Workout management of non‐performing loans. A formal model based on transaction cost economics

Pages59-79
DOIhttps://doi.org/10.1108/14635780810845163
Published date08 February 2008
Date08 February 2008
AuthorNico B. Rottke,Julia Gentgen
Subject MatterProperty management & built environment
Workout management of
non-performing loans
A formal model based on transaction cost
economics
Nico B. Rottke and Julia Gentgen
Real Estate Management Institute, European Business School,
Wiesbaden, Germany
Abstract
Purpose – The German banking sector has recently been facing high real estate loan default rates
resulting in the accumulation of a high volume of distressed real estate debt in the banks’ balance
sheets. As a consequence, German banks are confronted with the workout of their non- and
sub-performing real estate loans to proactively solve the problem. When doing so, banks have to
decide whether they want to conduct the loan workout in their own workout departments (integrative
approach) or whether they prefer to outsource the workout to a third party servicer or even sell their
bad loan exposure to an external investor (disintegrative approach). This paper aims to investigate
this issue.
Design/methodology/approach – A bank’s decision to employ an integrative or a disintegrative
approach can be transferred into a make-or buy-decision as described by the transaction cost
economics. The transaction between the bank and the workout manager is analysed by the transaction
characteristics of the transaction cost economics. The specificity of the human capital required for the
loan workout of real estate loans is a key consideration for answering the question of integration or
disintegration. Assuming highly specific investments for both, the workout manager and the bank, a
formal model compares the aggregated pay offs for the bank and the workout manager to determine
the optimal control structure for the specific assets.
Findings – Following the assumptions of the transaction cost economics, the specificity of the
investment of the workout manager (and also the bank) is crucial for the decision of integrating or
disintegrating the workout of real estate loans. The degree of specificity required to perform the
workout tasks depends on the status of underlying credit engagement and the characteristics of the
collateral (the real estate). The formal analysis shows that the bank and the workout manager both
under-invest in integration and disintegration scenarios. However, if the degree of specificity of the
investments is equal, nonintegration is superior to integration. Forward integration is superior to
nonintegration, if the bank’s investment is more specific than the workout manager’s investment.
Originality/value – This research paper approaches the problematic from an academic stand point,
integrating both the banking and the real estate perspective and aims to provide a recommendation for
banks on the integration or disintegration of the workout unit for a certain real estate secured loan
portfolio.
Keywords Banking, Germany,Real estate, Loans, Default, Transaction costs
Paper type Research paper
1. Problem environment and aims of the study
While non-performing loans are a phenomenon that is permanently present in the
balance sheets of banks and other lending institutions, the significant rise of
non-performing loans in banks’ balance sheets and the emergence of a non-performing
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
Workout
management
of NPLs
59
Received July 2006
Accepted October 2006
Journal of Property Investment &
Finance
Vol. 26 No. 1, 2008
pp. 59-79
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780810845163
loan (NPL) market are a temporary phenomenon. Several economies have experienced
such distressed debt cycles. In the USA, the non- and sub-performing loans resolution
was embedded into the savings and loans crisis from 1989 to 1994. In Japan, the NPL
cycle began in 1997 and Chinaand the rest of Asia deal with NPLs and SPLs since 1999.
In Germany, the firstpublicly known transaction occurredin 2003 (compare to Figure 1).
To estimate the magnitude of the NPL-problem to be solved in order to lead the
market back into a healthy environment, the following rule of thumb might apply to
Germany: If the sum of all German bank balances equals EUR 6.400 billion and the
default ratio of loans typically lies around 5 percent, this leads to a market potential of
NPLs of around EUR 320 Mio. Approximately 50 percent of these loans are secured
with real estate, so the maximum potential of a German real estate NPL-market lies
around EUR 160 billion. Other estimations with regard to lending volume as basis
show even lower figures.
It has to be kept in mind though, that not all of real estate NPLs will be sold as some
credit relations or their underlying real estate are too specific in order to achieve an
acceptable market price. Thus, the potential might even be a little lower than the
afore-mentioned figure.
A market generally builds up an amount of NPLs over time. The structural reasons
for the upcoming of such markets vary for every country. German banks suffer from a
low return on equity. There are several reasons for this phenomenon which lead to
efforts in cost savings and concentration on core competencies and consequently to the
necessity of an active management of non- and sub-performing real estate loans. The
following reasons are the origin of the emergence of a non-performing loan market in
Germany:
.German banks are affected by the current recessionary environment and feel the
consequences of the volume-, but not a risk-oriented aggressive lending policy of
the last decades.
.The banking sector itself is over banked. Consolidation and restructuring
becomes necessary.
.The expiration of state guarantees for banks governed by state became effective
in June 2005. Therefore these institutions have to clean up their balance sheets in
order to increase their profitability.
Figure 1.
Temporary worldwide
non-performing loan
markets
JPIF
26,1
60

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