| Guidelines for FHA Condominium Project Eligibility ↓ Community Association Institute - Long Island Chapter
February 25, 2010
How the Heck Do We Get Financing These Days ↓Published as part of the “Navigating for Growth – Opportunities in
challenging times” insert, April 20, 2009, Fairfield County (CT)
Business Journal, HV (Hudson Valley NY) Biz, and Westchester County
(NY) Business Journal
Asset Based Lending ↓Presentation to the Junto of New York Financial Professionals Group –
October 15, 2008, NY, NY
The Financial Crisis Celebrates its First Birthday; Where Are We? ↓Presentation to the New York State Society of Certified Public Accountants –
Bankers’ Committee, August 14, 2008, NY, NY
|
Guidelines for FHA Condominium Project Eligibility
Community Association Institute
Long Island Chapter
February 25, 2010
By Barry P. Korn, CFA
I. HIGHLIGHTS
- Temporary Guidance for Condominium Project Eligibility; Mortgage Letter 2009-46 A
- Spot Loan Approval Process
- Ended February 1, 2010. Replaced by
- Direct Endorsement Lender Review & Approval Process (DELRAP)
- HUD Review and Approval Process (HRAP) continues
- FHA Concentration Requirements
- Cap on FHA loans per Condo Project increases to 50% from 30% through December 31, 2010
- Cap increases to 100% if
- Project has been 100% completed for at least 1 year; and
- 100% of units are sold and other FHA requirements are met
- Cap on FHA loans per Condo Project reverts to 30% beginning January 1, 2011
- Owner-Occupancy Requirements
- 50% of Units must be owner occupied or sold to owner occupants
- REO's may be excluded from calculation (remove from numerator + denominator)
- Pre-Sale Requirements for New Construction
- Reduced to 30% through December 31, 2010, if properly documented
- Documentation consists of
- Copies of sales agreements
- Evidence that lender is willing to make loan
- Evidence that units have closed and occupied or certification from developer
- Florida Condominium Project Approval
- Require review and approval from the Atlanta Homeownership Center under HRAP
- Not eligible for DELRAP
- Permanent Guidance: FHA Approval Process for Condominium Projects and Mortgage Insurance Requirements
Pursuant to the Housing and Economic Recovery Act of 2008 (HERA) Mortgagee Letter 2009-46 B
- Project Approval
- Site Condominiums: NOT required
Defined as Single Family Detached Dwelling (no shared garage or attached building)
- Land-Home Co-operative Developments are ineligible, per revised guidelines
- Environmental Review: NOT required under
- HRAP for projects with infrastructure substantially complete; or
- DELRAP, subject to known conditions
- Manufactured Housing Condo Projects (MHCP)
- Now eligible for FHA Mortgage Insurance (Per HERA)
- Requires HRAP (DELRAP not applicable)
- Condominium Conversions
- Condo Conversion waiting period eliminated
- Conversion from non-residential or rental will be treated as new construction
- Project Eligibility
- Right of First Refusal now permitted
- Commercial Space limited to 25%
- Single Investor limited to 10% of units
- Delinquency (over 30 days) not to exceed 15% (Defined by total number of units)
- Owner-Occupied percentage at least 50%
- Legal Phasing (NOT Market Phasing) required
- Capital Reserve Study: requirement eliminated
- Reserve Requirement: 10% of Annual Budget
- Budget Review required by Lenders
–Lenders are now required to confirm:
- Provision for sufficient funds to "maintain and preserve all amenities and features unique to the condominium project"
- Funding for the replacement of capital maintenance reserves in an amount at least equal to 10% of the Condo’s Budget
- A separate Capital Reserve Fund bank account
- Lenders' Authority
Lenders now allowed to
- Determine eligibility
- Review project documentation
- Certify Section 203 (b) compliance
- Insurance Requirements
- Hazard Insurance required: 100% of current replacement cost
- Borrower must obtain "walls-in" coverage (HO-6 policy)
- Comprehensive Liability Insurance required for common elements and commercial space owned by HOA
- Fidelity Bond/Insurance required for 20+ units
- Flood Insurance required if HOA is located in a Special Flood Hazard Area (SFHA) or in a 100 year flood plain
- HOA, not unit owner, is responsible for amounts up to the National Flood Insurance Program (NFIP) standards.
- Lender Review to confirm adequate funding of insurance coverage and deductibles.
