Credit Tolerance

[Presuming the Context of] Bank Risk Aversion

Since banks, as a class, are heavily involved in the corporate debt market and by default (or, perhaps more accurately, through default) the distressed debt market, it is worth reviewing for a moment why banks are relatively risk averse. The basic reasons are their business model and regulatory oversight. As a great simplification, banks make money by borrowing money at a low rate from depositors and relending it at a higher rate to individuals and businesses. For example, a bank may offer 4% interest to borrow money under a one-year certificate of deposit and then relend that money to a company at 7%. This results in an "interest margin" of 3%. If the bank's operating expenses are 1% of loans outstanding, this implies a pretax, precredit expense (i.e., risk of loan loss) margin of 2%. Although the absolute interest levels fluctuate, these relative spreads are actually fairly representative.

Relatively speaking, 2% is not very much. In Chapter 2 it was noted, for example, that the long-term inflation-adjusted historical return on equity investments was approximately 13%. Thus, to offer sufficient returns to attract equity investment, banks must employ high leverage. In other words, they must borrow and relend many multiples of their equity capital. Consider the following simple example. A bank has $10 in equity, takes in $60 in deposits, and then makes $70 in loans. If it makes 2% net of operating costs on the amount of the loans, this would equal $1.40, which represents a 14% pretax, precredit expense return on its $10 in equity. So, assuming away taxes, the bank will have a competitive equity return as long as it does not have any lon losses. This could be characterized as a low-margin, low-risk, high-financial-leverage (6:1) business model.

The model is viable, but only if loan losses are well managed. If our hypothetical bank has a loss rate of 1.2% on loans, [footnote omitted] it would have to increase its interest margin to 4% (through a combination of lowering its borrowing cost and increasing its loan rates) to still achieve a 14% pretax return on equity. Thus, banks as a financial proposition tend to avoid making loans that have a very high risk of loss.

In addition, bank regulators (i.e., the government) monitor the risk profile of bank loan portfolios. The government's regulatory interest is twofold: first, budgetary, because the government, through the Federal Deposit Insurance Corporation (FDIC), insures most deposits and thus might have to pay out money if a bank has large losses and fails; second, economic, because large-scale bank failures could hurt investor and consumer confidence and thus do broad harm to the economy. Together, regulatory scrutiny and a low-margin business model tend to make banks fairly risk averse.

Stable Cash Flow Scenarios

Table 6-1 sets forth a cash flow model that shows the borrower's ability to repay a loan under some well-defined scenarios. The model assumes that all cash flow (defined as EBITDA) after the payment of interest expense and capital expenditures (CAPX) is used to retire debt (taxes are ignored in the interest of simplicity). CAPX is held constant across time and EBITDA is assumed to be highly predicatble, growing at a specified growth rate (2%) across the time horizon. This scenario shows that if leverage (defined as a multiple of EBITDA) is only 2.0x, the borrower is able to repay the loan in its entirety within the five-year forecast period with internally generated funds.

. . .

Table 6-1. Debt Capacity with Stable Cash Flows and 2.0x Leverage

---EBITDA STABLE SCENARIO---

However, as illustrated in Table 6-2, if the scenario is changed to increase the leverage to 3.0x, even with a higher growth assumption of 4% per year, only 56%[sic] ([750 - 330] / 750) of the loan can be retired.

Table 6.2. Debt Capacity with Stable Cash Flows and 3.0x Leverage

---EBITDA STABLE SCENARIO---

Table 6.3. Sensitivity of Debt Repayment Abillity to Leverage and Growth Rate

---GROWTH RATE---

The trade-off between leverage and assumed growth rate in the ability of the hypothetical firm to retire its debt can be more generally seen in the sensitivity analysis provided in Table 6-3. In this analysis, the percentages in the table represent the percentage of loan repayment for a given leverage (vertical axis) and EBITDA growth rate (horizontal axis) scenario.

