Lending collateral: the Quadruplet Borrowers, Part 2
[Continued from yesterday’s Part 1.]
“Two other forms of lending.” Having had a blog break to refresh himself after describing consumer lending and project finance, Holmes repacked his pipe and lit it, sending up contented clouds of blue smoke.
To understand lending, you have to read a lot of mortgage documents
“Those are indeed the only forms available to individual borrowers, yet borrowers include two other types of legal and finance entities — corporate entities and governments. Each offers unique features that enable additional lending types.”
3. Corporate finance, said Holmes, “deals with lending to an enterprise that conducts a trade or business, because the business’s cash flow or profitability provides the source of repayment. In real estate, this includes home builders, developers, large owners like REITs, and non-profit acquirers. The corporate entity uses the money to do more business — in real estate, build or acquire or renovate more properties — but from the lender’s perspective, all that is secondary, for the lender is underwriting the business’s aggregate revenue stream.”
“Why is that not project finance?”
“The lending is against the entity’s aggregate revenue stream, rather than against any individual recoverable asset.”
Consider a typical twenty-first century English housing association, Holmes went on, like Circle Anglia, Hyde, or Regenda. Each of these has a large portfolio of properties, yet none of them is individually financed or encumbered — instead, the lender gains a broad blanket lien or security covenants that give the borrower freedom to operate each property but not to encumber them or sell them.
(Usually, and when the lender is cautious, the borrowing entity is the parent company, and the company covenants not to merge upward or create a new borrower. Conversely, some larger and more diversified or established companies will use a holding-company structure where each division or subsidiary does its own corporate-finance borrowing. This keeps the parent company clean from liability. In such cases, the subsidiary and parent must make binding commitments that the parent company cannot raid its subsidiary for cash or capital.)
Holmes occasionally considered subsidiary entities
Corporate-finance borrowing significantly changes the optionality and risk profile on both sides.
· Underwriting approach. Whereas project finance underwriting is done very specific to each property, corporate-finance lending focuses on the entity itself. What is its stream of earnings? How strong is the entity’s balance sheet? How much borrowing will it have relative to its net worth? To its liquid assets? How does proposed debt service compare with the company’s EBITDA?
“Its what?” asked Watson.
“Earnings Before Interest, Taxes, Depreciation, and Amortization,” Holmes answered. “Pronounced ee-ba-dah.”
Watson subsided.
Watson was trying to visualize the organizational structure
· Borrowing scale. Corporate-finance lending occurs at much larger scale — the lender is providing one loan covering all the organization’s needs. This offers greater efficiency. Indeed, many lenders offer a line-of-credit approach, where as the borrower identifies new properties and acquires them, that adds to the entity’s net worth (or operating cash flow) and entitles the borrower to draw down more funds.
· Effective cross-collateralization. Because all the properties are owned by the entity, and the entity itself is the borrower, as a practical matter all the properties are cross-collateralized into the loan. In a corporate-finance situation, therefore, the borrower has traded individual property financial flexibility and risk containment (it’s no longer possible to restructure an individual property’s loan) for efficient capital raising and a flexible debt pool.
“Project finance and corporate finance are thus incompatible,” said Holmes, “for the blanket lien generally prevents the borrower from removing any given property from that security. So if a locality, say, wishes to offer favorable soft debt on a particular property, it must do so by lending directly to the borrower rather than to the property.”
I am prepared to lend if this mortgage can be recorded against the property
“Can the borrower create a subsidiary, and have the loan to that entity only?”
“Yes, but that does not avail the specific lender, since the subsidiary’s assets can normally be reached downward through the parent. So the parent-subsidiary structure, which is a useful risk-containment device in project finance, is of limited or minimal value in corporate finance.”
“It’s a complicated choice, is it not?” asked Watson after thinking about the issues for a bit. “Project finance is inefficient in transaction costs — each loan must be done separately — yet the ‘every tub on its own bottom’ approach assures each transaction is carefully underwritten. And if one goes bad, the individual entity borrowers act like bulkheads in a submarine, trapping and containing risk.”
