Turkey has staged a remarkable recovery. Under guidance confidence, Turkish NPLs are expected to remain at their current 2005 levels (between
from a special bank restructuring agency, the Banking and Regulation and Supervi- U.S. $5 billion and U.S. $6 billion), thanks to increased macroeconomic and political
sion Agency (BRSA), and from the International Monetary Fund, Turkey has pushed stability. In addition, weak banking governance – which was historically due to a sig-

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 66
nificant number of family-owned banks with ties to industrial conglomerates – seems August 1998 financial crisis, it seems that few of the proposed reform efforts have
to be a thing of the past. Now, foreign investors are interested in Turkey’s financial been fully considered and implemented. Today, Russia’s banking system, with total
sector: General Electric’s financial services arm owns a 25% stake in Garanti Bank assets of RUB 9.4 trillion (U.S. $327 billion), remains fragile and is characterized by
and other recent entrants include UniCredito (Italy), BNP Paribas (France), Fortis over-supply and fragmentation. This was evident when, in summer 2004, the Russian
Bank (Belgium), and Rabobank (Netherlands). central bank’s poorly managed attempt to expunge problem institutions (i.e.,
Sodbiznesbank) from its financial system caused a run on deposits that almost
Turkey Strengths and Weaknesses induced a mini-crisis or what the government called “tension.”
Metric Strengths Weaknesses
GDP GDP should continue its expan- Although textiles represent one-third of Banking Tension – Summer 2004
sion into 2006 especially with new Turkey’s exports, the end of WTO quotas Institution Alleged Problem Impact
progress toward EU membership as in 2005 will put pressure on the indus- Guta Bank Liquidity issues Sold to Vneshtorgbank (state-owned)
announced in October 2005. try. Loans to textile-related businesses Alfa Bank Deposit run Lost about US$200 million of deposits
should be watched carefully.
Sodbiznesbank Money laundering License revoked
Bank Paveletsky Bad loans License revoked
Unemployment Unemployment is around 10%, but Turkey’s economy is moving toward
should fall slightly with acceler- modern industry and commerce, but Bank Dialog-Optim False financial statements License revoked
ated export growth and domestic traditional agriculture still accounts for KreditTrust Bank False financial statements License revoked
demand. more than 35% of employment. Source: Nikoil Investment Co. (Moscow) in association with Auerbach Grayson
Loan Growth Draft legislation is anticipated to Since lending will now comprise a
introduce an established second- larger part of banking income, loans to
ary market for mortgage banking small and medium-size enterprises and Although the 1998 crisis was a result of imprudent borrowing practices by the state,
with floating interest rates and consumer credit will test the banks’ the 2004 tension was due to the central bank’s poorly implemented announcements
early loan repayment without management skills. regarding compliance reviews and its inability to instill trust in the inter-bank market.
penalty.
Luckily, the Government averted a full-blown crisis by reducing the banks’ mandatory
NPLs According to the Banks Asso- With 26.7 million credit cards at 2004 reserve requirements from 7% to 3.5%, forcing a flow of emergency funds into the
ciation of Turkey, NPLs to total year end, the consumer market has
loans were about 5.4% in 2005 become saturated and is carrying an inter-bank market, and, for a time, approving deposit insurance for all bank deposits.
(about US$5.5 billion) which is NPL ratio of about 7%. So the battle
much improved from 2001-2002, for market share will possibly shift to Despite heightened bank volatility, NPL issues have remained relatively quiet. Ac-
when country-wide problem loans mortgages and asset management
measured over 20%. Increased products – hopefully not at the expense
cording to the central bank, overdue debt in Russian banks totals RUB 83.6 billion
cooperation with foreign inves- of prudent underwriting. (U.S. $2.9 billion) on total extended credits of RUB 5.9 trillion (U.S. $203 billion) –
tors will lead to improved product a NPL ratio of around 1.4%. at 2005 year end. NPLs have been relatively subdued
diversification, risk management, because domestic banks have benefited from the country’s strong economic growth
and IT controls.
(between 1999 and 2005 GDP per capita increased 175% from U.S. $6,417 to
U.S. $11,209 according to the IMF) as well as the return of ruble deposits in the bank-
Russia ing system after the 1998 and 2004 scares. Furthermore, Russia’s lending business has
In our 2004 NPL report, under the assumption that proposed reform efforts would be expanded rapidly. In response to robust demand for capital in 2004, loans to commer-
properly implemented, we said that Russia had made “made great progress in rehabili- cial entities reportedly grew by about 45% while credits to individuals and households
tating its financial system.” However, despite eight years having passed since Russia’s (i.e., retail banking) reportedly doubled to approximately 15% of total loans.

