Here my focus will be on distressed debt securities and my idea of distressed securities is broad enough in including the investments in non-performing assets of financial institutions. Investors are generally attracted towards distressed securities/assets to earn higher risk adjusted returns. The prominent reason for such risk adjusted returns is the arbitrage opportunity created by the regulatory/ accounting process.
The financial institutions in general and commercial banks in particular are highly regulated. Such regulatory pressures do create the opportunity for the investors to purchase the distressed loans (NPAs) at the attractive prices. Given the regulatory costs involved in having large amount of distressed loans, many banks prefer to sell the loans at the throw away prices (even at less than the recovery value). Such behavior of the banks may be attributed to two reasons. First, tax laws allow the banks to deduct such losses from the EBIT. Second, market pursues the larger amount of NPAs thereby higher regulatory reserves as the negative information (may be market short sightedness). The buyers of these assets (may also include commercial banks) do place them in their trading account. As the assets in the trading account are marketed to market and no ‘regulatory’ reserves need to be held against the assets in the trading account, they provide the economic value to the buyers. Hence, the sellers of the distressed assets do sell them on the regulatory/accounting reasons where as buyers of such assets do buy them on the economic reasons.
(Your comments and suggestions do inspire me the most. Thanks….)
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