Understanding loan security

One of the consequences of the financial crisis is that lenders are now scrutinising their security (ie, assets earmarked for a lender by a borrower as part of a loan deal to the business of lending and borrowing money) more carefully, writes Max Cole.

Security gives the lender comfort that if the borrower goes under he will have a better chance of recovering the value of the loan. The better the security, the better the chances. Of course security benefits borrowers too – a secured loan is cheaper than an unsecured one.

When Lehman toppled in autumn 2008 and share values tumbled, we saw many clients facing cash calls on a grand scale. These clients were sophisticated private investors and family offices who had pledged shares and other paper assets to secure their borrowing. Those shares had fallen in value and the banks were asking their clients to make good the difference with cash. The alternative was a fire sale of the shares. It was a worldwide phenomenon which even hit investors with substantial and long-standing banking relationships.

A year later, with share indexes in rude good health, this is much less prevalent. But other assets have taken their place. Banks are now looking in particular at the value of property portfolios which have been put up as security.

Here is a typical example. A family owns substantial real estate. It decided in summer 2007, as the market continued to boom, to buy and redevelop a shopping centre for £50m. It borrowed 80% of the costs (£40m). It offered the shopping centre as collateral for the loan. Two and a half years later that real estate has fallen in value and the bank is threatening foreclosure even though the loan is performing in all other respects. In particular the borrowers continue to make all payments of interest and capital on time.

What is happening here? Commercial loan agreements almost always include terms that specify that the ratio of the loan to the value of the secured assets - shares, property or something else - must not exceed a specified level. These are called "loan to value" covenants. A loan agreement might specify that the loan must not represent more than 85% of the value of the secured assets. In my example that means that - if the loan stays at £40m - there will be a breach of the loan if the value of the shopping centre falls below (about) £47m.

In today's market there is plenty of scope for the kind of falls in property prices that bring these covenants into play. The result is that lenders are usually entitled to call in the full amount of the loan and exercise their security with catastrophic consequences for the investment.

What can be done? Generally the loan documentation itself is difficult to challenge – these agreements have been tried and tested over many years. But perhaps there is something amiss with the way in which the valuation of the property has been conducted. Or, better, the bank has said something to the borrower that alters the effect of the loan agreement. It is astonishing how frequently a relationship manager will have told a client "don't worry we don't enforce those covenants in practice". These sorts of statements can have legal consequences for the lender which can be exploited if the threat of foreclosure comes.

Banks are still looking to repair their balance sheets and increase their liquidity. If the borrower is making scheduled payments then it's rarely the bank's aim to take ownership of the secured assets just because a covenant has been breached. Typically the bank's real aim is to renegotiate the terms of the loan so that it produces more revenue using the threat of foreclosure as leverage. The borrower's position in the negotiations is immeasurably stronger if he recognises this.

In practice the negotiations that follow are likely to lead to higher interest payments by the borrower. But armed with a clear understanding of the strengths of the bank's legal position and commercial motivation, and with robust representation, these can be minimised and covenants which look dangerous in the new financial landscape can be removed.

The importance of security may be obvious, but no less fundamental for that.