What Is a Nonperforming Asset (NPA)?
A nonperforming asset (NPA) is a debt instrument where the borrower has failed to make scheduled interest or principal payments to the lender for an extended period. As a result, NPAs do not generate any income for the lender through interest payments.
Breaking Down Nonperforming Asset
Example Scenario
Imagine a mortgage now in default. After the borrower misses several payments, the lender may have to forcefully liquidate any assets pledged as collateral for the loan. If there are no pledged assets, the lender might write-off the debt as bad and subsequently sell it at a reduced price to a collections agency. Most banks categorize loans as nonperforming after 90 days of missed payments.
To illustrate further, consider a company with a $10 million loan that requires interest-only payments of $50,000 per month. If the company does not pay for three consecutive months, the lender might classify the loan as nonperforming to comply with regulatory standards. A loan may also be designated as nonperforming if the borrower can make interest payments but fails to repay the principal at maturity.
The Effects of NPAs
Carrying NPAs, also referred to as nonperforming loans, brings three major challenges for lenders:
- Reduced Cash Flow: Nonpayment of either interest or principal disrupts the lender’s cash flow, affecting budgets and cutting down earnings.
- Loan Loss Provisions: These are reserves set aside to cover potential losses from these loans, reducing the capital available for new loans.
- Earnings Impact: Once the actual losses from NPAs are identified, they are written off against earnings, decreasing profitability.
Recovering Losses
Lenders usually have four primary strategies to recover losses from NPAs:
- Restructuring Loans: Proactively restructuring the loan terms to ensure cash flow and forestall nonperforming status.
- Seizing Collateral: If defaulted loans are collateralized, lenders can seize and sell the collateral to recoup losses based on market value.
- Converting Loans to Equity: Lenders may convert bad loans into equity shares, which can appreciate to cover lost principal. However, this often wipes out the value of original shares.
- Selling Bad Debt: As a last resort, banks may sell bad debts to specialized loan collection companies at significant discounts, particularly when the debt is unsecured or recovery through other means is impractical or expensive.
Related Terms: bad debt, loan loss provision, collateralization, collections agency.
