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					DEFAULTS AND RECOVERIES


  AECM SEMINAR – BAD HONNEF, 2006
  André Douette, AECM
DEFAULTS AND RECOVERIES

  -Context of the seminar
  -Is benchmarking possible?
  -Accounting matters.
DEFAUTS AND RECOVERY MANAGEMENT
I. Context

 Insovencies, fresh start, probability of
  defaults, bankruptcy proceedings are in the
  forefront of business concerns nowadays.

 The AECM Seminar sees in it an issue of
  setting a business strategy and establishing
  sound management practices.

 The seminar is an opportunity to exchange
  good practices and not to settle standards.
DEFAUTS AND RECOVERY MANAGEMENT
Context

 Losses are an inevitable by-product of a
  guarantee activity.
 The question is not «how to avoid losses?»
  but rather to see to it that the mission of
  our Guarantee Schemes is achieved
  properly with an adequate balance between
   Their incentive mission in favour of SMEs access
    to finance
   Their long term sustainability: bearable losses
    and capacity to increase the equity.
DEFAUTS AND RECOVERY MANAGEMENT
II. Benchmarking ?

 Benchmarking Guarantee Societies
  accordingly their rate of loss is unrealistic
  and leads to erroneous conclusions:
   Their guarantee contract is diversely qualified
   They pursue different objectives
   Their creation is recent / ancient,
   They operate in diverse economic situations
   They have different kinds of relations with
    partner banks
   They serve different types of clientele
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to guarantee qualification

  Loss Sharing guarantees: the loss is
   shared between lender and guarantor
   on credit balance after recovery of
   pledged collaterals

  Joint and several guarantees: the
   proportion of the guarantor in the risk
   is paid on the credit balance at the
   time of credit denunciation.
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to guarantee qualification

  Example
     Investment credit(purchase machine): 100
     Collaterals: exclusive right on machine+ financial
      account (20) + Guar. Soc ( GS: 60%)
     Denunciation: 84 (Cap. 75 + Int. 9 past due)
     Recovered: 30 (20 account + 10 machine)
                        Breakdown of losses

                  Loss sharing           Joint & Several
 Share GuarSch (84-30)*60%= 32,4          84 * 60%= 50,4
 Share Bank    (84-30)*40%= 21,6         84-30-50,4 = 3,6
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to additionality objectives

  Promotion of start-ups financing, of long term
   loans represent virtuous objectives that lead to
   a higher economic additionality of the scheme
  They potentially involve higher credit risks…

  E.g. Portfolio             EU Country1   EU Country2
    -   Start-ups               42%            15%
    -   Average maturity       7 years       3 years
    -   Guar/ Loan %             80%          50%
    -   Rate of default          4,6%         1,5%
    -   Net leverage effect       7x          6,4 x
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to additionality objectives

  Promotion of High Technology firms bridges a
   serious market gap and is good for the
   economy (relevance and economic
   additionality)…
  This strategy involves higher credit risks…

  E.g. Portfolio               EU Country3
   - Early Stage Biotech, IT:    > 70%
   - Rate of default             > 10%
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to anciennity of the scheme

  More ancient schemes have track records and
   statistical materials + larger portfolios Thus
   better predictability
   Ex. Spain, Italy, Germany…

  Recent schemes had a business plan in which
   the expectation of losses was the most
   unpredictable element. They must have careful
   policies. Nothing is worse than a too rapid
   growth in a launch phase.
   Ex: MGS created in 1994. First loss cases: 1 in
   1999, 3 in 2000… TIME LAG!
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to economic situations

  UK survey confirmed by Belgian case in the
   early 80’s: loans granted in the peak of the
   economic cycle will results in increased rates of
   defaults

  Increasing inflation rates are a factor of risk
   worsening, mainly in countries where the credit
   interest rates are fluctuating and linked with a
   reference rate (e.g. Euribor)

  Systematic discrepancy between more- and
   less developed regions (South / North Italy;
   Flanders / Wallonia in Belgium…)
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to relationship with banks

  EU Country: MGS + its sister Bank
    A actual partnership + a mutual mindset = a supply
     also to clients with a real creditworthiness
    Default rate≈ 0,6% p.a.


  A « Anglo-Saxon » banking culture
    Banks apply for a guarantee in cases of « extreme »
     need, unless either they would grant the loan at own
     risks or they would refuse it.
    Rate of loss up to
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to clients’ position

  UK Survey SBS 2004:
    Larger loans are more likely to default than smaller
     transactions

    Start-ups less than 2 years are much more
     vulnerable than existing Cies.

