Pushed by the Agency for Restructuring of Home Mortgage Lending (ARHML) and the government, most banks restructured their problem mortgage loans. Many market participants preferred performing such operations unofficially, in order to avoid diverting funds to build up reserves. However the debt grace period granted to problem borrowers will end soon; and then banks will have to either shake up their portfolios, or think of new workarounds to keep their accounting reports 'positive'. Andrey Yazykov, CEO at the Agency for Restructuring of Home Mortgage Lending talked about restructuring of mortgage loans and about issues that banks would have to tackle in the nearest time.

ACCOUNTING IS A RELATIVE CONCEPT

NBJ: Mr. Yazykov, according to experts, about 40 thousand loans have been restructured from the moment the ARHML began operating. What part of them was restructured according to the ARHML program?

A. YAZYKOV: According to our assessment, about 40 thousand loans have indeed been restructured by now. However one has to take into account that the size of the problem was much larger: approximately 25 thousand borrowers had tackled their financial problems through their social connections; and cases of other more than 20 thousand borrowers are currently in court. Consequently, during the financial recession roughly 80 to 90 thousand borrowers were facing active problems; 40 thousand, which is virtually half of them, received restructuring. With help of the ARHML, about 7.000 loans were restructured.

I believe what we have now at the home loan restructuring market is the perfect situation. Let me remind that last spring, the ARHML began its active campaign on loan restructuring for mortgage borrowers who had found themselves in difficult circumstances. While doing so, we were willing to make concessions for borrowers even if a bank was refusing to reconsider terms and conditions of a loan payoff.

One should admit, creditors found themselves in a very difficult position. First, especially in the beginning of recession, effectiveness of such measures was very vague, and many banks believed that restructuring would just prolong the agony of borrowers while credit organizations would incur losses as a result. Second, according to the Central Bank standards, in cases of loan restructuring, the financial load on creditors increases, as they would have to build up reserves for problem loans. According to the Central Bank's instruction #2156-U, when forming reserves, a bank has a right to disregard the quality of loan servicing yet it is obliged to consider the borrower's financial standing. Thus, if a client appeals for the loan restructuring, the loan is automatically excluded from the homogenous loans portfolio, necessitating making reserves for it in the amount of at least 51% of the loan.

For many banks, a large-scale restructuring was simply impossible due to low capitalization; therefore they began developing their own loan restructuring programs which allowed them to avoid allocating funds for additional reserves. For example, they changed payment schedules without official applications for that.

We are happy that our active operation evoked response from banks. Even though it's worth admitting that we faced an objective conflict with creditors at first. By now, according to our assessment, banks had restructured about 5% of mortgage portfolios.

NBJ: Is 5% the official figure?

A. YAZYKOV: This is our averaged assessment. Some banks say that they restructured only 1% of the mortgage portfolio. Other banks that have been exchanging information with us admit that this index is much higher and amounts to approximately 5%.

It's difficult to assess the volumes of restructuring because, as I've said, banks often use 'exotic' restructuring schemes which enable reducing financial load on borrowers without reflecting this in their accounting reports and, correspondingly, without increasing volumes of reserves. Therefore, when a bank's official accounts show 0.1% volume of reserves for restructured loans, a bank cannot openly state that this figure doesn't correspond to the facts.

NBJ: What 'exotic' schemes were banks using exactly?

A. YAZYKOV: The most popular 'unofficial restructuring' is to grant borrowers a new loan with an 'easier' payment schedule to repay the previous loan. This scheme became popular, because it allowed formally repaying the problem loan; while for the new loan, minimal reserves were formed. There was a curious incident when two regional banks arranged for a mutual cross-crediting for their clients to repay their overdue loans. The trick of this case was the following: when a loan is given to serve another loan, a 100-percent reserve has to be formed for it. In order to bypass this requirement of the Central Bank, the partners were providing regular consumer loans making minimal reserves. This was actually noted even by the statistics of the Central Bank of Russia: while the total credit volume was dropping, unsecured loans up to one year had strangely grown.

