Lucro often receives examiner feedback, which we use to improve our member services. Lately, and considering the recent change in regulation from the prescriptive requirements to the current broad principals-based regulatory approach, Lucro has noticed an uptick in examiner pressure related specifically to loan covenants. Of course, this is not unexpected since the NCUA has made clear they will focus on the effectiveness of a credit union’s risk-management processes.
The following was issued to a member by the NCUA.
“While your loan documents contain provisions for loan covenants, your current usage of loan covenants is minimal and basic. It is recommended that as a loan relationship increases in size and/or complexity, the need for customized loan covenants is warranted in the areas of debt service coverage ratio, working capital, liquidity, leverage, reserve requirements, and additional documentation such as rent rolls and updated leases. It is important that when using covenants for ratio calculations, the exact formula needs to be disclosed so that there is no confusion on the numbers to be used. Loan covenants are an important tool that when used, can monitor the risk profile, as well as set expectations for financial performance with the borrower. The monitoring of these covenants could be used as an early warning tool should the trends be negative. Also, covenant monitoring can be used as a channel of communication with the borrower. The policy should also be enhanced to address the use of loan covenants.”
Another example of the NCUA’s expectation can be found in recently issued guidance:
“A change in risk is generally reflected in an adverse change in the financial condition of a borrower or associated borrowers. A credit union’s policy should establish requirements for financial covenants, financial reporting, and regular site visits. Early detection of adverse changes in a borrower’s operation provides a credit union with the best opportunity to assist the member and protect itself from losses.”
To summarize the above, here are three key points about loan covenants:
- Covenants should be used to mitigate/ control the risk that comes with large loans or complex relationships.
- Covenants need to be simple and quantifiable so they may be understood by all parties and easily tested.
- Don’t set yourself up for failure with your covenants. Make them pertinent to the relationship and the industry of the borrower.
Effectively monitoring and enforcing covenants
Lucro’s position is to use clearly defined covenants, only when appropriate, and make sure each is enforceable with teeth (rate escalation). In my experience, open conversation with the borrower will often resolve most issues, assuming the borrower is willing and capable.
What works are simple-to-understand covenants with remedy periods and penalties for non-compliance.
As an example, the most common covenant Lucro recommends is debt service covenant ratio (DSCR). I agree with the examiners in that the definition/calculation needs to be in the loan documents. Normally, Lucro uses global DSCR as a covenant, but that can be a tricky definition to write out due to the number of entities, which could likely change over time. To define, the loan documents say the ratio will be calculated as it was for initial underwriting, using all the same information available at that time and just updated to the current period. If you’re using a real-estate project DSCR as a covenant, that definition is easy to write out.
What to do if a covenant is violated
If a covenant violation is noted at the time of the loan review, the credit union has several choices:
- Call the loan (if they’ve been having consistent trouble with the borrower).
- Allow the borrower a period to remedy the violation. (I’ve seen six months; however, time can be flexible depending on the violation.) This will require the borrower to provide updated financial information to calculate the updated DSCR.
- Do nothing, and document the reason the violation occurred and why no action was deemed necessary.
Reminder: Importance of monitoring
Don’t forget to monitor your loan covenants. Never place a covenant on a loan unless you intend to monitor that covenant. Not monitoring a covenant may create a situation where the borrower has legal defense to fight default.
Avoiding loan default with proper loan structure
Lucro’s loan documents contain standard default/performance covenants and use additional affirmative, negative and financial loan covenants also defined by calculation, loan type and frequency. Credit unions should reserve the right to impose covenants when appropriate due to complexity or the lack thereof. As a rule of thumb, specific loan covenants should mirror your policy’s annual review schedule. Proper loan structure is one of the more important factors in avoiding loan default.