Asia's underwater loans. (Cover Report: Commercial).

"WE KNOW THAT YOUR STRATEGIES WORKED IN THE UNITED STATES, JAPAN, KOREA, THAILAND AND CHINA, BUT THEY WON'T WORK HERE." That's the mantra we hear over and over again from officials throughout Asia as we move to help governments, banks and regulators address the staggering nonperforming loan (NPL) problem. It's a problem all across the region--in Thailand, Indonesia, Malaysia, South Korea, China, Japan, even Taiwan, the Philippines and India (see Figure 1).

* NPLs in Asia have reached US$2 trillion, a whopping 30 percent of regional gross domestic product (GDP), literally smothering economic growth and fiscal recovery in the region (see Figure 2).

* Once kept in the shadows as Asia's dirty little secret, these distressed assets are now front-page news and the topic of endless debate. Yet despite this increased visibility--certainly slow in coming--the NPL problem and its impact on the global economy go unaddressed.

* Why is a phenomenon so rampant among Asian economies being dealt with so secretly by central b anks and finance ministries? Hasn't the whole world witnessed the effects of nonperforming loans in all major economies at one time or another? Canada, Mexico, Sweden and other European countries all had to address the problem long before it struck Asia, and the United States struggled through the granddaddy of them all: the savings and loan crisis.

The key to economic recovery

It is difficult to understand what makes NPL resolution so abhorrent to government bureaucrats and bank executives in Asia. If a loan made to a borrower was secured by a property valued at $100 and that property today is worth only $50, no amount of wrangling will make a bankrupt borrower repay the $100 when his or her collateral is worth only half that amount. Neither will any reasonably astute borrower offer to turn the property over to the bank if he or she will still be on the hook for the balance of the loan.

Moreover, no amount of pressure can cause the value of the building to increase to $100 again, although it will gain in value as the economy recovers. And therein lies part of the problem--the idea that "if I hold on to the asset, maybe it will be worth more in the future." When all lenders and borrowers take that approach, the result is the kind of economic strangulation that is taking place in Asia today.

We view the resolution of nonperforming loans as an economic moral imperative to return local Asian economies to health and sustained growth. NPLs can serve as an economic engine to kick-start the local economy and create tens of thousands of jobs, producing a multiplier effect on the economy as those payroll gains reverberate throughout the economic system.

Start the ball rolling

So who has the moral imperative to go first to make a better economy for everyone? Clearly, this is not the purview of the private sector, whose primary obligation is to shareholders. The government must get the ball rolling but it is Loath to take on the direct responsibility unless forced to act, as was the case with the bank failures in the United States, Korea and Japan.

The countries that have tackled their NPL problems most successfully have been those where the government initiated action early on. In each case there were fits and starts, but on the whole the efforts had a beneficial effect on the economy in the short term and positioned each country for economic recovery.

In many countries, the recovery faltered as reform fatigue set in at the first sign things were getting better. Examples include Korea and Thailand, where the International Monetary Fund (IMF) bailout called for the closure or sale of several government-owned banks to foreign investors. Parliament was unable to accept market value for these assets, viewing the prices as too cheap, and efforts to sell troubled institutions faltered. The delay has cost taxpayers untold billions as these troubled institutions languish under government stewardship.

The government should not necessarily purchase the loans from troubled banks as a form of bailout--enriching bank shareholders at the expense of taxpayers. It does have an obligation to enforce sound banking principles, safeguard the financial system, provide transparency and full disclosure, and ensure the safety of deposits. By the same token, the government cannot nationalize every bank in the country, neither should it take on the massive task of trying to micromanage each and every bank.

The role of government should be to provide the incentives for banks to address their own problems and to support them in taking the important first steps needed. In this regard, Ernst & Young believes that the majority of the NPLs must be removed from the bank and placed with an agency that will organize the private sector to take responsibility for the timely resolution of the NPLs on a case-by-case basis. That was the primary function of the Resolution Trust Corporation (RTC) in the United States, and it is the stipulated goal of the most successful asset management companies (AMCs) in Asia--most notably Korea's KAMCO and Thailand's Financial Sector Restructuring Authority (FRA).

Why not leave it to the banks?