67
 E u r o p e : H o t sp o t s

non-state banks, will transition to the new general deposit insurance program by
In order to keep pace with the banking boom, many Russian banks are looking to 2007, thereby neutralizing its current advantage in the private deposits market.
international markets for funds. In 2004, Russian banks accounted for around • In the post-Soviet period, Sberbank has been the only Russian bank permitted
U.S. $5.8 billion or 31% of all Russian Eurobond issuances according to The Banker. to service pension payments. Reforms are being implemented to create a new
By the end of 2005, banks accounted for around U.S. $9 billion or 53% of all Russian system based on savings and investments managed by a selection of funds
Eurobonds. The largest Eurobond issues by Russian banks in 2005 included: linked to private financial institutions.
2. Accounting changes. The move to international accounting standards by the end of
10 Largest Banking Eurobonds of 2005 2004 and the plans to extend the minimum capital requirements of all banks to
Amount Rank among all €5 million by 2007 (currently this requirement is obligatory for newly established
Financial Institution Issue Month
(U.S. $ Millions) 2005 Russian Eurobonds banks) may result in Russian banks more closely resembling their Western counterparts.
Vneshtorgbank December 1,000 4 3. Non-callable deposits. The Duma Banking Committee is proposing Russia’s
Vneshtorgbank June 1,000 4 first bona fide time-deposit program whereby depositors will either be allowed to
Gazprombank September 1,000 4 withdraw their money early for a penalty fee or, in exchange for a premium inter-
Sberbank February 850 7 est rate, will agree to leave the funds for the full term.
Vneshtorgbank January 750 8 4. Deposit insurance system. By the end of 2005, Russia’s individual deposit in-
Russian Standard Bank September 500 11 surance system was nearly implemented after a two year transition period and the
Industrial Construction Bank September 400 12 finalization of several bank audits. As of December 2005, over 930 banks, or
Russian Standard Bank April 300 15 approximately 75% of all operating banks authorized to handle household
Bank of Moscow May 300 15 deposits, were admitted to the insurance system which guarantees deposits up to
Industrial Construction Bank July 300 15 RUB 100,000 (U.S. $3,470).
Source: Thomson One Banker, December 2005

