The Pricing of Covenant Strength: the Lenders’ Perspective

Norman Hutchison, Alastair Adair

and Nicky Findlay

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

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

The Importance of Covenant Strength

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

The impact of default

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

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

Lenders’ Assessment of Loans

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

Loan to Value Ratio(Source: De Montfort University)

Interest Cover - multiple by sector (Source: De Montfort University)

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”

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

Repricing of securitised loans AAA Stock

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)

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?

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

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?

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”

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.

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?