- Certification for Initial Approval
- Lender Certification required on Lender letterhead indicating:
- Project complies with FHA requirements
- All legal docs meet HUD requirements
- Pre-sale, owner-occupancy and FHA concentration ratios met
- Developer Certification
Same as for Lender
- Recertification of Project
- Approvals expire 2 years from placement on approved list
- Re-certification required every 2 years
- Mortgagee Liability
- Deficiencies
Mortgagees are responsible for "material deficiencies" associated with projects approved using DELREP
- Projects approved by Others
Mortgagees who rely upon a project approved by another mortgagee are responsible for loan certification
II. IMPACT & POINTS OF VIEW
- HOA's and Boards of Managers
- Provision for Capital Reserves
Budgets will now require provision for a capital reserve
- Capital Reserve Studies
Capital Reserve Study not be formally required, but planning for capital projects still required for compliance
- Insurance requirements
Insurance costs may increase
- Increased Dollars Needed
Increased dollars to be raised from unit owners present a challenge in this fiscal environment
- Fiduciary Responsibility
Improved financial condition in line with increased fiduciary responsibility
- Lenders
- Due Diligence Requirements: increased
- Liability for compliance: increased
- Community Association Institute
- Guidelines counter-productive?
CAI opposed Guidelines as burdensome
- Delinquencies Cap
Cap of 15% on delinquencies a challenge in this environment
Thank you.
|
How the heck do we get financing these days?
Think outside the bank.
Published as part of the “Navigating for Growth – Opportunities in challenging times” insert, April 20, 2009, Fairfield County (CT) Business Journal, HV (Hudson Valley NY) Biz, and Westchester County (NY) Business Journal
By Barry P. Korn, CFA
If you had any doubt about the critical role banks play in today’s economy, you need look no further than the federal government’s willingness to dump trillions of dollars into the U.S. banking system. We’ve all come to learn that the current crisis was brought forth by “irrational exuberance” that resulted in unrealistic prices and associated debt levels within the financial, commercial and consumer segments of our economy. And when combined with the lack of regulatory oversight by both government and the rating agencies, the overblown bubble burst in a big way. Looking back to when the financial crisis first hit late in the summer of 2007, financial institutions and banks in particular became paralyzed, bringing financing activity to a screeching halt. Even with the extraordinary actions taken by the new administration this year, progress to date has been modest. But the question remains: why?
For starters, while the Federal government has come forth with billions in bank aid it is somewhat unrealistic to expect those institutions receiving the hand-out to immediately start lending again for one simple reason: these funds are needed to replace the real losses already incurred by banks and to cover future losses that bank management knows to expect. (As a commercial banker for the past 4 years I have experienced firsthand how banks make loans or choose not to). Instead of making funds more available to American business people, the government’s money is allowing banks to maintain minimum capital levels, a fact the government and the banks know, but isn’t getting much notice in the press.
Further muddying the waters, while “mark to market” accounting rules have been blamed for exacerbating the financial crisis by further decreasing banks’ capital positions, they do not represent the root cause of the problem. As economic activity declined precipitously in the fourth quarter of 2008, the creditworthiness of many borrowers slid along with it, giving bankers an additional reason to curb lending.
THINKING OUTSIDE THE BANK
Given our current overall circumstance, commercial banks, more than other companies attempting to survive in these unprecedented times, have been limited as to what they can actually do. While banks may want to lend, and in fact are doing some lending, the focus of each individual bank has narrowed to support a sustainable comfort level within its core area of geographic or industry-specific competence.
By thinking outside the bank, therefore, companies would do well to contact an investment banker or financial consultant who specializes in the placement of loans and lines of credit. These organizations are designed to 1) analyze a borrower’s creditworthiness, 2) understand the types of financing feasible in today’s restrictive marketplace, 3) know which type of institution would lend to such a company, and 4) which specific bank or non bank lender would represent an appropriate match for the borrower.
In order to properly understand a company’s creditworthiness, a capital source advisor will analyze the balance sheet in terms of the tangible assets, liabilities and current level of debt relative to the company’s stockholder’s equity, statements of income and cash flow in order to determine its present and future ability to generate enough cash to support the ongoing activities of the business. Further analysis will yield considered judgment about the company’s ability to add additional debt onto its capacity to pay interest and principal on both existing and future indebtedness. Companies that have outstanding payments-in-kind (PIK) debt may be saddled with deferred obligations for which there is no current cash outlay, but rather is added to the obligation and due in the future when the debt matures and must finally be paid. The general ignoring of deferred obligations has been one further cause of the financial crisis and is yet another reason why lenders who have money to lend have been unwilling to do so for such borrowers.
FINDING THE RIGHT LENDER
Bank and non-bank lenders that have money to lend these days tend to be relationship oriented and more sensitive to a borrower’s potential future problems. While there are numerous companies that are very creditworthy, have positive earnings before interest, taxes, depreciation and amortization (EBITDA) and free cash flow (after capital expenditures and debt service) and deserve to be financed, a company’s projected future results are going to based on conservative assumptions as well as a conservative outlook for the economic environment in which the company operates.