Note that for the particular assumptions of this case, even at a fairly high 8% growth assumption, if initial leverage is 3.0x EBITDA, only 73% of the loan can be repaid over the five-year horizon. The primary determinant of this result, as you may have realized, is the CAPX assumption of $125 per year. This consumes almost 50% of EBITDA (although such a percentage is not at all uncommon). If leverage were measured on the basis of EBITDA-CAPX (a common adjustment discussed in Chapter 5), leverage would be 6.0x. Thus, although this example should not be taken as leading to any general conclusions, it does help illustrate the correlation between duration of debt repayment and leverage.

Volatile Cash Flow Scenarios

This initial example, however, assumed highly stable cash flows - a simplifying assumption that in the real world the lender makes at its peril. [***emphasis added***] Next, the effect of cash flow volatility on debt capacity is considered. In Table 6-4, the EBITDA assumption for the company has been changed to make it cyclical. This can be easily seen by looking at the EBITDA growth rate line that tracks the change in. EBITDA.

Focusing on just the future EBITDA assumption, Figure 6-1 charts the scenario in Table 6-4. The modeled scenario illustrates the most dangerous environment for the lender in a cyclical business: at the time of the loan, the borrower is on a cyclical upswing, looking forward to another year of improving fundamentals; thus the lender might feel comfortable lending $750, or 3.0x EBITDA. Then the corrective part ofthe cycle begins, and EBITDA trends down for two years before rebounding.

It is beyond the scope of this book to debate the inherency of either industry or economic cycles, but whatever their causes they seem to recur with sufficient regularity that the prudent lender must consider them, depending on the past history of the industry.[citation omitted] The above pattern may seem quite severe, but many high-fixed-cost businesses can experience such volatility because it is difficult for them to adjust costs when revenue weakness occurs. Exampining the debt/EBITDA (i.e., leverage) line in Table 6-4 reveals the dilemma of the lender. Initialy, leverage is falling as debt is reduced, but in years 3 and 4 EBITDA has fallen so much that leverage has risen even though the absolute amount of debt is lower. If the loan had a minimum amortization requirement (e.g., $50 per year), the borrower would be in default, and since neither the borrower nor the lenders know with certainty in year 3 that there will be a rebound in year 5, everyone is likely to be quite nervous. Fortunately, the rebound comes, and at the end of the six-year horizon the loan has been reduced to $540 and leverage has fallen to a "manageable" 2.4x.

Table 6-4. Debt Capacity with Volatile Cash Flow and 3.0x Leverage

---EBITDA VOLATILE SCENARIO---

In Table 6.5, the sensitivity of loan repayment capability (the percentages in the table again represent the relative amount of loan repayment over the six-year horizon) to leverage and EBITDA is calculated. Unlike the constant growth model in Table 6-1, the EBITDA parameter in this case (shown on the horizontal axis) represents the severity of the cyclical swing. The level illustrated in Table 6-4 corresponds to a severity factor of 1 in this scale (think of this as the average cycle). Thus, relative to the hypothetical average cycle, the percentage change in EBITDA at level 1.5 is 150% as much: the severity factor essentially amplifies the pattern. What the analysis illustrates is that EBITDA volatility can lower a firm's debt repayment capacity. Notice that the most favorable scenario shown - 2.0x leverage and a cycle severity of 0.5 - is the only case in which the loan is [extinguished by the end of its term].

The negative values in the table indicate that, under the given assumptions, the firm would have been a net borrower of funds rather than have the ability to reduce the original balance. From a mathematical perspective, the simple explanation for the uniformly lower credit capacity is the average EBITDA over the forecast period. The average EBITDA in Table 6-1 was $270 per year versus $225 in Table 6-4; however, the effect was compounded by extra interest expense that was incurred because in the cyclical scenario there was less free cash to pay down the loan in the early years. Nonetheless, the point should be clear: the greater the expected volatility in cash flow, the more difficult it is to assess a borrower's debt capacity. [footnote omitted]

Table 6-5. Sensitivity of Repayment Capability to Cycle Severity and Leverage

---CYCLE SEVERITY---

STEPHEN G. MOYER, DISTRESSED DEBT ANALYSIS: STRATEGIES FOR SPECULATIVE INVESTORS, 123-129 (J. Ross Publ'g. 2005) (providing a pragmatic description of pre-petition and post-petition investment opportunities and challenges).

Compare supra with Example EBITDA Comparison, and EBITDA Caveats.