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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 D&B• 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 IPD UK Annual All Property Returns 1981 - 2007
-15
-10
-5
0
5
10
15
20
25
30
Income Return Capital Grow th
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The impact of default
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Economic and Property CyclesAverage probability of insolvency
Source: D&B Average probability of insolvency - selected sectors
March 2006 - September 2008
0.0000%
0.5000%
1.0000%
1.5000%
2.0000%
2.5000%
3.0000%
3.5000%
4.0000%
4.5000%
Mar2006
Jun2006
Sep2006
Dec2006
Mar2007
Jun2007
Sep2007
Dec2007
Mar2008
Jun2008
Sep2008
Period
%
Heavy Construction Warehousing, Storage and Distribution
Food Retailers Clothes RetailersFinancial Institutions Government
Business Services Overall Mean
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Economic and Property Cycles Average probability of delinquency
Source: D&B Average probability of delinquency - selected sectors
March 2006 - September 2008
0.0000%
5.0000%
10.0000%
15.0000%
20.0000%
25.0000%
30.0000%
35.0000%
40.0000%
45.0000%
50.0000%
Mar2006
Jun2006
Sep2006
Dec2006
Mar2007
Jun2007
Sep2007
Dec2007
Mar2008
Jun2008
Sep2008
Period
%
Heavy Construction Warehousing, Storage and Distribution Food Retailers
Clothes Retailers Financial Institutions Business Services
Government Overall Mean
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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 >80% <70%
Margin (in bps) <100 >140-170
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 achievedWhere 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 supervisoryapproach’ 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?