Knowing what is feasible in today’s market, therefore, is critical and this means that companies must come face-to-face with today’s financing realities by accepting what independent advisors say is necessary to get the funding that will properly support the business. Nowhere is this more evident than in the treatment of interest expense. Many companies don’t appreciate the fact that the Federal government’s infusion of money and the Federal Reserve’s pushing down of interest rates have created artificially low rates. Offsetting this, however, lenders have increased their spreads (the difference between a base rate and an offering rate) dramatically. Further, many lenders have established “floors” or minimum price levels for their borrowers. In practical terms, however, with the Prime Rate and LIBOR at record lows - despite higher spreads and floors - creditworthy borrowers are able to obtain financing at historically attractive interest rates.
CONCLUSION
Companies looking to tap a commercial lending source will do well to consult with an investment banker or financial advisor who knows the market, can properly assess your situation and perhaps most importantly, represent your best interests to a financial institution. Your advisor, having done his or her homework will be able to recommend financial institutions that want to lend to your company. Your likelihood for success is further strengthened when you take advantage of your advisor’s credibility with your prospective lender.
|
JUNTO OF NEW YORK
Financial Professionals Group
Presentation, October 15, 2008
Asset Based Lending
By Barry P. Korn, CFA
Introduction
Given the multitude of financing choices available from different types of lenders it is not surprising that asset based lending means different things to different people. So, I thought that it might be beneficial to use my 15 minutes of fame in sharing with you my interpretation of asset based lending and the differences among commercial finance options.
Asset Based Lending
In one sense, Asset Based Lending, referred to as ABL, simply means: making loans that are secured by assets. Which assets, you ask? The four major ABL asset classes are 1) accounts receivable, 2) inventory, 3) equipment and 4) real estate. More recently, intangible assets such as trademarks and customer lists have been used to back up asset based loans. And given today’s financial crisis, you have probably heard about Asset Based Securities called “ABS”, which includes CDO’s, formally known as collateralized debt obligations.
The first distinction that may appear self evident is that while all loans are paid back from the cash generated from an enterprise, asset based lending relates to loans or lines of credit directly related to and secured by specific assets, referred to as collateral, whereas so called “Cash Flow” lending describes loans expected to be repaid through the business’ cash flow, not related to any specific collateral. While the reality of today’s sophisticated and complex financial markets reflects our “masters of the universe” having sliced and diced the positioning of their loans, blurring the lines between secured and unsecured, for this overview, I am limiting my remarks to the position of Senior Lender; that is, the lender at the top of the capital structure, with a priority secured recorded or “perfected” interest in the collateral. A discussion of Junior, Subordinated, Second Lien and Mezzanine loans must wait for another time.
Longer lived assets such as equipment and real estate offer the opportunity to be financed over a period of time more in keeping with the useful life of that asset and, therefore, generally are the basis for what is referred to as a “Term Loan”. While in some cases, lines of credit include all 4 or more asset classes, my focus for this discussion is on financing for accounts receivable and inventory, which generally replenish themselves several times a year and collectively fall in the category described as “Working Capital” financing.
A second important characteristic distinguishing ABL is the concept of controlling cash, known in the industry as “Dominion”. Asset Based Lenders tend to require the borrower to have the payments on its invoices remitted directly to a bank account controlled by the lender. This “blocked” account is swept daily so the excess funds can be moved to an operating account used by the borrower. A modified version of this procedure is called “Springing Dominium”. In this arrangement, monies are deposited into the client’s regular operating account, and then the funds necessary to pay down the line are transferred to the lender or to a “blocked account”.
Asset based lenders establish a formula by which “advances” under the line of credit can be taken. For example, a borrower might finance 85% of its eligible accounts receivable and 80% of the net orderly liquidating value (“NOLV”) of its inventory. The ABL lender focuses on the borrower’s assets on a daily basis, both to secure and monitor the performance of the loan, since the loan is directly tied to those assets, the quote “underlying collateral”. By comparison, Cash Flow lenders generally are satisfied with monthly reporting, often just requiring a “Borrowing Base Certificate”.
Asset Based or Cash Flow Lending
Please allow me to emphasize that given the efficiency of computers and the flexibility of the internet, unlike years ago, the reporting requirements today for asset based borrowers in minimal. Nevertheless, you ask, why would anyone opt for an asset based line over a cash flow line?
Glad you asked. There are several valid answers. The principal reason, but not the only one, reflects the borrower’s creditworthiness. Because middle market and upper market Cash Flow lenders are not relying on specific assets to support their loan, and are not closely monitoring any underlying collateral, they properly require the borrower to maintain a more conservative financial position. For example, the typical commercial bank requires that the ratio of total liabilities to tangible net worth be less than 4 to 1. And, the amount of free cash flow needed to pay interest and principal, known as debt service, to exceed a ratio of 1.25 to 1.5 to 1. Thus, there are a lot of creditworthy companies, with positive cash flow, but whose leverage exceeds 4 to 1, that won’t qualify for Cash Flow based loan but can obtain necessary working capital financing by utilizing an asset based loan (“ABL”).