Reports, such as that issued by Standard & Poor’s Corp., have directly questioned how It appears Russia’s banking sector is slowly improving – the tension of 2004 has
long such a fragile banking system can sustain its rapid credit growth. Furthermore, passed, loans are growing, and the debt markets are keeping the banks flush with
we note that Russian banking is additionally risky, since it is still developing and there capital. However, the future remains unclear about how well Russia can balance – let
are a handful of reform efforts being considered and processed by the central bank. alone accentuate – these measured successes with its hopeful reform efforts. Even the
most well intended reforms can be quickly neutralized if the banking sector remains
1. More level playing field. At the end of 2005, Russia still had over 1,250 licensed exposed to NPL risks because of unrestrained credit expansion and profit pressures.
banks (most of whom simply perform treasury functions for their owners’ other
interests – namely industrial). This number hides the fact that Russia’s banking Russia Strengths & Weaknesses
industry is dominated by state-controlled institutions like Sberbank, the former Metric Strengths Weaknesses
Soviet savings bank. GDP GDP should continue to expand in Russia continues to face significant
• With an extensive branch network and previously the only bank to enjoy a 2006 as the ruble continues to be structural issues. Its oil, natural gas, met-
deposit guarantee from the state, Sberbank attracted more than 60% of all retail targeted against a new currency als, and timber account for more than
basket – one which is purposely 80 % of its exports, leaving it exposed
deposits. However, by the end of 2004, special state responsibility regarding
being decoupled from the steadily swings in world prices.
new deposits in Sberbank was abolished. Now Sberbank, along with the many weakening U.S. dollar.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 68
 Metric Strengths
Unemployment The Federal Statistics Service
reported unemployment at 7.5%
in 4Q 2005. This could fall in
anticipation of Russia’s accession
to the WTO (expected by many to
occur in 2006).
Loan Growth Although the penetration level
of banking services is among the
lowest in Eastern Europe (less than
10% of private-sector investment
vs. around 50% for other developed
countries according to The Econo-
mist Intelligence Unit), loans have
been growing fast, reaching 22% of
GDP by the end of 2004.
NPLs NPL ratios remain very low since
Russian families have histori-
cally prided themselves in having a
strong repayment culture.
Weaknesses
Russia’s bid to join the WTO is still facing
challenges from the US and Austra-
lia. Even if bilateral talks are finished
soon, full accession might not occur for
another six months or so.
As the domestic economy develops and
prospers, international players might
seek to enter the local market, thereby
further bolstering competition and erod-
ing profits of smaller and less-sophisti-
cated Russian banks.
• Greece. Despite having a low NPL ratio, Greece still has potential issues which
As a metric, an NPL ratio can hide the
level of problem loans during periods of
rapid credit growth. Additionally, Russian
banks sooner rather than later might feel
the pain of NPLs if economic expansion
stalls and competition for creditworthy
borrowers tightens.
Instead, banks which have previously merged and consolidated prefer to lessen
the workload within their resolution departments so managers and staff can be
redeployed. According to the Banco de Portugal, banking sector assets total
€320 billion (U.S.$379 billion) and recognized NPLs stand at about €3.8 billion
(U.S.$4.5 billion) on total loans of €201 billion (U.S.$238 billion). Although
this implies that Portugal has a low NPL ratio (2%) and clean-up by some banks
has been and is underway, we note that there is no true rental market for hous-
ing – forcing citizens to buy their homes, usually on credit equal to as much as
80% to 90% of the total property value. If the economy continues to remain flat,
unemployment increases, and interest rates rise, it is highly probable that Portugal
could be awash with mortgage-backed NPLs.
could lead to future loan defaults. The economy, while still growing at a faster
rate than most other European-area countries, has slowed following the 2004
“Olympic boost”. As the economy continues to slow, at least into 2006, so will
private consumption, and unemployment is anticipated to hover around 10%. In
preparation for future NPLs, the banking sector could benefit from reform: the
bankruptcy law needs to mature and the regulatory framework surrounding the ef-
ficient transfer of bad loans to investors needs to solidify. As both of these issues
continue to evolve, so might the Greek market for disposing of NPLs.

