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Distressed Loans: Can Automation Solve the Settlement Backlog?

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.