Another important difference between ABL and traditional commercial bank lines of credit, and why very creditworthy borrowers often choose an ABL arrangement, relates to the application of the credit limit set by the lender. In a traditional cash flow based “Line of Credit”, an annual fixed amount is established, based on an analysis of the balance sheet, combined with the cash flow generated by the enterprise. Once the credit limit is set, and provided no default has occurred, the borrower has the right to draw down up to the full amount of the line. However, this can limit a borrower facing a seasonal buildup of inventory or receivables, or one in a high growth mode. With ABL, a line is set, but the borrower has more flexibility to draw down on the line, or more quickly obtain an increase in the line, since the borrowings are formula based and directly related to the underlying assets established for the “Borrowing Base”.
Finance Company compared to Bank Asset Based Lenders
What I have described so far is a commercial bank based Asset Based Lender. However, working capital financing is not limited to commercial banks, nor the criteria so far described. There are many companies requiring working capital financing whose creditworthiness is not up to commercial banking standards. Non commercial bank asset based lenders and finance companies distinguish themselves by accepting a greater degree of credit risk. Specifically, banks’ ABL divisions generally require positive cash flow, sometimes referred to as EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization, or Free Cash Flow, which is EBITDA less capital expenditures, informally called “Capex” and “Debt Service”, which represents payments of principal and interest on the borrowers total outstanding debt. Finance companies may not look for positive EBITDA at the time of the loan, but rather to the collateral and the ratio of the loan to the value of the collateral (LTV) and/or extra or “side” collateral provided to the lender.
Understandably, the cost to the borrower from a finance company is expected to be higher to reflect the increased credit risk underwritten. Borrowers need to understand the ways the cost may be higher. For example, how the cash receipts are credited against the loan can represent a “hidden” charge. For example, are 100% of the receipts credited against the loan or only the advance percentage? How many days above the Federal Reserve Bank clearance days before the cash receipts are credited against the loan? Asset Based Lenders refer to these as “Collection Days”. Zero, 3, or 5 days? These extra days add to the borrower’s expense.
Factoring
Factoring, which is an alternative financing method, often is confused with ABL. For companies whose creditworthiness is not strong enough for a traditional formula based ABL, but who sell to customers who are creditworthy, factoring makes sense. The difference is that while an Asset Based Lender is making a loan to a creditworthy company against its receivables, the Factor is purchasing outright from the less creditworthy company, referred to as the client, its receivables. This type of factoring is referred to as Advance Factoring. A valuable function provided by the Factor in this connection is the credit review process. Because Factors deal with so many companies, and for many of whom, financial information is not available, Factors are able to offer credit guidance and help establish credit limits for its client. The cost of factoring generally is higher than ABL financing. Borrowers also need to understand that the pricing model is different. While the stated interest charge may appear comparable to an ABL or Finance Company, because the receivables are being purchased at a discount, the effective yield to the Factor is higher. An alternative factoring arrangement is a variation called “Collection Factoring”. In this option, the Factor provides the credit review and guarantee function for a fee, but does not provide the financing. The financing is provided by a lender such as a bank ABL who relies on the guarantee of the factor to provide a better pricing option to the borrower.
Credit Insurance
Credit Insurance also is an alternative to Advance Factoring. A Credit Insurance company provides the Borrower with a credit review process in a manner similar to that of a Factor. However, rather than purchase the receivables as does the Factor, the Credit Insurance Company provides the borrower with an insurance policy covering the receivables, similar to the guarantee under Collection Factoring. And, just as a Factor may limit its exposure to certain customers, or tell the borrower that the receivables from certain customers are not acceptable, the credit insurer may do the same. Not to confuse the issue, but it is not uncommon, for example, for Asset Based Lenders who are financing companies in the retail industry to require credit insurance. The cost is modest and depending on the specific circumstances, where ABL financing is viable, purchasing credit insurance may prove to be a less expensive alternative than factoring.
Another circumstance where the use of factoring and credit insurance may come into play is with respect to foreign receivables. Due to the specialized laws of the different foreign countries regarding perfection and collection, utilizing firms specializing in factoring of or providing credit insurance on foreign receivables represent sound financial risk management complementing one’s domestic receivable financing.
Purchase Order Financing
Lastly, with respect to working capital financing, I want to mention lenders who provide what is known as Purchase Order financing. Purchase Order financing is ideal for those companies with limited working capital availability who receive an unusually large order from a customer and, as a result require additional funds to buy materials to manufacture or supply its product, prior to the purchase qualifying for an inventory or receivable advance. A Purchase Order finance company accepts the purchase order from the customer as collateral for a loan. These are companies that are willing to accept the added risk that the order will be completed, delivered and accepted by the client’s customer. While the cost is also higher than traditional ABL, based on the profit margin for the client, and maintaining or establishing its relationship with the customer, the cost of the Purchase Order financing may be minimal.