Europe’s Newest Watchlist
Although this report doesn’t claim to be the final voice or complete overview for all
countries with NPL issues, we are, however, becoming increasingly aware of other
NPL markets which should be closely monitored as they deal with a host of issues in-
cluding accounting, economic, demographic, and political changes. Some of the more
commonly mentioned markets to consider include:
• Portugal. This small country of 10.6 million citizens hosted its first NPL transac-
tion in 2003 with a €150 million (U.S. $178 million) portfolio of bad debts which
were sold to a well known global NPL investor. Since then, Portugal has disposed
of NPLs each year, ranging in size and type from €30 million (U.S. $36 million)
in small and medium-sized enterprise (SME) loans to around €150 million in
retail mortgage assets. In 2006, we understand that another five or so portfolios
(averaging about €100 million each or U.S. $119 million) could come to market.
So far, Portugal’s motivation to drive NPLs out of the banking system is report-
edly not because of out-of-control credit lending or lack of viable customers.
• Spain. In 2004, Spain accounted for 20% of all new mortgage loans granted in
the EU. Real estate has also dominated corporate lending, as evidenced in 2004,
when almost 70% of loans to nonfinancial companies went to construction or
property development groups. So far, official estimates can tout low NPL ratios,
thanks to easy monetary conditions and robust consumer spending. However, if
property values drop and interest rates rise in the EU, loans with high levels of
indebtedness could become the banks’ real estate NPLs of tomorrow.
• Slovak Republic (Slovakia). As a former member of Czechoslovakia, Slovakia
has transitioned reasonably well from a centrally planned economy to a modern
market economy. Major privatizations are complete and, like the Czech Republic,
most of the banking sector is foreign-owned. Despite having a high unemploy-
ment rate of around 15% and strong household credit growth, NPLs, for now,
remain a lesser topic of reform. However, the National Property Fund of the
Slovak Republic (NPF) quietly solicited bidders for a portfolio of 260 delinquent
borrowers with a face value of €400 million (U.S. $474 million) to be sold in
early 2006. The outcome of this initial transaction will perhaps shape the future
of NPL dispositions.

69
 At the beginning Governments and banks world-wide clearly continue to progress in address-
ing NPL issues. Japan has succeeded in reviving its economy, reforming
its banking system, and disposing of problem loans. Since 2000, Korea has

of this report, we
disposed of most of its NPLs.

Germany’s banks have been actively selling portfolios of NPLs. Equally im-
portant, regulators have not had to push them to sell portfolios – they
have done so on their own.

asked whether China is at a defining moment: its banks are burdened by a heavy legacy of
NPLs, and more NPLs loom. However, they continue to progress in moving
NPLs off their balance sheets in anticipation of China’s opening its banking

the NPL crisis is

sector to foreign competitors in 2007. Meanwhile, banks in Eastern Europe’s
emerging NPL markets, such as Poland, Turkey, Czech Republic, and others
are moving forward in identifying and resolving bad loans.

Accelerated Resolutions

finally over.
Going into 2006, global NPL activity was the highest in the 20 years that we
have been tracking, analyzing, and commenting on the NPL market. Over
the next few years, the pace of NPL resolutions will further accelerate, as
more banks in more countries sell NPL portfolios. The adoption of Basel II
beginning in 2007 will be a powerful incentive for banks to improve their risk
management of loan portfolios, to quickly identify problem loans, and to act
expeditiously in restructuring or disposing of NPLs. Another reason for the
faster pace of resolutions is the continuing shift from government-directed,
state-subsidized, opaque, local NPL markets to capital-driven, transparent,
global, and increasingly competitive markets. State-owned banks are giving
way to investor-owned institutions; governments are moving from large sub-
sidies of banks and big bailouts of troubled institutions; and, as in China, they
are pushing banks to attract private investment capital and compete globally.

