In an age where just about anything can be bought and sold entirely through the Internet, there is still an exception or two. A house is one.
That's because the new potential owner will need to conduct a title search to ensure that the old owner does in fact legally own the property and has the right to sell it. And the old owner has to oblige by providing the paperwork.
Distressed loans are another. These are loans to corporations that require buyers and sellers in the secondary market to negotiate new terms with each other to settle their trades. That is because the company's financial condition has weakened.
Settling the terms of each transaction can take two months or more, as the buyer of the distressed loan and the large brokerage or bank selling it work to sign a complicated purchase and sale agreement.
"The buyers and sellers-and their attorneys have to do a whole lot of extra work to ensure their right to buy and sell their loans but also to enforce them according to their terms," said Alan Gover, a partner with White & Case in New York specializing in bankruptcy law.
That enforceability is needed should the final owner of a distressed loan find itself in bankruptcy court after the corporate borrower goes bust and is unable to pay off any principal or interest owed on the loan.
Proving ownership means that the buyer who holds the distressed loan can stand along with other creditors when a bankruptcy judge decides who is to be paid from the estate of the bankrupt corporate borrower. Over the past few years hedge funds have been the largest buyers of distressed loans; other active buyers include brokerage firms, mutual funds, private equity firms and specialized debt funds.
Sometimes the alleged owner of the distressed loan doesn't even have legal ownership, said David Neier, a partner in charge of the bankruptcy practice with the law firm of Winston & Strawn in New York. "Hedge funds often pledge the distressed loan as collateral for a financing transaction such as a total return swap with a large bank or other financial institution so the hedge fund isn't really holding the loan."
Distressed loans typically start off at par or close to par value but can quickly decline in value due to the corporate borrower's mounting financial woes. Syndicated loans are loans by an institutional investor or bank to a corporation in exchange for interest payments. The corporate borrower hires a bank as its agent to make certain that the borrower and lenders complete the correct paperwork so different lenders can own parts of the total loan. That's called the primary market.
Then, in a secondary market, investors wanting to trade parts of the loan to other banks or institutional funds must exchange clear documentation, the purchase and sale agreements. An agent bank hired by the corporate borrower also needs to know which lender bought what percentage of the total loan so it can know how much to pay to the final owner of the loan and when.
The longer the time the loan is considered distressed the longer the time it will take for attorneys of the buyers and sellers to research the past ownership. That translates to a long settlement time and a greater potential for the borrower to disappear or the loan to change value. That means that either the buyer or seller will have an unrealized gain or loss.
Now two firms are now vying to find a way to bring some standardization and automation to the process. Markit Group and Trade Settlements Inc. (TSI) each have developed automated systems for transferring information between buyers, sellers, attorneys and agent banks.
Markit, a global data and processing firm based in London and New York, which specializes in over-the-counter derivatives, entered the syndicated loans market through two recent acquisitions. In January, Markit purchased the technology assets, i.e. the computers and intellectual property, of Storm Networks and in February bought Storm's competitor ClearPar from Fidelity Information Services. Also based in New York and London, TSI opened shop in 2003 to settle par loans. In February, TSI announced that it had upgraded its platform to accommodate distressed loans.
The entries of Markit and TSI come in the knick of time. The market and investment appeal for distressed loans is growing. A study of 20 buy- and sell-side firms conducted by the Loan Syndications and Trading Association (LSTA), the New York-based trade group for the syndicated loans market, estimates that a total of $104.5 billion in loans settled in the secondary market for the first quarter of 2010; of those $32.5 billion represented distressed loans.
Of the total of 25.655 trades settled, 5,183 settled for distressed loans while 22,472 settled for par. Only 16% of trades in distressed loans settled within the LSTA's recommended guideline for settling within 20 days.
Neither Markit nor TSI would disclose the number of users of their platforms. Markit says that its ClearPar platform settled 11,000 distressed trades last year, about a tenth of the 110,000 trades in par loans it settled.
Key Issue: Counterparty Risk
Should settlement delays continue, both buyers and sellers will start facing even greater market and counterparty risk, not to mention costs. Broker/dealers and fund managers have dedicated operations teams specializing in settling distressed loans. Those so-called closers often spend several weeks not only negotiating the terms of the loans but faxing or emailing the purchase and sale agreement multiple times to each other for approval. Then they have to keep track of the due diligence conducted by their attorneys on the past ownership history of the loan. And that doesn't include keeping track of the financial viability of the corporate borrower: the corporation which borrowed the money.
The potential pricetag: One New York-based fund manager told Securities Industry News that legal fees alone can easily come to $5,000 per transaction for the buyer and the seller each. Add the administrative costs and the $5,000 turns into a minimum of $10,000.
Joe Widner, director of syndicated loans for Markit in New York, says that a module of the ClearPar platform allows buyers and sellers to create purchase and sale agreements and to confirm the terms of the trade. The module can also be accessed by attorneys representing the buyers and sellers so they can input the appropriate information on continuing changes in legal ownership of the part of the distressed loan. That means the process of tracking down the past ownership of the distressed loan can be completed through a central location.
"ClearPar's distressed module allows banks to handle increased volumes of distressed trading," says Widner. "Without the module, the settlement throughput would have been less and caused even longer timeframes."
Still, he concedes that it takes users of ClearPar 64 days on average to settle a trade in a distressed loan. That's a timetable he hopes can be reduced when Markit integrates ClearPar with Storm Network. Although the three-year-old Storm has no customers it was developing technology that allows buyers and sellers to also link to the agent bank of the corporate borrower to verify the availability of inventory, credit restrictions and corporate actions. Such information is required to settle the loan and must be included in the purchase and sale agreement.
Pat Loret de Mola, president of TSI, says its platform will also allow buyers and sellers to generate purchase and sale agreements and confirm the terms of the trade. The platform also permits access to third parties such as attorneys and will soon link to a separate database on purchase and sale agreements so that attorneys and closers will have an easier time keeping track of the history of the ownership of the distressed loans.
Corporate Borrower Details
While the paperwork involved in the contract between buyers and sellers of par loans is pretty short and standardized, that's not the case when it comes to distressed loans. "There are additional fields that must be used to create purchase and sale agreement for distressed loans which include the financial status of the corporate borrower, whether or not it is in bankruptcy and the procedures the buyer of the loan can take should the corporate borrower default on its payments," says Loret de Mola. "Some of the information has to be typed in manually by the trader of the loan and the closer, an operations executive responsible for settling the loan while other information can be automatically uploaded into the purchase and sale agreements from internal databases."
The merits of using automated platforms: not only is the settlement time reduced but there is a potential for greater operational efficiencies and lower processing costs.
Then there are other reasons for settlement delays that cannot be solved just by automation. One cause; whether a loan should be considered par or distressed. Or, perhaps there is no regulatory requirement that trades settle on time. The LSTA is considering implementing a buy-in sell-out (BISO) policy for distressed loans, the way it does for par loans. That means the seller of the loans cancel the contract with the seller and find another buyer.
While the syndicated loans industry struggles to find a way to automate the settlement process for distressed loans, financial firms and their legal counsel are dealing the old fashioned way. Adding more muscle to grease the wheels.
