Liquidity and risk in ‘the new normal’
Adam Michaelson is a director at Charter HCP
The last major financial crisis to hit the sector was characterised by two key underlying elements:- A) Liquidity drying up across the world and B) existing risk pricing models and covenanting practices being ripped up overnight as lenders got to grips with a combination of new regulation and a complete realignment of asset values.
In other words, the bank didn’t want to lend as they had no idea as to whether they would be able to get the money back by sale of assets in the event of a default, and in any event, the bank had no money to lend even if they wanted to.
This crisis is different. Unlike 2007, the market is awash with cheap money, a flood that will get more pronounced as the various government schemes come into action.
However, if anything, the asset pricing and risk evaluation issues are even more pronounced than they were in 2007. The real estate market as a guardian of risk pricing doesn’t currently exist, and whilst there is general consensus that it will return ‘in the long run’, A) it is not clear when that will be, B) it is not clear how temporary the dramatic economic contraction will be and C) possibly most importantly, it seems very clear that the pandemic will give rise to dramatic structural alterations in economies worldwide that will impact on asset pricing in a way never before seen.
With the business travel market set to collapse, and big businesses now questioning the need for large office headquarters, to name but two areas, it is no longer clear at all the assets that will be suitable for security purposes.
Typically, this sort of uncertainty would simply lead to lenders not lending. This issue is compounded by the fact that one of the immediate effects of the crisis has been to cut off the supply of credit to secondary lenders.
However, given the amount of cheap money now coming into the system this will create an imbalance that, combined with significant political pressure, will require banks to lend.
As such, this has the potential to lead to a significant problem for lenders, particularly those that have to remain Basel III compliant, as it will make it extremely difficult to price their loan books and the underlying assets.
In this environment, securitization and how this is undertaken will be key as lenders look for ways to ‘lay off’ at least part of the risk. In that respect, the industry will look for examples from other areas of the business that securitize in a more complex manner such as those used in more classical investment banking models, particularly in emerging markets where more of a ‘mille feulle’ approach is used with various institutions securitizing and resecuritizing until the liquidity can be supplied.
Instrumental in this is the use of Surety Bonds to get an insurance underwriter to take some of the risk from the lender. Surety is a form of financial credit known as a bond guarantee. The transaction always involves three parties: the beneficiary, the principal, and the surety. The surety bond is a written promise to pay for direct loss or damage suffered by the beneficiary as a result of a breach of contract.
A surety bond protects the beneficiary (the party to whom the bond is paid to in the event of a default) against losses, up to the limit of the bond, that result from the principal’s (the party with the guaranteed obligation) failure to perform its obligation.
The surety assumes the obligation if the principal cannot.
Surety bonds are designed to ensure that principals act in accordance with certain laws. They provide beneficiary with financial guarantees that contracts and other business deals will be completed in accordance with mutual terms.
If the principal breaks those terms, the harmed beneficiary can make a claim on the surety bond to recover losses incurred. The surety company then has the right to reimbursement from the principal in the case of a paid loss or claim.
The surety bond will always require 100% security but they will take a differing view of the risk to the ultimate lender and further they are taking at least some of the default risk out of the hands of the lender thereby allowing them to get the loans onto their books.
Funding is more expensive as a result but in an age of historically such cheap money, very little investment will actually be crowded out.
Up until now this sort of securitization model has been purely the preserve of specialist brokers and somewhat exotic investment banking transactions, usually in emerging markets.
However, their use in mainstream lending is increasing. We have used AMI Specialty, a Lloyds Broker specialising in this type of transaction several times in the past six months for this type of transaction in European markets and we have been taking significant numbers of enquiries from both clients and lenders for whom such surety may be an option.
Its fiddly, involves more moving parts and requires expertise in all parts of the transaction to make it work as well as sympathetic credit committees and knowledgeable closing lawyers.
As such, it is not a straightforward solution but in the new normal it may be the difference between projects being funded and not and in a world where traditional capital asset pricing and risk asset pricing is no longer reliable it may be the only way for lenders to be able to satisfy clients and lending requirements alike.