G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6 70
Investors
Around the globe, investors will have more choices in acquiring NPL portfolios based
on geographic region, barriers to entry (high or low), yield requirements, risk toler-
ance, portfolio chracteristics (e.g., large or small portfolios), type of loan collateral
(corporate, real estate, or other) as well as other criteria. In acquiring NPL portfolios,
investors will continue to employ various resolution strategies, including discounted
payoffs and negotiated settlements; loan workouts, restructurings and rehabilitations;
judicial procedures including foreclosures and liquidation; and securitization. They
will need to pay particular attention to the servicing of their portfolios because, as we
noted in this report, proper servicing can make a difference in whether investors meet
their yield requirements, especially in hyper-competitive markets such as Germany.
Going forward, the investment market will evolve into a broader, deeper, and more
sophisticated market, with investors acquiring not only NPL portfolios but, increas-
ingly, portfolios of subperforming and performing loans and, as NPL markets mature,
diversifying into direct investments in banks, corporations, real estate, and other
assets. That will create more opportunities for banks in regional financial centers like
Singapore to provide capital for financing investments in Asia and globally.
Improving Risk Management
While great progress has been made, the question of whether the NPL crisis is over
depends on governments and banks remaining diligent in preventing and managing
NPL problems – they cannot lapse into complacency. Much of the advancement in
NPL markets in recent years – the establishment of global standards and best prac-
tices, the acceleration of portfolio sales, and so on – has occurred in relatively good
times, with the global economy and national economies generally growing, interest
rates relatively low, and inflation in check. The next cyclical economic downturn will
test how well countries and banks have done in reforming banking systems, imple-
menting more stringent capital standards, and improving risk management of loan
portfolios. Those that are not prepared could face a new wave of NPL problems. The
loan problems in the U.S. technology market, Korea’s consumer debt (credit cards)
market, and China’s residential real estate market are all recent reminders that history
can repeat itself. Risk management is a concern of banks in every market, not only in
71
emerging markets such as China, but also in mature markets such as the U.S. Federal
Reserve Chairman Ben Bernanke has said some U.S. banks have experienced rapid
growth in commercial real estate exposures relative to capital and assets and must
ensure they have proper risk-management systems in place.
Successful Resolutions
In contrast with the early days of global NPL resolutions, there are now practices
and strategies for successful resolutions that have been tested and proven in global
markets. These include:
• Leadership. Successful NPL resolution begins with leadership. Government
political leaders and regulators must have the political will to reform national
economies and banking systems in order to build stronger financial institutions,
minimize banks’ NPL exposure, and enable them to compete in global markets.
Certain countries also need to develop the legal framework to facilitate NPL
dispositions, such as clearly defining the rights of creditors (including investors
who have purchased NPLs) and borrowers. Bank leaders must take the initiative
in implementing government reforms within their institutions, adapting global
standards and best practices in portfolio management, and creating systems to
quickly identify and address NPL issues.
• Transparency in NPL portfolio transactions. In order to sell NPL portfolios,
banks must provide detailed information in four areas: the loan, the borrower, the
collateral, and the guarantees. This information must be current, accurate, and
complete, with out-of-date and extraneous information eliminated.
 “Growth of Commercial Real Estate Loans Concerns Fed,” USA Today, March 9, 2006
 Outlook
The key elements of a transparent system are:
• Quality of information. The biggest influence on investor pricing is the quality