In conclusion, despite the financial crisis in which we find ourselves, working capital financing is essential to drive business and, forgive my shameless commercial, but I represent banks and finance companies that continue to offer working capital financing on attractive terms with superior customer service.
Thank you and I will be pleased to answer any questions, which you may have.
|
GUIDELINES FOR FHA CONDOMINIUM PROJECT ELIGIBILITY
COMMUNITY ASSOCIATION INSTITUTE
LONG ISLAND CHAPTER
February 25, 2010
By Barry P. Korn, CFA
I. HIGHLIGHTS
- TEMPORARY GUIDANCE FOR CONDOMINIUM PROJECT ELIGIBILITY; Mortgage Letter 2009-46 A
- Spot Loan Approval Process
- Ended February 1, 2010. Replaced by
- Direct Endorsement Lender Review & Approval Process (DELRAP)
- HUD Review and Approval Process (HRAP) continues
- FHA Concentration Requirements
- Cap on FHA loans per Condo Project increases to 50% from 30% through December 31, 2010
- Cap increases to 100% if
- Project has been 100% completed for at least 1 year; and
- 100% of units are sold and other FHA requirements are met
- Cap on FHA loans per Condo Project reverts to 30% beginning January 1, 2011
- Owner-Occupancy Requirements
- 50% of Units must be owner occupied or sold to owner occupants
- REO's may be excluded from calculation (remove from numerator + denominator)
- Pre-Sale Requirements for New Construction
- Reduced to 30% through December 31, 2010, if properly documented
- Documentation consists of
- Copies of sales agreements
- Evidence that lender is willing to make loan
- Evidence that units have closed and occupied or certification from developer
- Florida Condominium Project Approval
- Require review and approval from the Atlanta Homeownership Center under HRAP
- Not eligible for DELRAP
- PERMANENT GUIDANCE: FHA APPROVAL PROCESS FOR CONDOMINIUM PROJECTS AND MORTGAGE INSURANCE REQUIREMENTS
Pursuant to the Housing and Economic Recovery Act of 2008 (HERA) Mortgagee Letter 2009-46 B
- PROJECT APPROVAL
- Site Condominiums: NOT required
Defined as Single Family Detached Dwelling (no shared garage or attached building)
- Land-Home Co-operative Developments are ineligible, per revised guidelines
- Environmental Review: NOT required under
- HRAP for projects with infrastructure substantially complete; or
- DELRAP, subject to known conditions
- MANUFACTURED HOUSING CONDO PROJECTS (MHCP)
- Now eligible for FHA Mortgage Insurance (Per HERA)
- Requires HRAP (DELRAP not applicable)
- CONDOMINIUM CONVERSIONS
- Condo Conversion waiting period eliminated
- Conversion from non-residential or rental will be treated as new construction
- PROJECT ELIGIBILITY
- Right of First Refusal now permitted
- Commercial Space limited to 25%
- Single Investor limited to 10% of units
- Delinquency (over 30 days) not to exceed 15% (Defined by total number of units)
- Owner-Occupied percentage at least 50%
- Legal Phasing (NOT Market Phasing) required
- Capital Reserve Study: requirement eliminated
- Reserve Requirement: 10% of Annual Budget
- Budget Review required by Lenders
–Lenders are now required to confirm:
- Provision for sufficient funds to "maintain and preserve all amenities and features unique to the condominium project"
- Funding for the replacement of capital maintenance reserves in an amount at least equal to 10% of the Condo’s Budget
- A separate Capital Reserve Fund bank account
- Lenders' Authority
Lenders now allowed to
- Determine eligibility
- Review project documentation
- Certify Section 203 (b) compliance
- INSURANCE REQUIREMENTS
- Hazard Insurance required: 100% of current replacement cost
- Borrower must obtain “walls-in” coverage (HO-6 policy)
- Comprehensive Liability Insurance required for common elements and commercial space owned by HOA
- Fidelity Bond/Insurance required for 20+ units
- Flood Insurance required if HOA is located in a Special Flood Hazard Area (SFHA) or in a 100 year flood plain
- HOA, not unit owner, is responsible for amounts up to the National Flood Insurance Program (NFIP) standards.
- Lender Review to confirm adequate funding of insurance coverage and deductibles.