While one can argue that banks should tackle this task directly, self-regulation and self-assessment of NPLs have failed in every country where it has been tried. Even today, the total value of NPLs reported by government statisticians represents only half the actual value of the distressed loans, based on Ernst & Young's experience working in Asian countries (see Figure 3). Why is this? Clearly there is political pressure on banks in some countries to understate NPL problems. Yet there are also difficulties in defining an NPL, and there is no standard valuation methodology for financial institutions to follow in establishing reserves for loan losses. Our estimates are based on our years of experience as a financial adviser stretching back to before the evolution of the Resolution Trust Corporation (RTC) in the United States.

Additionally, the problem of resolving the loans within the originating bank creates a moral dilemma for two reasons. First, it is anathema for bankers to reward what is in their view a deadbeat borrower by offering a discounted payoff or debt forgiveness in exchange for an uncontested sale of collateral. How can a bank explain to a "good" borrower who is struggling to keep his or her loan performing that a "bad" borrower is being rewarded with a large discount and debt forgiveness to settle the loan quickly? This creates a terrible moral hazard for the bank.

Second, bankers by nature expect borrowers to honor their financial obligations and make every effort to repay their loans in full. An account officer in a bank's NPL department might not be rewarded by his superiors for advocating a 60 percent discount to resolve a problem credit. However, an account officer working for an asset management company in the private sector as a special servicer might receive a huge bonus for resolving a loan for 40 cents on the dollar, even though the investor paid only 20 cents. At this point, the history of the loan and the relationship between the bank and the borrower is irrelevant. What counts is the present value of the recovery.

Loan-servicing specialists working in asset management companies to resolve troubled loans are not burdened with the whole history of the loan. They did not originate it. They were not the ones deceived by the borrower. They were not involved in renegotiations time after time. So they can address the situation objectively, focusing on developing the best strategy for getting the maximum amount repaid in the shortest amount of time. If the way to do that is to offer the borrower a negotiated settlement and a big discount to repay the loan, or to hand over collateral in exchange for debt forgiveness, then that strategy becomes the preferred option.

But how can this approach be good for the economy? It appears that only the borrower and the investor have benefited. The answer lies in what happens to the asset and the borrower when the bank is relieved of the burden of a dead loan. Possibly the borrower will be free of its debt burden or will be restructured so that it can continue operating. The investor bought the asset at its fair market value (albeit at a discount), and can reinvest new capital in the asset to improve it.

The bank is unburdened with the NPL off its books, and management doesn't have to spend a disproportionate amount of time on troubled assets. With a clean balance sheet, the bank can recapitalize and provide new loans to creditworthy borrowers to help stimulate the economy. In every country Ernst & Young has surveyed, a market to finance purchasers of NPLs has emerged, providing investors with loans at a conservative loan-to-value ratio (generally 50 percent to 60 percent of the purchase price) to acquire NPL portfolios.

Overcoming objections

When government regulators and bank management teams lecture me on why the NPL situation in their country is different, I always listen attentively. Then I point out that for every difference in their country, there are an equal number of similarities that will allow us to overcome the legal, business and cultural barriers to bringing in foreign investors to purchase and manage NPLs. Let's address some of the most commonly voiced concerns:

"We don't want to sell our assets to foreign investors (i.e., vulture funds) at fire-sale prices." No country wants to be forced to sell assets to foreign investors at huge discounts. But where else will the capital come from to buy NPLs? There are no long lines of local investors in any country waiting to purchase NPLs from banks at any price. So if only foreign investors are willing to open the market and go first, then that process results in the current fair value for the assets. (Note: a competitive auction with excellent seller due diligence and an experienced financial adviser are essential to ensure that foreign investors pay market clearing prices for their purchases.)

"Our legal and regulatory framework does not allow foreign investors to own real estate) service loans, use foreclosure or bankruptcy proceedings to enforce creditor rights, repatriate capital and profits, or provide a currency hedge." In every country, much can be accomplished under current laws and regulations. And all countries have been successful in establishing AMC laws and special-purpose corporations to allow foreign participation in the NFL resolution process.

"Foreign investors do not understand how to do business in our country, so why should we turn our assets over to them to resolve?" Foreign investors will establish operating partnerships with local companies to assist them in servicing their loans. This is an important component of the economic-multiplier effect mentioned earlier. Local professionals will be employed to help in this effort. This is due to the fact that foreign investors have only a handful of experienced expatriates in the country to develop the business, establish the systems and infrastructure, and train the local personnel on their strategies and loan-servicing processes.

In Japan today, more than 6,000 Japanese professionals are working for foreign asset-management companies servicing NPLs. This industry did not exist just a few years ago.

