Western Independent Banker - July/August 2008 - (Page 12)

Financial Covenants What Good Are They Really? THE FOLLOWING IS a recent situation confronted by many of our lender clients … Sometime in 2006, a lender made an acquisition and development (A & D) real estate loan to one of its very good customers. At the time the loan was made, the loan to value ratio, on an as-completed basis, was at 70 percent. The guarantor had maintained liquidity of $5 million, as required in the loan documents. The customer was a well-known, reputable developer in the area and the lender had made several loans on a number of this customer’s projects. All loans had paid as agreed. This most recent A & D loan was different. Twelve months had passed. The value of the real property had decreased and the loan to value ratio increased to 100 percent. Recent activity in the stock market resulted in the guarantor’s liquidity dropping to $2.5 million. There was no monetary default since the loan payments were interest only funded from loan proceeds. If the financial covenants were intended to serve as a means for a lender to track and monitor its collateral and the financial viability of a guarantor, what good are they if there’s no monetary default. Can a lender reasonably refuse to make any further advances, let alone call the loan? The unfortunate answer is “maybe.” In this article we will discuss fi nancial covenants, the types of covenants generally available to lenders, the importance of defining financial covenants, the need to monitor and enforce them and options available to lenders when a covenant fails. What Financial Covenants Do Financial covenants are often included in loan documents in order to allow a lender to monitor performance of a company, guarantor or collateral. They provide tools to a lender in determining whether the lender is at risk with respect to repayment, whether directly from the borrower or through its collateral. It enables a lender to monitor the operations of a company without being involved in its day to day operations. If consistently used and monitored, they could serve as an early warning signal for lenders. Common financial covenants include the following: • Debt Service Coverage Ratio is used frequently in real estate secured loans where the real property collateral is generating revenue. • Liquidity typically measures the current assets of an individual in order to determine rapidity with which a person can pay off a loan. • Tangible Net Worth covenants measure the gross assets of a company against its liabilities. Defining Your Terms While these covenants can be extremely beneficial, fi nancial covenants are only as good as the defi nitions. The defi nitions and formulas used for fi nancial covenants mean different things to different people. How a lender is measuring compliance with a fi nancial covenant may be different than that of the borrower. The lender must understand how it is using these covenants (including the period of time used to measure a covenant) and must make sure the borrower knows how they are measured. Too often, we have seen loan documents including fi nancial covenants and ratios without defi nitions. From a legal standpoint, an issue surfaces as to whether the fi nancial covenants are even enforceable if the loan document is not clear. A lender may confront a surprised borrower about a failed fi nancial covenant. The borrower may argue that it was calculating the covenant one way and thus was in compliance. Additionally, lenders will sometimes include items in a covenant that do not help. For example, liquidity is used to measure readily available assets so that including long-term securities will inflate and not help in measuring true liquidity. If the financial covenants were intended to serve as a means for a lender to track and monitor its collateral and the financial viability of a guarantor, what good are they if there’s no monetary default. 12 www.wib.org Western Independent Banker http://www.wib.org

Table of Contents Feed for the Digital Edition of Western Independent Banker - July/August 2008

Western Independent Banker - July/August 2008 Contents A Message from the President & CEO Getting Creative and Competitive with Leaders' Incentive Compensation Financial Covenants - What Good Are They Really? Homes Within Reach Revisiting Credit Quality and Risk Management Loan Yield Shock Wave - What Can You Do? What Lending Crisis? - Community Banks Flex with Lending Strength How to Fine-Tune ALLL During Uncertain Times Productivity, Technology and Export Growth Trump Housing's Fall in the Long Run - The Economy According to Brian Wesbury Distressed Real Estate Loans and Their Property Tax "Kicker" WIB Calendar Welcome New Members Index to Advertisers advertiser.com

Western Independent Banker - July/August 2008

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