Comments for Comments on Credit

Comment on Risk Culture at MF Global? by Mike P.

Mike P. — Tue, 03 Jan 2012 18:44:18 +0000

Without more information its hard to know what the right approach would have been to MF Global. It sounds like there was at least one person who identified the risks, but the board was a push over. This reminiscent of some of me of the problems at Tyco and Enron (management style). Was this trade outside of policy and the company’s risk tolerance? Hard to know from the information provided above. Were the board members truly independent members or where there conflicts of interest? Was this really a “pet strategy” or did the CEO feel the risks were properly mitigated for other reasons? Is the CEO properly incentivized to make good long term decisions? How is top management compensation structured? Does the company have an ethics and compliance program in place?

Comment on Risk Culture at MF Global? by Norman Toy

Norman Toy — Mon, 02 Jan 2012 23:56:21 +0000

Super. Just the kind of article needed. It would be even better if you had more specifics on the specifics of the risks and what each party did about them.

Comment on Why are covenants so bad? by Bill P.

Bill P. — Tue, 13 Dec 2011 01:42:34 +0000

Robert,

Excellent point. As an analyst by background, I have found that it’s all too easy to overload a loan agreement with excessive ratio measurement–in effect, virtually guaranteeing that the borrower will be out of compliance at some point in the future.

Focusing on a few key ratios for compliance is a far better loan management strategy. Not only will there be fewer opportunities for misinterpretations by either party.

Comment on Why are covenants so bad? by Robert F.

Robert F. — Tue, 13 Dec 2011 01:41:30 +0000

Its good to have a few different ratios but I would not go beyond 2 or 3 ratios and I would stay as clear as possible and as standard as possible. If you get too many or unclear or unusual ratios (even if you define them in your loan agreement) there is bound to be confusion and disagreements between borrower and lender.

Comment on Counterparty Risk Trips Up MF Global by allaroundguy

allaroundguy — Tue, 13 Dec 2011 01:25:46 +0000

Much has been made about MF Global’s exposure to European sovereign debt. In the long term, that might have been a good trade – the bonds they bought (at a discount) may well pay off in full at maturity (and many of the bonds had relative short maturities). The problem was that in the mean time, they dropped in value in the secondary market. Thus, as you point out, their counterparties demanded collateral on those trades, and since they were marking these positions to market, their capital position eroded too, causing more general worries.

Still, if they were only able to survive until the bond matured, they may have made a lot of money. There is an old saying (something like) “the market can stay irrational longer than you can stay solvent.” That seems to be what happened to MF Global.

Comment on Why are covenants so bad? by Bill P.

Bill P. — Fri, 02 Dec 2011 11:26:53 +0000

James,

Great suggestions. I particularly like the idea of using a ’suite’ of ratios that measures cash flow, liquidity and capital simultaneously. It can also be helpful to allow the company to continuously measure its adherence to the covenants more frequently than stipulated in the loan agreement–i.e., suggest the company measure its compliance monthly, even if quarterly compliance is required. By doing so, a lender can help business management more effectively adjust its procedures as operating conditions change.

It’s better to have an early warning of a deteriorating trend than to be surprised with an out-of-compliance condition.

Comment on Why are covenants so bad? by Jd A.

Jd A. — Wed, 30 Nov 2011 02:15:03 +0000

A few points to add:
- EBITDA is not based on accounting standards (unlike NPAT) and is therefore often defined by ‘market standard’ (which changes) as opposed to a more independent, stable standard.
- Anyone who has ever negotiated how EBITDA is defined for LBO or restructuring purposes knows that the ‘accuracy/simplicity’ tradeoff with EBITDA very quickly dissipates. I have negotiated EBITDA definitions 2-3 pages long with various carveouts and cross-references. (Good luck to the portfolio guy who has to calculate it 3 years later.)
- Nothing beats understanding your borrower. E.g. no one should willingly use EBITDA coverage for a high-capex/high-growth business that burns through cash.

Comment on Why are covenants so bad? by James U.

James U. — Tue, 29 Nov 2011 22:18:13 +0000

Good discussion. You all have hit on the main point, the balance sheet and income statement work together. A good covenant package will take this into account. UCA is great analytical tool, but like Bill I think it has issues as a covenant (in my mind the issue is mostly practical – it’s too complex for most small business borrowers). I too like EBITDA less maintenance cap x / total debt service as the base coverage ratio. True, it can be “gamed” by the savvy CFO, but this can be limited by employing other measures that take liquidity and capital into account. For these I always use a relative and an absolute measure, i.e. current ratio and minimum net working capital for liquidity and D/TNW and minimum equity for capital. The key is to craft these as a package and test them through projections to know what causes one to “break”.

Comment on Why are covenants so bad? by Theodore C.

Theodore C. — Tue, 29 Nov 2011 22:17:30 +0000

Bill,

I think I’m going to respectfully agree and disagree with you on this one. In operating companies the uCA is the best method, but it can be manipulated, though EBITDA can as well by simply pushing off an expense at month, quarter, year end.

I like using AR and AP and inventory covenants. For example, keep inventory turns below or above X, keep payable days above or below Y.

Just a thought!

Comment on Why are covenants so bad? by Jonathan K.

Jonathan K. — Tue, 29 Nov 2011 22:12:27 +0000

Bill makes a great point and I would like to add on to that to include the use of a Limitation on CapEx, Dividends and Officer Compensation Covenants. This helps keep the profits in the company required to maintain or improve upon the financial condition of the company as exhibited at approval. Often we approve a loan with favorable rates and terms.

Comment on Why are covenants so bad? by Bill P.

Bill P. — Tue, 29 Nov 2011 12:02:41 +0000

Barry,

I respectfully disagree that the UCA coverage ratio be included in loan documents. Unfortunately, company financial officers can manipulate the inputs to UCA cash flow to the detriment of a lender. Moreover, even a ‘conforming’ coverage ratio, when measured via the UCA cash flow, can give a lender a false sense of security. For example, an increase in accounts payable is recorded as a source of cash in the UCA cash flow even if that source isn’t recurring. If you are attempting to evaluate a company’s cash flow generating ability for servicing long term debt, you may be lulled into thinking the firm can look to that source of cash on a continuing basis.

In my opinion, measuring a company’s cash flow generating ability through traditional measures (EBITDA-maintenance capex)/(Total Debt Service) will prove more accurate, and more enforceable, when considering loan documentation.

Comment on Why are covenants so bad? by Mike P.

Mike P. — Mon, 28 Nov 2011 17:17:29 +0000

Just witnessed a company go BK a year ago but EBITDA and debt service looked great! Thus, underlining the importance of free cash flow and knowing a company’s working capital requirements.

Comment on Why are covenants so bad? by Arthur C.

Arthur C. — Sun, 27 Nov 2011 11:43:15 +0000

The best coverage ratio is the debt service ratio this would provide the ability of the debtor to pay obligations without the need for external/bank financing. We flucuate between EBITDA, Debt Service and New Worth regarding the later. A number of factors dictate the change in debt covenants however one should mirror the other.

Comment on Why are covenants so bad? by Barry C.

Barry C. — Sun, 27 Nov 2011 01:46:40 +0000

For an operating company, the UCA cash flow should be used. There are covenant definitions for each method easily found by searching Google or RMA.