- CERTIFICATION FOR INITIAL APPROVAL
- Lender Certification required on Lender letterhead indicating:
- Project complies with FHA requirements
- All legal docs meet HUD requirements
- Pre-sale, owner-occupancy and FHA concentration ratios met
- Developer Certification
Same as for Lender
- RECERTIFICATION OF PROJECT
- Approvals expire 2 years from placement on approved list
- Re-certification required every 2 years
- MORTGAGEE LIABILITY
- Deficiencies
Mortgagees are responsible for “material deficiencies” associated with projects approved using DELREP
- Projects approved by Others
Mortgagees who rely upon a project approved by another mortgagee are responsible for loan certification
II. IMPACT & POINTS OF VIEW
- HOA'S AND BOARDS OF MANAGERS
- Provision for Capital Reserves
Budgets will now require provision for a capital reserve
- Capital Reserve Studies
Capital Reserve Study not be formally required, but planning for capital projects still required for compliance
- Insurance requirements
Insurance costs may increase
- Increased Dollars Needed
Increased dollars to be raised from unit owners present a challenge in this fiscal environment
- Fiduciary Responsibility
Improved financial condition in line with increased fiduciary responsibility
- LENDERS
- Due Diligence Requirements: increased
- Liability for compliance: increased
- COMMUNITY ASSOCIATION INSTITUTE
- Guidelines counter-productive?
CAI opposed Guidelines as burdensome
- Delinquencies Cap
Cap of 15% on delinquencies a challenge in this environment
Thank you.
|
NEW YORK STATE SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS
BANKERS’ COMMITTEE
Presentation of August 14, 2008
The Financial Crisis Celebrates its First Birthday
Where Are We?
By Barry P. Korn, CFA
How did we get here? A brief review:
Some say the origins of our current situation began after 2001 when interest rates were driven to exceedingly low levels and stayed there for too long, opening and keeping open the spigots of easy credit. And “Asset Backed Securities”, are also blamed for the mess in which we find ourselves, although they gained prominence in the mid 1990s. However, around 2005 credit derivatives such as “Credit Default Swaps”, replaced credit insurance as the preferred alternative for credit enhancement of asset backed securities. And unlike traditional bond insurance, the underlying debt issuer is not involved in the credit default swap transaction. As a result, the market for credit derivatives grew to be larger than the market for the underlying assets themselves. It is estimated that credit derivatives now exceed $50 trillion.
Structured Investment Vehicles (SIV’s) such as Collateral Debt Obligations, a type of asset backed security backed by pools of diversified debt instruments, continued to gain popularity with fund managers, particularly those with sub-prime loans and home equity lines of credit (HELOCs). Collateral Debt Obligations or CDO’s accepted riskier loans in securitizations that bond insurers and traditional investors would reject. In so doing, the benefit to the market provided by these groups, that is, the limit on the riskiness of loans that originators could securitize went away. The result was that the trend through 2006 was that of deteriorating sub-prime loan quality and the beginning of defaulting subprime mortgages.
The easing of credit standards through 2007 allowed financial institutions to maintain liquidity by securitizing CDO’s and thereby continue lending, particularly to support the private equity, hedge fund and leveraged loan markets with loans that had little in the way of covenants; often referred to as “Covenant Lite” loans. When several large mortgage companies filed for bankruptcy citing sub-prime issues, credit agencies took notice and in July 2007 began to downgrade certain mortgage backed securities. Since the pricing of these securities was based on the strong ratings given to them by the credit rating agencies, to that just below US Treasuries, the market for the downgraded securities disappeared and trading virtually stopped as demand and values dropped.
The impact began to be felt by lending financial institutions including commercial banks, investment banks and private equity firms. When securities these institutions held could not be sold, and remained on the books of the underwriting organizations, liquidity in the market evaporated. This event has been referred to by some as a “Black Swan” event, representing an extremely rare occurrence as seeing a black swan may happen only once or twice in one’s lifetime. Under normal circumstances, it is the smaller weaker credits that are affected first. However, in the current financial crisis, the opposite occurred as the ability to finance the largest size transactions in the upper market (companies with sales in excess of $1 billion) ceased, while financing to middle market companies (with sales from $20 million to $1 billion) continued, albeit at a slower pace. Pricing also reversed, being higher for large syndicated loans than that of the smaller loans, which were being held and kept on the books of a single institution, or a small group of 2 or 3 lenders, sometimes referred to as a “Club”.
The credit crunch, that is the lack of liquidity in the capital markets, continues as financial institutions of all sizes now concentrate on raising enough capital to maintain balance sheets with tangible net worth, reasonable leverage and, to stay in business. To gain some perspective, allow me to offer some statistics, thanks to Arthur D. Little, Standard & Poor’s and Allied Capital. Senior loan volume to middle market companies went from almost $200 billion in the 2nd quarter of 2007 to just over $40 billion in the 1st quarter of 2008. The senior loan pipeline went from $235 billion in 2007 to an estimated $70 billion in the 2nd quarter of ’08. And, of course, this includes transactions that were in the pipeline in ’07 prior to the summer credit seizure. With the liquidity freeze, private equity firms were unable to obtain the leveraged financing necessary to complete acquisitions. Senior bank debt in the 1st quarter of 2008 represented only 36% of leveraged buyout financing compared to 60% in 2007 and 2nd tier mezzanine debt took up 19% of the financing, up from 5% in ’07. Covenant Lite term loans went from $97 Billion in 2007 to $0 in the 1st quarter of 2008.
