Making Debt Restructures Work When Interest Rates Rise

Debt restructures are challenging in markets with increasing interest rates, as many organisations impose policy restrictions that virtually prevent reasonable restructures.

by Ulrich Wiesner

January 15, 2019

Debt restructures are an important tool to address financial hardship-change. The toolkit can include measures such as arrears capitalisation, term extension, interest reduction or even a haircut on the outstanding balance. When applied appropriately, a restructure serves both the debtor and the creditor. From a debtor perspective, the instalments become more affordable. From a creditor perspective, the reduced instalment amounts increase the likelihood of the payments to happen, and hence increase the Net Present Value of the loan. Applied correctly, restructures ensure a right outcome for all.

Many organizations struggle with the idea of compromising on the contractual payment terms. Concerns include the risk involved, “rewarding” customers who don’t perform, and “giving up” money that is contractually owed. However, the realistic alternative to a restructure frequently is not that the customer sticks to the original agreement, but that the customer defaults, is charged off and that only a low percentage of the balance is recovered. Not having an appropriate restructuring toolkit can hence be expensive.

By contrast, a well-governed restructuring framework increases the value of the restructured loans by increasing the likelihood that the new payment schedule is actually affordable and met by the debtor, even if compromising on contractual terms. To address the risk of over-restructuring, evidence should be sought for the customer’s financial hardship, and the available income of the debtor should be thoroughly assessed.

Additional challenges arise in markets with increasing interest rates, as many organisations impose policy restrictions that virtually prevent reasonable debt restructures. A policy rule we frequently see in such markets is that the restructured loan needs to be re-written with the current interest rate, which can be much higher than the original interest rate of the loan. This can defeat the purpose of the restructure — to reduce the monthly financial burden of the customer. It is specifically the case for medium- to long-term products such as mortgages and auto loans, where the interest part of the instalment dominates amortization during the majority of the lifecycle of the loan.

Asking for More Can Be Expensive

As an example, mortgage interest rates in Turkey have been between 10 and 15% during most of the past 10 years, but on the back of the devaluation of the Turkish Lira recently they shot up to 25% and more.

A customer who took up a 10-year mortgage at 12% will have initially spent 70% of the instalment on interest. By the time the interest portion of the instalment is down to 50%, the customer will be more than 50 months into the contract. This means that in a period when interest rates have doubled, every customer who is into the mortgage for less than 50 months will need to spend the previous instalment amount or more just on interest, if the current interest rates are applied.

This defeats the purpose of the restructure and consequently prevents the creditor from increasing the likelihood of the payments. In a market with increasing interest rates, creditors insisting on applying current interest rates effectively remove debt restructures from their collections toolkit, which is likely to result in higher default rates and more losses.

Using Analytics to Solve the Problem

Analytics can help to shape appropriate restructuring tools even in difficult market conditions. By modelling the likelihood of a re-default of a restructured account depending on the restructure terms, we are able to quantify the financial impact of a restructure.

Mathematical optimization can help to develop an optimal restructure strategy, considering the goals and constraints of an organization. Analytics and optimisation can also help to reduce the risk of unsuccessful debt restructures, which fail within the first couple of months and therefore do not address the risk situation effectively. Finally, optimization provides a tool to simulate performance of a restructured portfolio under given constraints, and helps to shape restructure solutions and policy rules that really create value.

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This is largely because they have trade lines that have been open longer, which leads to higher scores (assuming the trade lines are in good standing and all other things equal). The most credit savvy among you will remember that length of credit history accounts for roughly 15% of the overall <a href="http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx" target="_blank">FICO® Score calculation</a>. But for younger consumers, it isn’t too helpful to say, “just wait until you are 50 years old, and that will fix things!” Thus, I decided to dive deeper with our analysis, including looking at the credit behavioural characteristics of younger consumers with high FICO® Scores. In this analysis, I looked at credit characteristics for the two highest score bands, 750-799 and 800-850, which have about 16% and 23% of the population, respectively. I further broke this down by looking at the characteristics of the youngest 15% in each group, which occurs at age 29 for the 750-799 group and 43 for the 800-850. We used FICO® Score 9 for our analysis, and examined typical variables of the categories that go into the make-up of the score. <a href="http://www.fico.com/en/blogs/wp-content/uploads/2016/10/FICO-Score-High-Achiever-table.png"><img class="alignnone size-full wp-image-29367" src="http://www.fico.com/en/blogs/wp-content/uploads/2016/10/FICO-Score-High-Achiever-table.png" alt="fico-score-high-achiever-table" width="715" height="747" /></a> Since there’s a lot to dissect in this chart, I’ll highlight a few findings that struck me: <ul> <li>Credit history. Higher scores are undoubtedly associated with a longer time on file. What’s striking is the higher average time on file for the 800+ group, both overall and for revolving accounts (the most common trade line). Clearly, it helps to start credit use early in life – but that’s not the sole determining factor for high scoring. The younger cohorts in both the 800+ and 750-799 groups have time on file medians significantly less than their older counterparts.</li> <li>New credit. High credit scorers do, in fact, pursue new credit. We see little variation in months since last trade line opening and last inquiry among all groups observed.</li> <li>Pay on time. As you might expect, the further in the past the delinquency, the higher the score – and that’s if a delinquency ever happened. 95% of the 800+ people and 72% of the 750-799 group have never been delinquent, which is a striking contrast to the 57% for the total population. The percentages for the younger groups are even higher, especially so for the 750-799ers. Collection items are also scarce for these high scorers. While 23% of the national population have collection items greater than $99, the figures are only 0.5% for the 800+ group and 3% for the 750-799 group. It is clear that, in conjunction with starting a credit file early, paying on time is a key trait of the FICO® Score high achiever.</li> <li>Balance and utilization. Finally, we look at how credit is being used, focusing on revolving product use. (Since most people only have one mortgage or one auto loan, variation in instalment product figures is minimal and driven by payment history, which is near perfect for high scorers, as we’ve seen.) FICO® Score high achievers tend to have more open revolving accounts. While the % active trades and utilization are generally lower, by no means do high scorers avoid the use of credit products. What drives the difference here is the amount of available revolving credit utilized. The 800+ group is roughly 1/4 of the national median, both in total and on their highest utilized card; they also have lower balances and more cards. The 750-799 group is more active and higher utilized, but still only at 2/3 of the national figures. The young 750-799 group compensate with lower revolving balances and, as a result, lower utilization, which is in line with what we see for the 800+ group.</li> <li>Benchmarks. I’d like to point out that while this study provides good benchmarks of the typical credit traits of the FICO® Score high achiever, individual credit profiles will vary widely. And keep in mind that when we sort groups of consumers as a whole by different behaviours, some results may look superficially odd. For example, the 800+ band has a longer median average open account time (128 months) than average revolving months on file (140 months).</li> </ul> So, what do we conclude? A huge takeaway is that high scorers don’t have too much in the way of serious delinquencies and negative public record data. In most respects, the young 800+ people are like their peer group. They really only differ markedly in their shorter credit history and higher non-mortgage balance, both of which are a function of life stage. Our results show that you don’t have to be a credit product hermit; these high scorers have more credit cards. The takeaway is to start credit activity early and maintain well-managed and moderate usage. In many ways, the young 750-799 people are more interesting because their age profile is much younger. Their credit characteristics differ more from their peer group, particularly in terms of length of credit history. They compensate by having almost pristine credit records and lower balances. Ultimately, 39% of US consumers are FICO® Score high achievers, which they accomplish by following common-sense credit practices. It ain’t rocket science!

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