However we turn a blind eye to such 'tricks', since our goal is not to disclose 'gray' restructuring schemes but rather to involve banks in tackling the problem loans issue together with the government. And we have succeeded in it. 5% is a good indicator.

NBJ: Was the unwillingness of banks to perform restructuring caused mainly by the need to make additional reserves?

A. YAZYKOV: I'd say the necessity of forming additional reserves was the key issue. But it would be wrong to say that credit organizations 'were not performing' the restructuring. To the contrary, they got involved in this process rather quickly. Whereas, each of them had logic in their actions: some tried to save on reserves by making their own programs; some made it their goal to preserve their clients or to 'straighten up' their accounting reports; and others were even trying to gain additional profit, since restructuring is performed on a paid, fixed-term basis.

Moreover, we attempted enhancing terms of 'open' restructuring performed by banks. Thus, we actively communicated with the Central Bank and regularly reported all data on the restructuring process. Consequently, the Bank of Russia issued the instruction #2355-U on making amendments to the clause #254-P according to which regulator permitted including restructured loans up to 6 million rubles in the homogenous loan portfolio, even if the financial standing of borrowers declined. Thus, the Bank of Russia had practically legalized restructuring. We believe this to be a significant achievement.

THE FIRST STANDARD WAS SPOILED

NBJ: You have reconsidered the Standard for restructuring several times. Why did you repeatedly have to soften it?

A. YAZYKOV: One has to consider that 18 months ago Russia had faced the mortgage crisis for the first time. By that time, nobody had ready answers for eliminating negative financial occurrences. We had no examples to follow either, as in some issues the Russian market is principally different from the Western ones. For instance, there are unofficial profits at foreign markets, but the volumes of 'gray envelopes' are much smaller, and they are unfamiliar with such concepts as 'earnings certificate according to the bank's form'.

Moreover in the West, the level of capitalization of the banking system is much higher, and creditors can afford selling loans at a discount to another more effective player. Therefore, we had to look for solutions on our own, moving practically 'by touch'.

At first, we didn't even have a clear profile of an average borrower. Guided mostly by statistics and empirical knowledge of the Agency for Home Mortgage Lending (AHML), we were developing our own standards and requirements for borrowers and for types of housing. However after the first transactions, we realized that we hadn't considered many factors.

For example, an average loan sum in our country amounts to 1.5 million rubles, and at the AHML, 890 thousand. Also, area of mortgage housing turned out much larger, since people use mortgage loans from commercial banks to buy not tiny “Khrushchev-era” apartments, as at the AHML, but rather modern apartments in new buildings of totally different area and price parameters.

NBJ: Perhaps not only the ARHML, but also banks weren't ready for restructuring, were they?

A. YAZYKOV: Indeed, other than the problems that I've mentioned, i.e. shortage of capital and lack of ready standards for restructuring, there was another one: lack of infrastructure to service bad mortgage loans.

Whereas the large players have made maintaining the loan support and servicing system for consumer lending an integral part of the process, most creditors treated mortgage borrowers as reliable clients who would not need extra control.

However experience showed that mortgage borrowers are practically no different from 'consumer' borrowers: they also need monthly reminders about payments; they can also experience solvency problems; and also, in case of significant financial difficulties, they go hiding.

Often banks, not having a proper base for working with overdue loans, would file a suit on day 91 and wait for law enforcement agencies to 'deal' with a borrower. As a rule, at the court a debtor agrees to any terms of his dept repayment. In such cases, an amicable agreement is made, and the bank restructures the loan by providing a new loan for covering the problem arrears including accrued penalties and fines.

But that's what was happening during the first stage. By autumn, many banks had formed the required infrastructure for serving mortgage loans, which included collection departments, and in some instances, credit funds and various mutual funds where problem assets were relocated to in order to clear the balance.

NBJ: And how popular were such 'dumps' in forms of closed-end funds and other funds?

A. YAZYKOV: According to some statistics, during one year the number of close-end funds has grown almost threefold. However regulatory authorities have been efficiently detecting instances of 'cleansing' activities and stopping them, since 'corrected' accounting reports don't free banks from credit risks.