of information. Poor quality or limited information increases the uncertainty fac-
tor; the greater the uncertainty, the lower the price that investors will pay. Banks
must ensure that electronic and original file information is relevant, properly
organized, useful, and readily accessible so that investors can get the information
they need quickly and efficiently.
• Consistency of sales process. Investors have come to expect sales processes that
are reasonably consistent from transaction to transaction. Banks therefore need to
organize a well-thought-out sales process based on standard protocols, including
built-in deadlines and key dates for completing the transaction. This signals that
the seller has committed the time, effort, and internal resources to develop infor-
mation and a transaction process consistent with best practices. Consequently,
investors are more confident that the transaction really will happen, which may
help sellers to attract more investors and obtain higher prices for their portfolios.
• LSPA Agreement. The loan sale and purchase agreement (LSPA) is the key legal
document defining the obligations and limitations of the seller, while providing
certain limited representations and warranties (also referred to as guarantees) to
the buyer. Generally the seller’s representations and warranties generate the most
attention. These are representations that the seller makes to an investor about such
things as the amount of the outstanding principal balance of each loan being sold,
the accuracy of loan information provided to sellers, completeness of the files and
enforceability of the documents contained in the files, and the existence of any
cross-collateralization of security interests with loans not being sold by the bank.
If this information turns out to be erroneous, the investor has recourse against the
bank. Consequently, a bank will have to conduct its own due diligence to know
whether to make a representation, determine how to characterize the representa-
tion, and evaluate the risk in making the representation.
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
• Market-driven transactions. Whenever possible, banks should bypass asset
management companies and sell assets directly to investors. Direct sales usually
enable buyers to obtain more complete, accurate, and current information about
portfolios; the portfolios usually are “fresher,” with a larger number and amount
of relatively recent loans and fewer legacy loans; and banks typically can obtain
a higher price than through sales or transfers to AMCs. To be sure, AMCs have
played a useful and important role in China, Japan, Korea, and other countries
in enabling banks to move large portfolios of NPLs off their books. But govern-
ments intended them only as a temporary solution until banks were able to sell
NPLs directly as part of the process of preparing to compete in global markets.
As we noted in this report, China’s AMCs are under a mandate to complete liqui-
dation of assets and transform themselves into commercial enterprises after 2006.
• Attract global investment. Global investors have the capital, the knowledge, and
the experience to efficiently identify investment opportunities, conduct due dili-
gence, negotiate terms and execute NPL transactions. As NPL markets mature, lo-
cal investors with the requisite capital may enter the market to bid for portfolios.
• Market clearing prices. Some banks have resisted inviting global investors to
bid on portfolios because prices for initial transactions may be relatively low. But
once these transactions have been completed, experience has shown that banks
often are able to attract more investors, increase competition, and push up prices –
assuming they are providing investors with current, complete, and accurate port-
folio information.
• Consider use of advisors. Banks may wish to consider the use of advisors with
global and capital markets expertise to assist them in analyzing portfolios, evalu-
ating NPL problems, planning and implementing dispositions, and finding and
qualifying buyers. Advisors can help banks to expedite the disposition process
and close transactions more quickly.
72
 Historical Peak NPLs – by Country ($ U.S.)
Over the past 20 years, governments and banks have had to struggle with
$ U.S. Billions
some U.S. $4 trillion in bad loans, which resulted partly from cyclical

