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Outline a workout procedure for loss assets, and weigh the approach of keeping loss assets on the books against that of writing them off.

FRM® Part II · Credit Risk Measurement and Management · Credit Risk Management · FRM2.CR.3.h

The idea

A loss asset is regarded as uncollectible in the normal course, but recovery work continues. A workout moves the file to a specialised recovery unit separate from the originating lender. It reviews the legal position and assesses the borrower's ability and willingness to pay and the realisable value of collateral. It then chooses the route with the best present value net of costs: restructuring where the business is viable, enforcing security, selling the claim to a distressed investor or litigating. Actual recoveries, costs and timing feed back into LGD estimates. Keeping a fully reserved asset on the books preserves visibility and the claim, but inflates gross loans and NPL ratios. Writing off cleans the balance sheet. A write-off is an accounting step that does not forgive the debt, and later recoveries are credited.

Formulas

Loss given default from a workout

LGD = 1 − PV of net recoveries ÷ EAD

PV of net recoveries
recoveries discounted to the default date, less workout costs
EAD
the exposure at default

Discount for the time a workout takes and subtract legal and disposal costs; using undiscounted gross recoveries understates LGD.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the principal aim of a workout procedure for a loss asset?

  1. To restore the loan to a pass classification as quickly as possible.Why not: Reclassification is not the objective; recovery value is.
  2. To maximise the present value of recoveries, net of costs, from the borrower and the collateral. - correct
  3. To release the borrower from the obligation so the balance sheet is cleaned up.Why not: Workout pursues recovery; it does not forgive the debt.
  4. To close the file as fast as possible, whatever the recovery.Why not: Speed matters only through the time value of recoveries; value comes first.

Workout is about recovery: restructure, enforce security, sell the claim or litigate, choosing the route with the best discounted net recovery.

A harder one

Which statement about writing off a loss asset is correct?

  1. A write-off is an accounting step; recovery can continue and later recoveries are credited. - correct
  2. A write-off legally forgives the debt and ends collection effort.Why not: Confuses an accounting action with release of the borrower.
  3. A write-off must wait until all the collateral has been sold and the final proceeds are fully known.Why not: Write-off does not require completed recovery; it follows the loss of reasonable expectation.
  4. A write-off adds an expense equal to the full loan even where it was fully reserved.Why not: The loss was already charged through provisions; a fully reserved write-off uses the reserve.

Writing off removes the asset from the balance sheet when no reasonable expectation of recovery exists. The legal claim survives, so collection can continue.

The hardest tier

For a loss asset, management compares two workouts at a 10 percent discount rate. Option A is to enforce collateral now and receive USD 9 million net in one year. Option B is to restructure: with probability 60 percent the bank receives USD 14 million in three years, otherwise (40 percent) it receives USD 5 million in four years from collateral. On a present value basis:

  1. Option B is better, by about USD 1.4 million.Why not: Compares undiscounted expected values (10.4 versus 9) and ignores time.
  2. Option A is better, by about USD 0.5 million. - correct
  3. Option B is better, by about USD 2.3 million.Why not: Values B using only the favourable 60 percent branch and ignores the downside.
  4. Option A is better, by about USD 1.9 million.Why not: Counts the 40 percent branch of B as zero.

PV(A) = 9 / 1.1 = 8.18. PV(B) = 0.6 x 14 / 1.1³ + 0.4 x 5 / 1.1^4 = 7.68. A exceeds B by 0.50.

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