Why no defaults until now?
Until the first quarter of this year there have been few defaults, which, when one looked at the statistics, in my view, gave a false impression of the state of wellness in credit circles. Standard & Poor’s reported that institutional loan default rates, based on a lagging 12 month index, ranged from 1% to 2% between 2004 and 2006 and less than 1% for most of 2007 and through the 1st quarter of 2008.
In previous cycles, lenders, particularly commercial banks had substantial work out departments so that when a loan defaulted, it would be transferred to its work out department. In this cycle, most banks eliminated their work out units. It may be circular reasoning, but they didn’t need them because there were so few defaults, and more importantly, the banks had plenty of buyers for their weaker credits. Private equity firms, in conjunction with turnaround management organizations were aggressively competing for loans that banks didn’t want. Thus, a bank only had to put the word out that a loan was available and a buyer or buyers would surface to take out the bank, generally at full value. In the event the bank had to take a “haircut”, the loss went against reserves for bad debts thereby precluding calling a default.
Another factor was the concept of Covenant Lite, mentioned earlier. With no covenants, there would be no default triggers. Thus the early warning system that covenants offer was not there. In addition, particularly with respect to loans related to private equity transactions, a “toggle” feature called PIK, which stands for Payment In Kind was very prominent. What this feature does is to allow the borrower to pay interest due in the form of additional debt at the maturity of the loan, rather than in cash on the payment due date. Thus with an option to “toggle” between cash and additional debt, defaults during the term of the loan are precluded.
An additional factor was the willingness of private equity funds to provide additional investment dollars when their portfolio companies needed cash. Now however, with many funds closed or nearing completion of the fund’s investments the cash is simply not available to bail out a problem company. Also, with firms financed through “fundless” sponsors, the money and willingness of investors to further invest in a deteriorating situation has vanished. While plenty of money is still around, the flavor of the day is distressed investment funds. And I suspect, these bottom fishers will wait to extract the terms they require. Here come the defaults.
Based on loss estimates that I will come to shortly, the institutional loan default rate is conservatively being projected to approach 5%. Other forecasters are suggesting default rates approaching 10%. Not a pretty picture.
Expanding Credit Turmoil and the Effects on the Economy
In my view, the credit crisis has only recently begun to trigger a deluge of negative consequences. Many experts both in the private sector and the federal government thought and acted on the belief that the crisis of last summer was limited to sub-prime residential mortgages and there would be little effect on the overall economy from the housing slump, which was to have ended in short order. WRONG! The problem of excess and loose credit involves much more than residential subprime mortgages.
As the Financial Times recently reported, the IMF while acknowledging that policy interventions – mostly by the US Treasury and the Federal Reserve had so far succeeded in containing systemic risk, further intervention will be necessary to preserve financial stability. And as NYU Professor Nouriel Roubini said in a recent interview with Barron’s Magazine, “near prime, prime, commercial real estate, credit cards, auto loans, student loans, home-equity loans, leveraged loans, muni bonds, corporate loans-you name it” are affected. The International Monetary Fund (“IMF”) effectively confirmed this assessment when the Financial Times reported two weeks ago that “Global financial markets are fragile and indicators of systemic risk remain “elevated” almost a year into the credit crisis.” The IMF warned that credit growth in the US could fall further as a result of ongoing financial system stress and said that credit quality “across many loan classes has begun to deteriorate with declining house prices and slowing economic growth.”
Let’s look at the consumer sector of the economy: For a few years now, economists have been saying that the economy remains strong because it is consumer driven. Unfortunately, that engine has now conked out in more ways than one. With the slump in housing, and home prices being down some 15% during the past year according to the Case-Shiller Home Price Index, the “safety valve” of tapping into one’s home equity to pay off credit card debt is gone. Credit card debt, in my view is out of control. Also, given the high rates and fees associated with credit cards, the ability of the average consumer to pay off his or her debt is slim. This issue has yet to hit the front pages. Look out.
And, with gas around $4.00 a gallon, consumers are feeling a real impact in their wallet. While oil is down from a peak of $140 per barrel, it is still well in excess of $100 a barrel. Again, a few years ago when oil was $50 a barrel, economists were saying not to worry, since oil would have to go to $100 a barrel before we have a negative impact. Well we have exceeded that figure and while oil prices may fluctuate, the impact of high gas prices is, in my opinion, here to stay.