RESERVES AT THE EXPENSE OF TAXES

NBJ: Banks were actively manipulating with the level of overdue payment. Has this situation clarified somehow?

A. YAZYKOV: Indeed, at times it's hard to predict the dynamics of changes in the levels of arrears and volumes of reserves formed. For instance, late last year we were expecting the level of overdue loans payment to drop, as the market situation began to stabilize. But this indicator grew, contrary to our predictions. At first, we got scared when we saw a decline in accounting reports. However having analyzed the situation, we realized that it wasn't the negative impact of the crisis, but rather totally different factors that had influenced the reports. As we know, during the last year the Central Bank had repeatedly reduced the discount rate. However, in spite of formal cost reduction of money, loan interest rates for businesses and individuals remained practically unchanged. This gap enabled banks to gain a huge profit which they most certainly didn't rush to share. In order to keep the funds, banks relocated them to reserves. However in order to increase the size of reserves for loan, the category of its quality has to be lowered. Therefore, the quality of portfolio has worsened, and reserves have grown.

It's very easy to determine such operations: just compare accounting reports according to Russian Accounting Standards and International Financial Reporting Standards. If RAS show minimal profit and even loss, but IFRS, to the contrary, high profit, even though I'd like to note that IFRS is much stricter regarding recording risks and reserves than RAS, this means that a bank has used this scheme to preserve its excess profit. Therefore, the statistics that we see in many banks now, unfortunately, doesn't reflect the real state of overdue mortgage payments.

NВJ: If these operations are easy to track down, why aren't any 'punitive' or 'educational' measures taken?

A. YAZYKOV: This activity cannot be univo-cally characterized as negative. On one hand, 'freezing' funds has a negative impact on tax revenues. But, on the other hand, formation of super-reserves increases the reliability of the banking system. What is more important in this situation: reliability of the system or replenishment of the budget? In this situation, I'd choose stability of the banking system. Moreover, we need to take into consideration that, as the situation becomes stabilized, reserves will be released, and then all the taxes will be paid.

THE 'BAD' MORTGAGE SPECIAL OPERATIONS BANK

NBJ: Have volumes of restructuring begun to drop?

A. YAZYKOV: Certainly, there have been fewer new applications for initial restructuring. However the problem is that the grace period that had been granted to many borrowers during the restructuring, will be over in summer. Clearly far from all borrowers will manage to improve their financial standing during this time. The Western experience shows that the outcome is considered good when at least a half of restructured loans restores. At present, according to our data, the number of restored borrowers (meaning borrowers who made their first payment to the bank on their own) on restructured loans within the ARHML program amounts to 65%.

NBJ: What number of applications are you expecting this year?

A. YAZYKOV: Statistics show that at present the situation has been developing according to an optimistic scenario which we had developed in our business plan. In this plan, we suggested that 4.2 thousand borrowers would apply for initial restructuring. About 5 thousand borrowers would require a repeated restructuring.

NBJ: Why was the decision still made to hold the repeated restructuring? Initially this option hadn't been implied.

A. YAZYKOV: We made a decision to hold the repeated restructuring, having analyzed prospects of changes in the income of borrowers who had found themselves in difficult situations. It's known that whenever creditors provide a loan they have to calculate two parameters: the loan/security ratio and the payment/income ratio. In our country, the average loan/security ratio is approximately 67%, and the payment/income ratio is 45%.

Borrowers come to the ARHML when their income drops drastically. In this case, we assume their debt obligations to banks, and they pay just the interest for the sum actually received. Consequently, the load on the borrower is 20 times less. But the problem is that, sooner or later, the grace period ends, and then borrowers have to start repaying not only as before, but repay their loan to the ARHML too. As a result, their load becomes averagely 15% higher than that before the restructuring, whereas according to statistics, the borrowers' income is restored at a point that is 20 to 30% lower than their 'pre-crisis' income. Therefore, in the past the payment/income ratio was 45% and borrowers were capable of repaying their loan, but now, at the end of the restructuring period, this indicator grows to 70% and higher. Clearly, repayment becomes beyond their strength under such conditions. Furthermore, we have to take into consideration that approximately half of all families get children after having taken mortgage loans.

