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By the latter part of 1998, the financial system of South Korea (the tenth largest economy in the world) was basically insolvent. Many banks failed as bad loans mounted. Capital flight so reduced Korea’s foreign exchange reserves that the country was teetering on the verge of defaulting on its sovereign debt obligations. Korea had to request an emergency funding from the International Monetary Fund or IMF, which, working closely with the US Federal Reserve, eventually provided the country with a $58 billion rescue package.
The package came with some strings attached, one of which was for the Korean government to sell off to foreign investors a couple of failed and nationalized big banks including Korea First Bank. The IMF reasoned that the failure of Korea's banking system was due to a total lack of a "credit culture," as lending had typically been done on the basis of either government policies or collaterals without much regard to the credit-worthiness of, or the ability to pay by, the borrowers. Credit culture was thought to permeate western banking and it was hoped that foreign investors would bring such a culture into Korea's banking system.
The U.S.-based Newbridge Capital was one of the only two bidders, among more than 40 invited, to have showed up at the government-mandated auction. I represented Newbridge as its partner. We finally reached a preliminary agreement with the Korean government on New Year’s Eve in 1998, after weeks of non-stop negotiations, to give us the exclusive right to acquire Korea First Bank. The key part of the deal was that all the assets be priced at fair market value. The memorandum of understanding specifically called for all the assets to be “marked to market” on a loan-by-loan basis, after which Newbridge and the government would jointly invest into the bank to recapitalize it.
The government agreed to give all its voting rights to Newbridge, so with 51% ownership, Newbridge would have 100% voting and operating rights. To its credit, other than asking for three observer seats out of the 17 member new board of directors, the government did not ask for any control rights even though its negotiators were among the toughest and best I have ever met. The Korean government knew what would be the best for the bank’s future and had no desire in sharing control or having a say in the running of the newly privatized bank. The deal would allow the government to capture more than half of the upside if the bank was eventually turned around by Newbridge.
The parties envisaged that the final contract be signed and the investment completed within four months. As it happened, the deal did not close until about one full year later. It turned out that the simple concept of “mark to market” was completely inoperative, especially in a financial crisis, because there was not a market for bad loans. As a result, the seller and the buyer could not agree to a fair value in the absence of the market in the midst of an economic crisis. They had very divergent expectations and concerns. The seller thought that the assets would be worth more when the economy eventually recovered. The buyer was worried they might be worth less if the economy continued to deteriorate. Both were right because there was a significant probability for either to happen, but their divergent expectations made it impossible for them to agree to the right price.
The parties finally agreed to a methodology that resolved the dilemma. The methodology made it unnecessary to determine a fair market value at the time of the transaction, but was nonetheless very fair to both parties. It removed all downside risks in the existing assets of the bank for the investor but also minimized the potential losses for the Government. The elegance of the methodology is in its simplicity.
We decided that since both parties were actually concerned about the future value of these assets, we should not attempt the impossible to try to determine their fair value today. Instead we would allow time to tell us what the true value of these assets was. We agreed to what we called a “buy” or “sell” arrangement to be implemented in the future. In the next three years on the anniversary, either party could have the right to simply name the price for any loan existing on the book of the bank at the time of the transaction, and the other party would have the option to either “buy or sell” that loan at that price. We would be indifferent as to which side would name the price and which side would have the right to say “buy” or “sell.” Eventually, it was agreed that the bank would name the price, since the bank ought to know better than the government what the true value of an asset was, and the government would have the right to “buy” or “sell.”
By this methodology, the government did not have to buy any bad assets from the bank at the time of closing of the transaction. One, two or three years later, for example, the bank might decide that some loans were truly impossible to be fully recovered. Then it had the right to make a claim against the government for what the bank considered to be the permanent impaired amount of the loan (naming the price for that loan). If the bank made a claim of, say, 30 cents on the dollar for the loan, the government would have the option and the right to either accept it and pay the 30 cents, or, if the government thought that the loan could fetch a better price than claimed by the bank, the government would buy the loan at face value and sell it to a third party, typically a distressed debt buyer.
The beauty of this methodology is several fold. First, the government did not have to sell bank assets to private investors at deeply distressed value in the depth of a financial crisis when the market for either normal or distressed assets has disappeared, incurring a huge loss for taxpayers. Time heals. It really does. Over time, as the economy recovers, the loan value is likely to improve.
Second, the bank was no longer crippled by the burden of these bad assets because it knew they were ultimately protected by the government. The new investors could concentrate on fixing the operations of the bank and making new loans.
Third, it removed any incentive for the privatized bank to cheat. To a bank, an interest yielding asset is more valuable than cash. Cash does not generate a return but a loan does. Producing assets is a costly process. Therefore a bank would want to hold on to an asset, and more importantly to a customer, as long as the loan is safe. In the buy/sell arrangement, if the bank made a mistake by under-pricing a loan, the government would buy it with cash and the bank would lose the loan and the customer. The bank had to spend more than the cash received from the government to replace the lost loan. If the bank over-priced the asset, the bank would risk losses. Therefore, the bank would be incentivized to work out the loan to the best of its abilities and to price the loan as accurately as possible, which is of course in the best interest of everyone involved.
This methodology worked so well for the Korean Government that, three years later when the program ended, the government eventually had spent a fraction of the original budget to rescue the bank. Under the new owners, many of the non-performing loans were worked out and recovered, along with the recovery of the Korean economy.
In retrospect, the methodology we used was the best for taxpayers. It did not give investors as much gain as in some other government-assisted bank deals elsewhere, which allowed new investors to buy the assets at substantially marked down values and to capture significant windfall gains when the market and asset value recovered. We earned our upside from revitalizing and building up the bank, not from gains on legacy assets at the expense of taxpayers. Both the Korean Government and Newbridge eventually realized many times their investments when the turned around bank was sold to an international bank five years later.
Just as with South Korea a decade ago, the US government is left with little choice but to nationalize insolvent banks. But in order to revitalize the banking system, it must immediately get private capital to invest into these banks. It should set up a Resolution Trust Corporation like "bad bank" ready to purchase bad assets from these banks to clean up their balance sheet. But in selling off the nationalized banks, the government does not have to price the bad assets immediately. It should use the same methodology used in Korea to price assets over time to achieve their maximum value while removing any downside risks in legacy assets.