That consumer engine I referred to that conked out needs to be replaced. Just a couple of weeks ago we received confirmation that the consumer is finally realizing that he or she can do without that gas guzzler engine and SUV. The front pages of our newspapers announced that the big three American automobile manufacturers are substantially reducing, if not eliminating leasing as a means to finance the automobiles and trucks they sell. They blame the losses they are taking on the sudden drop in residual values due to high oil prices. Give me a break! While there is no question that oil prices have caused residuals to drop more than may have been projected, the automobile manufacturers have used subsidized leases as a marketing tool for years in large measure because of studies demonstrating high consumer satisfaction from leasing. That the US based finance companies and banks providing automobile lease financing may not be able to get the financing they need due to their creditworthiness, or lack thereof, may well have been the catalyst.
The bear market in stocks doesn’t help either. Nicholas Perna, Economic Advisor to Webster Bank, reported that during the final quarter of last year and the first quarter of 2008, household net worth dropped more than $2 trillion due to falling home values and declining equity share prices. Employment also has been increasingly negative. Unemployment is up and this further affects consumers’ ability to spend or pay down debt. In sum, these factors combine to represent a brake, as is stopping the vehicle of consumer spending. And with the Government’s rebate checks now having been spent and retail sales down in real terms, a quick U turn in consumer spending is unlikely.
Now let’s turn to the Commercial side of the economy. The white swans have returned and we are now experiencing a return to the normal progression of smaller companies, more vulnerable to a downward economy than upper market companies, being the first to experience more defaults, prepackaged bankruptcy plans, bankruptcies and liquidations. The IMF says that while financial institutions have raised substantial new capital, globally they have written off about $400 billion since last August, and, that these losses have “exceeded capital raised.” Thus it is not rocket science to say there will be less new bank money for commercial borrowers, period. Distressed companies will have a more difficult time and it is unlikely that banks will be chasing bankrupt companies, if they aren’t already a part of a company’s capital structure before the bankruptcy. To give you some perspective, Lisa Lee in the Deal magazine just reported that research firm Dealogic calculated that US debt refinancings, for both distressed and healthy companies plunged 80% in the first half of 2008 to $67 billion from $338 billion one year ago.
The IMF reaffirmed its projection of credit losses approaching $1 trillion, yes, that’s trillion with a “T”. Tom Romero, Managing Partner and founder of Capital Research Partners in Westport CT in an article he titled “Dealing with the Coming Commercial Credit Crisis” referred to a Goldman Sachs report released in March that predicted global credit losses reaching $1.2 trillion, with Wall Street accounting for nearly 40%. The report said U.S. leveraged institutions, which include banks, broker-dealers, hedge funds and government sponsored enterprises, would suffer more than $500 billion in credit losses after loan loss provisions. Professor Roubini, in his Barron’s interview, has projected credit losses “most likely closer to $2 trillion”.
Reflecting both losses and lack of capital, banks and other lenders now are tightening their credit standards for all types of loans. Sound familiar? And, with the prodding of regulators, a new found conservatism is emerging that really represents a return to old fashioned commercial banking. This translates to looking at the underlying assets supporting the loan and providing for covenants. Forgive me for a shameless commercial, but as an asset based lender who continues to follow the same criteria I have for years, there is money to lend based on established formulas providing for advances based on a company’s accounts receivable and inventory. We also look for debt service coverage, that is, the company needs to have the cash flow to pay its interest expense and debt obligations as they come due. This may sound over simplified, but I see so many financial packages, even with underlying assets, where the company has so gorged itself on debt that it is unable to pay back what it has borrowed. The deleveraging of Corporate America must take place.
Whether we are talking $1 or 2 trillion in additional losses, the message is clear to me that it will take some time to deleverage, absorb losses, stabilize supply and demand and regain the confidence to support growth again. The use of the term Recession is, in my view academic, as we all know that the National Bureau of Economic Research declares a recession after the fact. The central theme I want to leave you with today is that we have a tough ride ahead, one that will last for a few years.
Impact of Deferred Write Downs and Fair Value Accounting
As I am addressing an audience of CPA’s, I would be remiss if I didn’t refer to the impact of deferred write downs and my views on Fair Value Accounting. Throughout my career as an asset based lender, both in a finance company borrowing from banks and now as a banker lending to companies, it has been standard banking practice to write off or fully reserve against a receivable that is 90 days past due. However recently, I have read of banks that have moved the 90 day rule to 120 days, possibly with the encouragement of government officials asking these banks to work with borrowers rather than move to foreclose on their property. The implication confirms to me the point that we continue to defer reporting losses.
As to Fair Value Accounting, having graduated with a degree in public accounting, it was drilled into me that when an asset’s value is impaired it needs to be written down. No argument. But, I question the logic to report as income the difference between the reduced value of a debt by a debtor experiencing financial difficulty without cash reserves, because the debt is now valued less than the obligation due.
Thank you for the opportunity to express my views on the current credit predicament. I will be happy to answer any questions, which you may have.
|
|