In there is our affordable housing development subsidiary
“Correct. A project-financed borrower has a much lower risk of going bankrupt, and has much greater leverage with individual lenders when it comes to work out or recapitalize a troubled property. For that matter, from the lender’s perspective, while the risk of a corporate-finance loan going into default is almost certainly lower, its restructuring is enormously more difficult, since the lender cannot readily tap any of the collateral, but must instead appoint a receiver or otherwise cause the borrower to release an individual property to be sold or refinanced.”
Watson added, “the flexibility in financial terms is counterbalanced by inflexibility at the property level.”
Holmes silently acknowledged that Watson needed to get some good lines
“Yes,” said Holmes. “The perverse example of corporate finance thinking run amok is in US public housing, where the authority cannot borrow against or lever any of its individual properties, cutting it off from all outside capital sources, and leaving it at the mercy of its sole corporate financier — HUD and the Federal government — with poor recourse if the funder becomes capricious or hostile.”
“Well, well,” said Watson. “And the fourth type of lending?”
Holmes smiled cynically. “This one is at once the easiest and hardest.”
Lending to the sovereign is … delicate
4. Sovereign lending. “Like our friend the Worldly Philosopher, who is currently grappling with issues both personal and professional, sovereign lending involves providing capital directly to an instrument of government — or indeed, the government itself.”
Lend smart for centuries, and you become both rich and respectable
“As has been previously observed, this type of sovereign lending dates back at least to the sixteenth century, where the great banking houses of Europe, such as the Rothschilds, lent to the contending Catholic monarchs — Louis XIV, Felipe II, and others, partly to fund the Counter-reformation, partly to support monarchical ambition, but mainly to make money. For that matter, the Venetians supported the Holy League’s arming of its great fleet culminating in the Battle of Lepanto against the
You know what makes these boats float? Credit.
“Sovereign lending is really quite simple,” Holmes observed. “The loan is provided directly to the national government, which pledges to repay it typically out of general budgetary revenues. Yet there is a problem — when the capital moves into a country to make a loan, it becomes ’stuck’ there. If the borrower defaults, the lender must physically go to the country in question to recover the capital, and who is the country’s arm of enforcement? Why, its government — judicial and military — who salute the delinquent borrower. Sovereign lending thus immediately raises the question of how to bind the sovereign, or a future sovereign, who may wish not to be permanently bound.”
“I could see where that would be a problem. What can the lender do?”
“Efforts include creating special-purpose vehicles (SPVs) that are legal entities with collateral of their own.”
“That’s not the special purpose vehicle I had in mind.”
“However, these are only as reliable as the country’s judicial enforcement system — and they will not avail when the sovereign or a confiscatory megalomaniac, a genocidal dictator and kleptocrat, or a tinpot strongman.”
Idriss Deby of
“What can the lenders do?”
“Little. Typically a bad borrower is ostracized from the financial markets, and that serves as a fairly considerable deterrent, except when the bad borrower sits atop an internal source of exploitable wealth such as oil. Two of the three rogues previously mentioned have this leverage. In such cases, as we have documented, the world’s most sophisticated lenders often face challenging problems of recapitalization.”
Watson felt a thought forming painfully. “Then,” he exclaimed, “if sovereign lending is predicated solely upon the borrower’s volition to repay, sovereign lending is simply consumer finance where the consumer is a country!”
“Yes.” Holmes’s tone was grim. “For this reason, nearly all of the modern world’s sovereign lending is done by socially motivated rich-nation donor-funded entities, such as the World Bank, IMF, or the various development banks: African, Asian, and Latin American. Entities that can afford to lose the sums in question, and that are consortia able to enforce a boycott against an irresponsible borrower.”
The malefactor must be pointed out and condemned
“What then of municipal finance?” Watson asked. “Suppose the loan is to a local or state agency that has issued bonds, typically secured by a large project such as a bridge, tunnel, highway, water plant, pipeline, but also backed by the issuing entity’s credit. Is that corporate finance, project finance, or sovereign lending?”
Holmes laughed aloud. “Well done, Watson! You scintillate today. You have grasped another essential truth of lending — just as the type of money can blend into one another through gradations and customized investment banking, so too do the boundaries among the four neat borrower types also blur, particularly when the entities involved become large, financially complex, and comprised of many individual people and properties.”
“How then do borrowers and lenders work out which is the best.”
“Engage a consulting housing finance specialist,” said Holmes, and he patted his wallet.
And the fees I charge can be … large
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