"Selling assets at discount to foreigners will further depress the market and create additional loan loss reserves." To the contrary--getting the assets into the hands of private investors will stimulate the market. Competitive auction bidding has increased the value of NPLs in every country that stayed with the program for more than one transaction (e.g., RTC, KAMCO and the FRA). In fact, as NPL prices increase through multiple competitive auctions, the NPLs remaining on banks' books increase in value. At KAMCO, we witnessed early sales of NPLs at 8 percent to 12 percent of face value rapidly increased to 35 percent of face value as investors competed to get into the Korean market while values were still increasing.

"Our banks and other financial institutions do not have sufficient capital adequacy to properly position their NPLs to be sold without taking losses that will impede their capital adequacy ratio." NPLs will only continue to erode capital adequacy, year in and year out, as they remain on banks' books. Eventually, regulators will force banks to write down their NPLs to current market value.

The key for most banks is to send a message to government regulators, rating agencies and financial analysts that makes these points:

* We have identified our NPL position.

* We have developed a strategy for resolving our NPLs over the next three to five years.

* We have embarked on an orderly and structured process to reduce NPLs to sustainable levels with specific annual targets.

* We are asking for forbearance from government agencies and the participation of foreign experts to assist us in this endeavor.

* We are committed to financial reform and using international best practices.

Many banks benefit from this straightforward approach to the NPL problem--most notably Thai Farmers Bank in Thailand, which brought in Goldman Sachs and GE Capital to help manage its NPL portfolio. Both companies have extensive experience in resolving problem loans and were instrumental in helping AMC recover cash totaling about 20 percent of unpaid principal for corporate loans and 50 percent or more for mortgages.

What is needed is a concerted effort to help countries accelerate their NPL programs and return these assets to the private sector, where they can be resolved and brought back to the general economy. Perhaps the multilateral agencies, which were quick to step into the Asian economic crisis in 1997, can refocus their efforts to help countries work through the detritus of the NPL problem.

The Asian Development Bank (ADB), the International Monetary Fund (IMF), World Bank and the U.S. Agency for International Development (USAID) all have shown strong interest and hosted seminars and studies to help educate stakeholders. And recently, in the first NPL portfolio sale at China Huarong AMC in Beijing, the International Finance Corporation (of the World Bank) agreed to provide acquisition financing to qualified international investors. A more direct effort by the IMF and ADB could make a vital difference to countries still struggling to get the NPL resolution process started.

It's time the NPL problem and resolution strategies get the attention that a $2 trillion problem deserves. Despite the massive size of Japan's economy or the strong economic growth in China's markets, the NPL problem still poses the most significant economic risk to sustained recovery in Japan and continuation of economic growth in China. All the other markets--despite some early successes--are still bogged down by the NPL problem, and even countries like Korea, Thailand, Malaysia and Indonesia, which took early action, haven't resolved enough of the problem to be sure of sustained economic growth.

There is a hidden "NPL effect" that impedes gross domestic product (GDP) growth through the overhang of nonperforming assets in the financial sector. Economic models generally do not take into consideration the lost economic activity resulting from 15 percent to 30 percent of nonproductive GDP that is not contributing to the economy. In late 2001, the World Bank reduced GDP growth across Asia, citing, among other things, a failure to adequately reduce NPLs in the financial sector and the slow progress being made in restructuring some of Asia's largest companies.

Until the NPL issue is formally addressed and a uniform approach is adopted to measure and manage NPLs, we can expect the moribund performance in the Asian economies to continue. Resolution of the NPL problem is key to economic revitalization in Asia, and will act as a flashpoint in creating a sustained economic recovery. The time for finger-pointing is over. The time for action is now.

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Jack Rodman is a managing director with Ernst & Young's Asia Pacific Financial Solutions Group in Tokyo. He has studied Asian capital flows since 1985 and has written an annual study on the subject. In 1997 he moved to Asia to begin assisting banks and government agencies with strategies for managing their NPLs. The Wall Street Journal credited Rodman with opening the distressed debt markets in Japan. Forbes, Business Week and Euromoney magazines have all reported extensively on Ernst & Young's success in establishing the distressed debt markets across Asia. In December 2001, Rodman served as financial adviser to China Huarong Asset Management Company, the largest AMC in China, in disposing of $2 billion of NPLs to an international consortium of investors. Rodman is currently helping to develop the distressed asset markets in Taiwan, the Philippines and India.