What Is a Nonperforming Asset?
A nonperforming asset (NPA) is a debt instrument where the borrower has not made any previously agreed upon interest and principal repayments to the designated lender for an extended period of time. The nonperforming asset is, therefore, not yielding any income to the lender in the form of interest payments.
BREAKING DOWN Nonperforming Asset
For example, a mortgage in default would be considered nonperforming. After a prolonged period of non-payment, the lender will force the borrower to liquidate any assets that were pledged as part of the debt agreement. If no assets were pledged, the lender might write-off the asset as a bad debt and then sell it at a discount to a collections agency.
Banks usually categorize loans as nonperforming after 90 days of nonpayment of interest or principal, which can occur during the term of the loan or for failure to pay principal due at maturity. For example, if a company with a $10 million loan with interest-only payments of $50,000 per month fails to make a payment for three consecutive months, the lender may be required to categorize the loan as nonperforming to meet regulatory requirements. A loan can also be categorized as nonperforming if a company makes all interest payments but cannot repay the principal at maturity.
The Effects of NPAs
Carrying nonperforming assets, also referred to as nonperforming loans, on the balance sheet places three distinct burdens on lenders. The nonpayment of interest or principal reduces cash flow for the lender, which can disrupt budgets and decrease earnings. Loan loss provisions, which are set aside to cover potential losses, reduce the capital available to provide subsequent loans. Once the actual losses from defaulted loans are determined, they are written off against earnings.
Lenders generally have four options to recoup some or all of the losses resulting from nonperforming assets.
When companies are struggling to service debt, lenders can take proactive steps to restructure loans to maintain cash flow and avoid classifying loans as nonperforming. When defaulted loans are collateralized by assets of borrowers, lenders can take possession of the collateral and sell it to cover losses to the extent of its market value.
Lenders can also convert bad loans into equity, which may appreciate to the point of full recovery of principal lost in the defaulted loan. When bonds are converted to new equity shares, the value of the original shares is usually wiped out. As a last resort, banks can sell bad debts at steep discounts to companies that specialize in loan collections. Lenders typically sell defaulted loans that are not secured with collateral or when the other means of recovering losses are not cost-effective.