00
00
00
00
0
0
0
0
0
0
0
0
0
downturns in national economies or property markets, a high rate of cor-

1,0
1,1
1,2
1,3
10
20
30
40
50
60
70
80
90
porate bankruptcies or business failures, and other events that they could

10

20

30

40

50

60

70

80

90
0
not directly control. But to a great extent, the NPL problem has been a
problem of their own making. Now, with the benefit of 20 years of experi-
ence, the growth of a global NPL market, the ready availability of foreign
Japan
investment in NPLs, and the establishment of global NPL standards and U.S.
best practices, governments are better able to manage banking systems –
and banks are better able to manage portfolios to prevent a recurrence of China
NPL problems. To be sure, the problems will never go away, but they are Germany
manageable. So the question of whether the NPL crisis is finally over is
one that will be decided by governments and banks themselves. Other Europe
Taiwan
Thailand
Korea
Indonesia
Malaysia Shaded area indicates change in scale

India
Philippines

Source: Ernst & Young

73
 E r n s t & Y o u n g P u b l i c at i o n s /C o n ta c t s
Ernst & Young Global Real Estate Publications
Market Outlook: Trends in the Global Real Estate Newsline
Real Estate Private Equity Industry
A new survey of fund sponsors by Ernst & Young’s
Global Real Estate group reveals why the various
forms of private equity funds are such a hot commod-
ity these days. Differing risk levels in the various fund
opportunities are one factor investors consider.
www.ey.com/us/realestate
Global Real Estate Investment Trusts (REITS)
Over the past 10 years REITS have been enacted
in many countries world-wide. The Ernst & Young
electronic Real Estate Guide includes the International
Tax Treatment of REITs chart and map and displays
important REIT information by country.
www.ey.com/realestate
G l o b a l N o n p e r f o r m i n g L oa n R e p o rt 2 0 0 6
“Real Estate Newsline” is a triannual newsletter
containing articles addressing hot topics and issues of
importance in the real estate industry around the world.
Included in each issue is an Insider’s Report by
Global and Americas Director of Real Estate, Dale
Anne Reiss. www.ey.com/us/realestate
Real Estate Market Outlook 2006
Professionals from Ernst & Young’s Global Real Estate
practice assess the numerous opportunities and chal-
lenges to the industry for the coming year. Read their
insights on global trends in housing, industry invest-
ments, growth economies, regulation, the hospitality and
gaming sectors, and more. www.ey.com/us/realestate
74
 CONTACTS
CHINA INDIA
8610 5815-3000 91 11 5159 4164 POLAND
48 22 557 7595
Jack Rodman Badri Narayanan
jack.rodman@cn.ey.com badri.narayanan@in.ey.com Tomasz Bieske
91 22 5665 5220 tomasz.bieske@pl.ey.com
Peter Chan
peter-kk.chan@cn.ey.com Jayesh Desai Arkadiusz Krasowski
jayesh.desai@in.ey.com arkadiusz.krasowski@pl.ey.com
Franny Yao Fang 91 11 4149 4170
franny.yao@cn.ey.com Andrzej Broda
INDONESIA andrzej.broda@plyey.com
EUROPE 6221 5289 5000
SINGAPORE
Chris Seyfarth Agustinus Irawan 65 6535 7777
chris.seyfarth @ey.com agustinus.irawan@id.ey.com
1 617 570 8420 Winston Ngan
JAPAN winston.ngan@sg.ey.com
Brian Smoyer 813 3595 8414
brian.smoyer@ey.com TAIWAN
49 160 939 16543 Ryo Kuwasaki 8862 2720 4000
ryo.kuwasaki@jp.ey.com
GERMANY Jenny Chen
Satoshi Yamada Jenny.Chen002@tw.ey.com
Andreas Diehm satoshi.yamada@jp.ey.com
andreas.diehm@de.ey.com 813 3595 8410 Rallie Cheng
49 61 96996 27430 rallie.cheng@tw.ey.com
Kenji Kobayashi
Thomas Griess kenji.kobayashi@jp.ey.com THAILAND
thomas.griess@de.ey.com 813 3595 8403 66 2264 0777
49 61 96996 26258
KOREA Ratana Jala
Karl Hamberger 22 3770 0849 ratana.jala@th.ey.com
karl.hamberger@de.ey.com
49 89 14331 13662 Tae-Ho Hong Kusuma Vivattanaprasert
tae-ho.hong@kr.ey.com kusuma.vivattanaprasert@th.ey.com
Chris Seyfarth
chris.seyfarth @ey.com PHILIPPINES United States
1 617 570 8420
John Ryan Dale Anne Reiss
john.ryan@ph.ey.com Global and Americas Director of Real Estate
632-894-8179 dale.reiss@ey.com
212-773-4500
Dominador T. Gregorio
dominador.t.gregorio@ph.ey.com
632-894-816


About Ernst & Young
Ernst & Young, a global leader in professional services, is committed to restoring the public’s trust in professional services
firms and in the quality of financial reporting. Its 107,000 people in 140 countries pursue the highest levels of integrity, quality,
and professionalism in providing a range of sophisticated services centered on our core competencies of auditing, accounting,
tax, and transactions. Further information about Ernst & Young and its approach to a variety of business issues can be found at
www.ey.com/perspectives. Ernst & Young refers to one or more of the members of the global Ernst & Young organization.

© 2006 EYGM Limited

All Rights Reserved.

This publication has been carefully prepared but it necessarily contains information in summary form and is therefore intended for
general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM
Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person
acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the
appropriate advisor.

EYG No. DF0005