Having analyzed this statistics, we decided to provide borrowers with the opportunity of the repeated restructuring when necessary, so that these people could consolidate their financial standing and to stand firmly on their feet. In this case, in the process of the repeated restructuring, the debt load will not be increased.

We understand that in case of accrual on interests during the repeated restructuring, the cost of a loan will become too high. And since it is not our purpose to gain profit, we are trying to mitigate the conditions of the restructuring process. In the past, our Stabilization loan rate was equal to the borrowers' primary mortgage obligation rate, which was averagely 13.4%, but now, as of March 2010, for those clients who have been sticking to the payment schedule for 6 months, the rate is only two thirds of the currently effective discount rate of the Central Bank. Also, the new stabilization loans rate is two thirds of the Central Bank's rate. This means that consequently, the borrowers' load growth is only 8%, instead of 15%.

NBJ: Are the restructuring programs of the second and third levels still working in the pilot mode?

A. YAZYKOV: Yes, they are. A delay happened at the third level, as the form had been negotiated and the documentation on the cooperation with regions had been developed. At present we believe that the form of creating lease housing fund is the most flexible one. On the basis of this fund, regions will be able to quite effectively form and develop their own programs of using real estate on the balance sheets of regions. We believe this is a very important and promising area of work. The thing is that Russia has a very high percentage of residential owners, whereas the lease/owned housing ratio is approximately 50/50 worldwide. The lease fund may become an alternative to mortgage. At the same time we realize that many regions are short on funds today, and they are unable to assign capital for the fund's development. Therefore we are willing to contribute residential estate to these funds, providing a good deferral of payment and drawing up a 'mild' payment schedule. At present we have been developing these mechanisms, with the AHML among others.

The second problem is the assets assessment mechanism. Clearly, problem assets cannot cost 100%, therefore they have to sell at a discount. This was when we faced disagreements with banks. In our opinion, the average discount should be 20 to 25% at the second level of restructuring, and 40 to 50% at the third. Creditors in turn are stating that they cannot realize their assets at such cost, as in this case they will face capitalization problems. In order to tackle this problem, we decided to try the UK's mechanism of realizing the assets: to apply just the economic discount, not the accounting one. For this purpose, we decided to issue special notes with non-market coupons: notes with coupons of approximately 2/3 of the effective Central Banks' discount rate for the second level, and 1/3 of the rate for the third level. Thus, we buy out assets at par value of 1:1, and banks don't end up with losses in their accounting reports. Certainly, the financial results would somewhat decline at the reassessment. However, if the note is assigned the 'held-to-maturity' status, the losses can be written off in increments over the entire term. Then the problem of large discount is removed.

NBJ: One of the reasons that a 'bad bank' was never organized, was the fact that regulators and market participants had never agreed on the amount of discount applied to problem assets. In this case, a similar situation can happen again.

A. YAZYKOV: As I've said, we disagree with banks on the matter of cost of problem assets. We are pushing banks toward the 25% discount, whereas they are justly talking about the 20% discount.

I admit that a fair discount today should be somewhat lower than what we're suggesting.

First, the average loan/security ratio on mortgage portfolios that we receive is 67%, which is a pretty high level of loan security. Second, experience shows that borrowers' solvency is gradually increasing, so our chance of getting the money back is fairly high.

Today, banks are ready to contemplate selling assets at a 20-percent discount. However, market players and we realize that a differentiated approach should be used when buying portfolios. The thing is that real estate price index has drawn a 'rainbow' over the last few years, and today the prices are where they used to be in the middle of 2007. Therefore, credits granted before 2007 have excellent security, since the real estate that secures them can be sold at the price stated in the loan agreement. This is why bankers are right in saying that even a bad debt issued in that period is worth 100%. Credits issued in 2008 and 2009 are perhaps less secure since the prices have fallen, so they should be cheaper. This is why the 20-percent discount I am talking about is the average figure for the market.

