Andy Smith is a Tax Director at PwC while colleague Mark Batten acts a Restructuring Partner. As distressed bankers seek a viable strategy for their distressed loan portfolios, Andy and Mark offer guidance on workouts.

It has been an unprecedented few weeks. Huge asset write downs and record losses posted at the main lending banks, commitments to wholesale internal restructuring and refocusing strategies on core business. With lenders lining up to commit toxic assets to the Government’s Asset Protection Scheme and the phone ringing “off the hook” from asset managers keen to assist with non-performing real estate loans, how do lenders navigate their way forward?

It is worth remembering that the Asset Protection Scheme does not absolve banks from continuing to manage distressed asset portfolios; it does, however, provide protection against further adverse loss development.

Selling loan portfolios in the current climate is certainly possible but pricing levels hardly make this an attractive option. Deals can be done but most lenders would prefer to take advantage of any price rebound in the medium term. The Asset Protection Scheme and/or further rounds of fundraising will allow lenders to avoid fire sales and, together with “good bank/bad bank” initiatives, enable institutions to plan a more measured realisation strategy.

However, such a breathing space may not make the task ahead any easier. Banks are faced with a series of exceptional challenges in developing medium term strategies to deliver shareholder value. These include seeking to support current carrying values and minimising further loan impairments.

Impairments are bad news for the balance sheet and P&L while requiring deductions against the regulatory capital base. Regulatory capital, as we have observed over recent months, is finite. Even where accounting impairments are unnecessary (e.g. the loan asset is ‘held to maturity’), short-term fluctuations in underlying values can still erode regulatory capital resources.
The regulatory capital models employed by Banks are subject to detailed technical rules. Loans are assigned a risk weighting that impacts upon the overall capital the Bank is required to hold. Should key performanceindicators such as LTV covenants or the security of the borrower deteriorate, the regulatory capital cost of holding loans may increase rapidly. The recent rise in LTV ratios (reflecting falling asset values) may lead to recalculated risk weightings - significant increases in regulatory capital requirements that impair and restrict workout options.

Structures are currently being developed that will enable Banks to hold loan assets minimising impairment and deductions against Tier 1 Capital while offering potential upside should economic conditions improve. Such structures can also be used as an effective platform for introducing 3rd party asset management and capital in a tax efficient manner.

Notwithstanding such structures, a key decision will be whether to hold/dispose of the loan asset or effectively foreclose and bring the property on to the Bank’s balance sheet. The latter option is not always attractive from a regulatory capital point of view. A preferable approach would be to retain the loans while exercising control over the underlying asset (assuming the borrower is insolvent) by exercising rights under the Bank’s security and appointing a fixed charge receiver or administrator. Assuming a sale is not appropriate, the intention will be to hold the property until conditions improve.

If there is any likelihood of value in the equity of redemption (e.g. the value of the asset after settling liabilities and costs), structures referred to above could be used in due course as a means of capturing or sharing this upside.

Where a wholesale disposal of real estate loans is unlikely at current prices, 3rd party capital can still play an important role in workout strategies. The challenge for the Banks is assessing the desirability of various offers for investment and support. Apart from obvious pricing considerations, such offers will have tax, accounting and regulatory capital implications as well as governance and risk management considerations. Investors that adopt a flexible approach, presenting deal structures that address these diverse considerations, will find they enjoy a warmer response.