I guess this is an important question on an area which is revolving fast with new facets:
NPA: when a person fail to pay loan to bank , the bank declares the asset (loan given to bank) as Non Performing Asset (NPA).
Earlier DRT or Debt recovery tribunal were used to deal with NPA matters which was superseded by SARFAESI Act meaning securitisation and reconstruction of financial assets and enforcement of security interest. SARFAESI empowers to take action to recover the loan money.
Under the act bank can take possession of assets, auction/sale them, change management of assets, even a third party where asset is mortgaged can be asked to pay.
Banks cannot keep immovable properties more than 7 (extended up to 12 with board resolution, approval from RBI).
ARC or asset reconstruction company buys loans from banks and try to make profit from distressed asset. Always ARC will buy a NPA lower than bank valuation. Say HDFC Bank reports a NPA as 100 Cr, ARC will buy at 90 Cr.
ARC administer the asset and pursue individual case till closure. This helps bank in outsourcing non core competency.In reality a special purpose vehicle is created for distressed asset.
When ARC pays bank it does not pay out of pocket. It pays via security receipts. Say in above case ARC requires 90 Cr to buy NPA. It will issue 90 Cr Security receipts to bank. Security receipts are financial instrument (but not fixed interest carrying like bond) purchased by QIB-qualified institutional buyers.
Now twist- ARC can convert the debt to equity. Meaning say the defaulter has 50 debt 50 equity in his own account. ARC will make equity to 100 and hold 50% shares in defaulter balance sheet. If the defaulter makes profit ARC goes there in as shareholder who will share profit.
HDFC Bank- asset value 100 Cr, NPA provided- 100% say to 100 Cr
HDFC Bank sell to ARC for 90 Cr. So immediate loss of 10 Cr.
ARC buys at 90 Cr, defaulter offers 95 Cr and ask ARC to sell assets. ARC is a subject matter expert in asset reconstruction, supposed to wield influence better than bank or defaulter.
Defaulter saves 5 Crores, instead of paying 100 Cr to bank he managed to get away by 95 Cr.
But if debts are converted to equity the story changes as business turn around takes time, due to NPA the share price of defaulter are unlikely to go up.
Mark to market for security receipts
Mark to market is reflecting the value of asset to current financial situation. Say I have shares purchased as 100 and market value is 80. Despite shares not sold, assets are marked to market value i.e. 80 on balance sheet date. As that is a fair value assessment on that date.
Security receipt as per SAFAESI means a receipt or security issued by securitisation company or reconstruction company to any QIB pursuant to a scheme evidencing the purchase of acquisition by holder.
SR’s are backed by impaired assets, they are not debt instruments. The cash flow from underlying assets can not be predicted in terms of value. Rated below investment grade.
The SR rated every year to assess their recovery potential, if downgraded further bank has to reduce the value of securities receipts to reflect current financial fair value assessment. This is nothing but mark to market.
So, if you have a severe downgrade coming from SR, the MTM accounting will have a higher value. This is a normal process of debt securitisation accounting!
Apologies for covering entire loop, it may help others. I used to have a transaction mapping file for debt securitisation- special purpose vehicle to redemption and MTM. Let me check, or else I can write it later as well.