Let me note that we pay up to 15% of the asset price in cash. That is, the higher the quality of a credit, the better is the offer that we make to the creditor.

LIFE AFTER THE RECESSION WITH A NEW NAME

NBJ: Most experts agree that such anti-crisis instrument as curing should always be in place. In your opinion, is the restructuring institution an anti-crisis mechanism or a regular one?

A. YAZYKOV: In most Western countries, debt restructuring is an ongoing operation. In the UK, for instance, mortgage borrowers can take a payment time-off anytime. Clearly, we cannot rule out that over 10 or 20 years, one runs into financial difficulties at a certain point. Thus, there are three main reasons that may cause borrowers to break the payment schedule. The first one is divorce of spouses that had taken a mortgage loan. The second one is change of employment that may cause a temporary gap in borrowers' income. The third reason is maternity leave during which a family's income drops. Therefore, in the worldwide experience, restructuring has been an ongoing instrument for quite a while now. And in my opinion, it would be feasible to implement it as a regular instrument in our country as well.

NBJ: What will happen to the ARHML when the situation on the market stabilizes? As we know, the Central Bank and the government have begun to actually wrap the anti-crisis measures.

A. YAZYKOV: According to its particular mission, the ARHML has to 'revive' restructured loans in order to bring them back to standard payment schedules, and then sell them to market creditors.

Closure or dissolution of the ARHML is not a problem. However during our agency's work, we have developed and implemented numerous advanced market technologies, such as technologies of remote retail crediting. These instruments will perhaps be in demand not only during the recession period but during the market's development as well. The ARHML may become a good ground for piloting new risk mechanisms which cannot be implemented on the basis of the high-rating AHML.

We don't plan far ahead these days, as with time, at least some of the ARHML's departments, if not the entire agency, will be no longer needed.

NBJ: So, the ARHML's structure may change in the post-recession period?

A. YAZYKOV: It's premature to talk about it now; structure may not be the only thing that will change, but its name as well.

NBJ: You've said time and again that gaining profit is not the ARHML's goal. However you were well in the black by the end of last year. What results are you expecting this year?

A. YAZYKOV: Indeed, last year we had quite a high profit of 274 million rubles, which was explained by excess capital. However I want to repeat that the capital turned out 'excessive' not because our calculations were inaccurate, as initially we were talking of approximately the same numbers; but rather, because we managed to launch the market mechanisms, and creditors took a large share of the load. All the profit we received last year will go towards reserves, as the next two years will be very hard for us from the viewpoint of working with our portfolio.

As for this year's indexes, I wouldn't make any predictions. In our business plan, though, the goal is to break even.

NBJ: In view of the fact that in restructuring, funds are granted on the payable basis, chances for you to go in the red are perhaps quite slim.

A. YAZYKOV: It's not quite so. According to our calculations, with the 71% loan/security ratio, funds gained from selling an estate object in case borrowers have never returned to their payment schedule, will be enough for both creditors and us. With the 84% loan/security ratio though, we will suffer 100% losses. In these circumstances, let me remind you that the average ratio in our country now is 67%.

NBJ: In your opinion, will the mortgage market change after the recession?

A. YAZYKOV: I have an optimistic view of the mortgage market in future. The recession had both positive and negative consequences for us. First, the crisis made borrowers understand that mortgage is not a scary thing. Certainly, at first the market was full of spooks saying that borrowers could lose everything. However, the government took an active position in rescuing mortgage borrowers, after which banks started taking measures to support their clients as well.

Second, in order to restore and develop mortgage crediting during the recession, numerous great instruments were implemented that enabled reducing credit rates. Primarily I mean the mechanism of mortgage insurance and participation of the Bank for Development and Foreign Economic Affairs as the largest investor in the mortgage lending. Therefore I believe that mortgage has good medium-term and long-term prospects. However there are still several problems to be tackled. Primarily, it's construction of new housing and, correspondingly, reduction of cost per square meter, as well as increasing the population's income.