    Working capital guarantees increase the rate of
     default insofar the lack of liquidity is not a result of
     growth but of a weaker position
DEFAUTS AND RECOVERY MANAGEMENT
Defaults related to clients’ position

  Specific risks run by SMEs:
    Business features
         Under- capitalisation,
         Weak economic power,
         Businessman= « all round man »
         Lack of long term strategy,
         Poor knowledge of their financial situation…
    Personal risks
         Desease, divorce, family disputes,
         Confusion business assets and personal havings,
         Unprepared transfer, death of the founder,
         Unwillingness to disclose difficulties…
DEFAUTS AND RECOVERY MANAGEMENT
IS BENCHMARKING POSSIBLE?
IS THE PREMIUM A REGULATION?

  A benchmark results of a comparison of
   similar situations.
   Losses can’t found a benchmarking analysis !
   Sustainability in a given environment of
   support and in a given strategy of additionality
   is the standard criteria of utility.
  Can the premium management match the
   fluctuation of losses? SLIGHTLY !
     Low premium =too may weak transactions come into
      the portfolio without a risk reward
     High premium= too few good transactions are
      registered because of the high price.
DEFAUTS AND RECOVERY MANAGEMENT
III. Accounting and statistical methods

  Confusion possible between:
    Rate of survivability / Rate of default
    Rate of default (PD) / rate of final loss (PD –
     LGD)
    Gross loss / Net loss
  Measure instruments:
    Accounts (financial statements)
    Statistical instruments
DEFAUTS AND RECOVERY MANAGEMENT
Vocabulary

 Survivability / Default
   Survivability: « How many transactions from
    a portfolio generated in year x remain
    standard (alive) in year x+1, x+2, x+3… »
      = approach for the forming of comprehensive
       risk provisions
   Defaults: « How many transactions out of
    the outstanding portfolio of year x have
    been qualified defaulting in that year? »
      = measure of PD in the Basel 2 approach
DEFAUTS AND RECOVERY MANAGEMENT
Vocabulary

 Default
      Usual meaning: claim, amount that the guarantor is
       entitled to pay to the guaranteed lender
      Basel 2 : an event occuring either if the obligor is unlaikely
       to pay its credit obligations in full without actions such as
       realising securities, or if the obligor is past due more than
       90 days on his credit obligations. Thus requiring a higher
       equity to back his risk (150% of ordinary requirement)
 Loss
      Usual meaning: the amount that has been disbursed to the
       guaranteed lender accordingly the contract signed with
       him.
      Basel 2 : economic loss, including material discount efffect,
       and material direct and indirect costs associated with
       collecting of the instrument.
DEFAUTS AND RECOVERY MANAGEMENT
Vocabulary

 Gross default / final net loss

    Gross default = total outstanding guarantee balance
     at the occurrence of the event «default »

    Net losses = total final amount paid by the Guarantee
     Scheme to the lender, resulting of the provisional
     gross amounts paid, the interventions received from
     a counter-guarantor and the amounts recovered from
     debt collection proceedings
DEFAUTS AND RECOVERY MANAGEMENT
Accounting principles

   Accounting toolkit provisions:
 General prescription: financial accounts must
  be sincere and accurate.
 International Accounting Standards (IAS 37)
   Provisions = liabilities of uncertain timing and
    amount.
   Must be recognised and disclosed when (only when)
           An enterprise has a present obligation as a result of a past
            event
           An outflow of resources will probably be required to settle
            the obligation
           A reliable estimate can be made of the amount of the
            obligation.
   Must only be used for the expenditure for which it
    was originally recognised
DEFAUTS AND RECOVERY MANAGEMENT
Accounting principles

 Toolkit for measurements: accounting
   What is registered in P&L?
   Mainly provisions, formed when it is likely that
    an outflow of resources will result from the
    substandard situation of a guaranteed loan.
   What amount? The best estimate of the
    expenditure (present value of the expenditure
    expected to be required to settle the
    obligation
 →Information delivered by P&L must be
  analysed with precaution
DEFAUTS AND RECOVERY MANAGEMENT
Accounting principles

 Reporting in Basel 1 (Belgium)
      Guarantees       P&L Provisions   Bal. Sheet Provisions



       Situation Time To
      + Increments in the period
      - Deduction in the period
      = Situation end of Period T1

 For each category; standard, uncertain and unrecoverable
DEFAUTS AND RECOVERY MANAGEMENT
Statistical methods

 Toolkit for measurements: statistics
   New methodology based on Basel 2:
     P.D. : the probability of default of a counter
      party over a one year period
     L.G.D.: the ratio of the loss on an exposure due
      to the default of a counterparty to the amount
      outstanding at default.

    Thus new calculations are necessary, in line
    with Basel 2 through a system of statistics.
Thank you for your attention


European Mutual Guarantee Association
 40, rue Washington, 1050 Brussels
info@acm.be www.aecm.be

				
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