Consider debt cut through debt-to-equity swaps

China is drafting a policy to allow lenders to convert bank loans into equity for the debtor companies. Do you think Vietnam can also use this method to deal with its heap of non-performing loans (NPLs)?

Yes. I have looked at this strategy and think it is an innovative solution to a long-standing problem. Like Vietnam, China long ago set up not just one company like Vietnam Asset Management Company (VAMC), but several “bad banks”, which buy NPLs from commercial banks. Fifteen years later most of them still sit there at full value. The plan to start auctioning them out on a distressed-asset market did not seem to pan out. Vietnam can follow the progress of this programme and draw appropriate conclusions for its own NPL problem.

What is your view on this method of handling debt? Is there any risk that stems from such an approach, or should Vietnam consider implementing it?

There is always some risk in policy making. But to do nothing, or to do the same thing over and over again is also risky. Einstein once said that to follow the same practices and expect different results is a questionable modus operandi. There should be some serious cost-benefit studies carried out before this question can be answered. Some of the costs have been enumerated by analysts in a different context. Two of the prime benefits are: (i) lowering the amount of frozen bad debts now piling up at state-owned “bad banks” and, (ii) banks can clean up their balance sheets, lowering NPL ratios, lessening provisions, and allowing them to make new loans.

Local banks often function as commercial banks, not investment banks. Current regulations prevent commercial banks from investing in non-core businesses. Can the debt/equity swap actually work in Vietnam, when swapping debts to equity stakes would mean banks should step into the debtor companies’ shoes, to manage and operate them, in a bid to recover their debts?

Actually, after the financial crisis of 2007-2008, all banks in the US became commercial banks (so they can borrow from the Fed), including Goldman Sachs, Merrill Lynch, and Morgan Stanley. But they still have investment banking divisions to handle M&As, corporate consulting and IPOs, among others. Vietnamese banks can do the same. Or if you want to be even more cautious, there could be a firewall between the deposit-taking side of the bank and the investment banking side. This is not an insoluble problem.

Banks do not take an equity stake in companies as a kind of non-core investment. That is not their intention (and in legal matters, intent is of paramount importance). They do this as part of an attempt to recover their capital, which would otherwise be lost.

When a bank swaps debt for equity, it does not mean that it has to run the operation. The management can be kept in place while the bank gets seats on the board. It can ask for changes in, or even replacement of, the management as the case may be. In the latter case, new managers would be installed. I agree that at no time should the bank run any companies. It should hire good managers to do that. And these hired guns are available for a fee. And they tend to be very good at what they do: their fee plus bonus depend on the results obtained.

You’ve mentioned that a better solution for banks would be to securitise the debts and sell them to the market. Can you please elaborate a bit more on this approach?

A better solution is for a bank to roll all of its NPLs together into a bundle of assets. Then asset-backed securities or bonds can be issued on the back of these loans. This is called securitisation, and is a widely-practiced strategy to resolve NPLs.

It is easier to sell securities based on a bundle of loans than to sell whole loans. The loans can be assembled then chopped up into tranches depending on their quality. Bonds can be issued reflecting the characteristics of each tranche, going from low-risk (yielding lower returns) to high-risk (yielding high returns). Since the bonds are priced according to the risk embedded in them, they can respond to investors’ wide range of risk appetites.

I think the distressed-asset market is based on the idea of auctioning off loan by loan (along with the underlying collateral). Investor response so far has been tepid, as seen in China during the past 15 years. VAMC has been trying to set up such a market, but progress has been slow.

To sum up, I think the best NPL solution may have two components: debt-to-equity swaps and securitisation of NPLs (and issuance of asset-backed securities into the market). The components can be allowed to proceed side by side, in a concerted effort to solve the NPL problem once and for all. But time is of the essence, because bad debts are like fish. They should be sold today because tomorrow they tend to get worse.