Recent Commentary from Leverage World®

“…recent loan market news does not connote ideal conditions for borrowers:

• In the Federal Reserve’s January survey of senior loan officers, one-third of domestic institutions reported tightening their lending standards on commercial and industrial loans. That represented a larger net fraction than in the October survey. ^[1]
• Since the beginning of the year, the weekly number of new loan deals launched has declined steadily from 6 to 1, versus an average over the last 12 months of 10.4^[2]
• Little more than a month into 2008, year-to-date loan defaults exceed the totals for 2006 and 2007 combined. (Plastech and SIRVA are recent examples.)^[3]
• January’s market performance was widely viewed as the worst since the crisis-ridden summer of 2007^[4].

Under the circumstances, one might suppose that the terms of trade have shifted toward lenders since the wildly borrower-friendly days of early 2007. That is not necessarily a safe assumption, however. A weakening of the borrowers’ relative bargaining strength logically ought to be starting to reverse the degradation of covenants observed since around 2004-2005. That is not happening in the case of certain provisions that could adversely affect lenders’ recoveries in bankruptcy, yet have attracted little attention.

More Loan, Less Value

Traditional limitations on collateral release and collateral substitution have vanished from many indentures. In earlier times, the typical loan indenture tightly controlled the disposition of proceeds of asset sales, with an emphasis on debt retirements. Over the last few years, the terms have changed to allow borrowers anywhere from six to 15 months to reinvest in a loosely defined “permitted business”. The practical implication is that a borrower might divest hard assets, such as a casino or fiber optic cable, and buy stock in a gaming or telecommunications company. A lien on assets with high expected recovery value, in short, would be replaced by a junior claim. Frequently missing are traditional safeguards in such sales of operating assets, e.g. size limits, lender approval rights, or a requirement that 90% of the proceeds be received in cash.

Often stripped away as well are constraints on creating senior claims through hedging of interest rates, currencies, and commodity prices. Five years ago, hedging counterparties’ claims generally were unsecured. The borrower typically posted cash, limited to an amount on the order of $25 million-$100 million, for the counterparties’ benefit. Now, indentures giver hedging-related claims secured status with priority over payment of principal and interest. These claims can be created without limit and without any requirement to inform lenders. Consequently, lenders’ essential analytical task of calculating the loan-to-value ratio is undermined by an inability to determine how much pari passu debt may ultimately be present in the absolute priority waterfall.

On top of all that, the loan’s administrative agent may also be a hedge counterparty. This creates a conflict of interest, as agents nowadays tend to retain little exposure to the loans. They may therefore be more concerned about their hedging fee than in pursuing any common cause with other lenders.

Takeaway

Borrowers have not given back any ground on diminution of lenders’ traditional rights, despite the dramatic and (from their viewpoint) disadvantageous shift in market conditions. Neither have lenders demanded a return to what was previously usual and customary. Inertia has set in through the incorporation of new (post 2004-2005) language into indenture boilerplate. A considerable expenditure of energy is needed to change it again to restore lenders to their earlier state of protection.”