The%20Pricing%20of%20Covenant%20Strength:%20the%20Lenders

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The Pricing of Covenant Strength the Lenders
Perspective

• Norman Hutchison, Alastair Adair
• and Nicky Findlay

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Structure

• The importance of covenant strength
• Income as the key driver of return
• Economic and property cycles
• Impact of default
• Levels of insolvency delinquency
• Lenders assessment of loans
• Balance sheet and securitised loans
• Credit rating agencies
• Debt overhang
• FSA

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Research Methodology

• Part quantitative, part qualitative
• Insolvency delinquency data from DB
• Yield data from IPD
• Interviews with lenders (8) investors (9)
• May to August 2008
• Questionnaire survey of valuers
• October 2008
• Research carried out during period of
  considerable financial turmoil

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The Importance of Covenant Strength
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The Importance of Covenant Strength - Income as
the key driver of return
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The impact of default
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Economic and Property CyclesAverage probability
of insolvencySource DB
8
Economic and Property Cycles Average probability
of delinquency Source DB
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Lenders Assessment of Loans
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Lenders Perspective- balance sheet
securitised loans

• Sharp differences in behaviour pricing
• Pre August 2007 strong growth in lending
• by end 2007, 11 of total lending to property
• covenant strength insufficiently weighted
• Post August 2007 severe illiquidity
• Repricing
• LTV decreasing
• Interest cover ratio increasing
• Margins increasing, over LIBOR, not base rate

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Loan to Value Ratio(Source De Montfort
University)
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Interest Cover - multiple by sector (Source De
Montfort University)
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Pricing of Loans No consensus on weighting, but
key factors

• Balance Sheet
• Property fundamentals
• Strength of the borrower
• Strength of tenant
• Cash flow of the scheme
• Lease length reletting
• Level of return
• Existing customer

• Securitised
• Expected rating of
• securitised vehicle
• Strength of the tenant
• Cash flow of the scheme
• Sector prospects
• Property fundamentals
• Velocity of capital

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Example of pricing of senior debt- 10/15year
lease, good covenant
Prior to mid 2007 2008 onwards
LTV ratio gt80 lt70
Margin (in bps) lt100 gt140-170
Interest cover 1.15 1.35 -1.45
Fees (in bps) 35 100
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Repricing of securitised loans AAA Stock
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Covenant Strength Ratings

• Mixture of in-house and external ratings
• Accuracy of credit ratings have come in for heavy
  criticism (particularly in securitised market)
• widespread failure across the main credit
  ratings agencies in providing accurate ratings
  for structured securities backed by US subprime
  mortgages. Ratings have failed to take account of
  loosening underwriting standards (FSA, 2009
  p22)

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Credit Ratings Agencies

• But not only the accuracy of ratings in doubt
• Ratings misinterpreted by investors
• ?belief that triple-A meant insignificant risk of
  default plus deep liquidity and low price
  volatility - not the case
• Conflict of interest - tension!
• ?rating agencies employed as consultants to
  advise on structuring of the issue
• ? triple-A ratings vital to issuance of
  structured debt
• ?originator pays for the rating higher the
  rating, higher the price achieved
• Where is the independence?

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Evidence of Mispricing of the Covenant Strength
Risk

• Prior to credit crunch plentiful supply of
  cheap money
• Less concern over covenant strength
• More concern over prospects for reletting and
  lease length but
• Pricing point in cycle not pricing through the
  cycle
• Inputs to risk model did not reflect possible
  range of outcomes and misread the stage of the
  cycle
• Little differentiation made between primary and
  secondary markets

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Major worry over debt overhang

• Concern over refinancing of loans
• global funding gap estimated at 20,000 bn
• rising to 25,000 bn by 2011 ((DekaBank)
• 39 of UK senior debt is due for repayment over
  2009/11
• ?equivalent yields higher in 2009 than 2003 (IPD)
• ?c43 fall in capital values from their peak
  (IPD)
• ?technical breaches of LTV covenants
• ?occupier market under pressure
• ?CMBS market very weak
• Number of major players looking to reduce their
  exposure
• Who will do the funding, if securitised market
  does not open up?

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The UK Financial Services Authority

• FSA has publicly admitted weakness it is own
  supervisory
• approach following the collapse of Northern
  Rock.
• Failure to act on macro-prudential analysis and
• a wide ranging intellectual failure

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Lord Turner, Chairman FSAFSA Business Plan
2009/10

• It was believed and said by many influential
  authorities that the development of the model of
  securitised credit, structured credit and credit
  derivatives, extensively traded between banks and
  near-banks, had diversified the holding of credit
  risk and contributed to a Great Moderation in
  financial and economic risk. This turned out to
  be diametrically wrong. p5.

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Conclusion

• Capital values in sharp decline and risk of
  default is increasing key differences between
  sectors.
• Cheap money and over zealous lending fuelled
  price spike. Emphasis on short term trading
  volumes.
• Covenant strength insufficiently weighted by
  lenders during boom. Lenders guilty of pricing
  at point in cycle.
• Risk needs to be fully evaluated in conjunction
  with sector and stage of economic and property
  cycle.
• Urgent overhaul of credit rating system to make
  securitised product more secure. Role for
  government?