Residential NPLs-As Safe as Houses

Investment theory dictates that the greater the investment, the higher the risk, but suitably originated, the greater the return. Conversely, the smaller the investment, the lower the downside, but with it, the potential gain. Investment in secured loans is then compounded by the presence of collateral security, which in principle should make bankrolling mortgaged NPLs bullet-proof. Having seen the original secured loan go sour, one would have thought that NPL investors could not make the same mistake twice, but they often do. Where all the number technology and theory goes awry is the people factor. Every individual borrower, loan-originator, servicer and investor is unique, and therein lies the NPL investment arbitrage, the uncertainty and the opportunity.

NPL monetization falls into three broad categories. At the bottom of the scale are small credit card and personal loans which are driven by systems and process efficiency. In the middle are residential mortgages that require elements of consumer loan collection, but demand a far more sophisticated management skill set. At the top end of the scale are the largest corporate loans which demand the highest technical knowledge and collector skills, but with the greatest potential for striking gold. In this rarified arena, mathematics, smart strategies and entrepreneurial skills come into their own, but conversely, so the people uncertainty risk peaks too. For the biggest loans, motivation for investor gain and borrower resistance to loss collide together to hit their zenith.

Commercial environment and jurisdiction also have a huge part to play in NPL monetization. In mature, western markets, where legal systems and processes are transparent and predictable, traditional investment theory stands the best chance of prevailing. This being the case, investing in the largest commercial or corporate debt should create the highest resource/time value return with the greatest potential upside for distressed investors. Predictability is the key to accurate underwriting and consistently maximizing returns. Where western investors are most likely to go wrong, is when they try to export this expertise and apply the same western market logic to the more opaque, immature, emerging markets such as those in Southeast Asia.

In adolescent markets, a lack of transparency is often compounded by a convoluted legal system that favors borrowers over creditors, particularly if the creditor is a rookie foreign investor. NPL investors who take emerging market appraisals at face value deserve to lose their shirts. Conversely, those who apply a broad-brush discount to create an artificial risk margin usually miss the boat and end up chasing shadows. Then they risk undervaluing assets, becoming uncompetitive and when they do invest, failing to optimize returns. Property appraisal is by definition imprecise beyond a given date, so getting the value accurate for a future uncertain date is extraordinarily difficult, except for the most hands-on experienced campaigners. Technical expertise is not enough. In developing markets like Southeast Asia, there is no substitute for detailed market knowledge and a full understanding of individual local market component patterns, psychology, habits and operations.

Beyond the legal and transparency issues, emerging and faster developing markets may also have their own unique quirks and anomalies. Compared with consumers in the generally more sluggish western markets, Asian property owning families may appear to hold illogical levels of emotional attachment to real estate that goes far beyond market cycles. Owner occupation levels in some parts of Southeast Asia can be far higher than western markets, and there is a general leap of faith that places confidence in land and property above trust in banks, governments, or even the Law.

The key to successful NPL investment in Southeast Asia is, in addition to the legal, cultural and business issues is accurately pinpointing when a given NPL will monetize and at what price level. For the largest corporate loans this can be enormously challenging. Corporate loan investment may benefit from upside enhancements such as restructuring, debt forgiveness, additional capital investment, bail-outs, industry and capital market upswing. Conversely though, if a loan creditor is confronted with a well-connected, well advised and resourced hostile borrower, it may take literally a decade to even start negotiations on how best to monetize the loan. Big hitting local borrowers understand that foreign invaders and investors both have time tolerance levels. With sustained, long term unyielding resistance, they know that ultimately there is a good chance that the foreign intruder may lose confidence, throw in the towel and return empty handed to focus on home markets that they understand better. Time can be the foreign investor's enemy, and any show of impatience or vulnerability, the key to their undoing.

Secured residential loans are by comparison much more predictable in terms of estimating when an NPL investment will be monetized. Even though a jurisdiction may be borrower-friendly, smaller debtors are likely to prove to be far less canny in manipulating the legal system to their advantage and are less likely to be represented by a barrier of top-flight, seasoned local lawyers and accountants. Predictability in terms of timing and pricing make investing in residential NPLs a significantly less risky and far safer investment bet than commercial NPLs. The downside for residential loan portfolios is that they are far more servicer-intensive than larger single corporate, and it is necessary to monetize a far higher number of NPLs in order to achieve a sizable investment return volume. The advice usually given by Capital Services Group to distressed investors looking to enter Southeast Asia is to avoid larger commercial loans until such time as the investor has some hands-on experience of operating in the local environment. Even in 2014, when we undertake diligence on commercial loans, we frequently come across loans that were victim to the 1997 Asian Crisis, and are still yet far from being resolved. A better option for a newcomer is to first focus on residential NPLs portfolios until a clearer understanding of the local market is gained. Establishing a bridgehead of predictable residential NPLs, and creating a consistent cash flow foundation, is generally a better option than jumping straight into the unpredictable, melting pot of large corporate NPLs. Looked at this way, in comparison with commercial NPLS, investment in residential NPLs in Southeast Asia could be deemed as safe as houses.