We recently worked with a bank that was competing for a loan relationship. This initial credit opportunity with this client was just over $4.5mm. The borrower’s and the corporate guarantor’s financial strength was good (1.73X global debt service coverage ratio (DSCR), and high tangible net worth), and the collateral for this specific loan was industrial real estate appraised at 64% LTV. Our client bank lost the loan to a national bank which offered non-recourse financing. Our customer bank’s policy requires personal guarantees on all real estate secured loans. In fact, many community banks have a strict policy on personal guarantees.
Community banks must rethink the requirement for personal guarantees for all commercial loans. Banks naturally want personal support as a strategy to increase recovery in a default scenario. However, blindly following such a loan policy may be counterproductive and is very likely, and inadvertently, to increase credit risk.
Why Have a Personal Guaranty?
Many borrowing entities shield individuals from liability. Owners of corporations, limited liability companies, limited partnerships and certain trusts are protected from personal liability for company actions and debt (with certain exceptions). Therefore, regulated lenders are obviously keen on allocating recourse to owners, especially if the owners are important principals and managers of the debtor’s business.
But how much benefit accrues to the lender through the personal guaranty? We believe that there are a number of reasons why personal guarantees are providing lenders with a false sense of credit security. We believe that all things being equal, personal guarantees are an advantage to the lender, however, in reality, all things are not equal and we see many reasons why forgoing a personal guaranty is prudent and justifiable.
Economic Value of the Guaranty
We have written on various aspects of underwriting to cash flow. We have also considered the important relationship between cash flow and collateral value. The relationship between these two variables and their impact on loss given default can be found in this blog HERE.
The high correlation between cash flow and collateral value in lending is not surprising. When the first level of credit protection fails (cash flow deteriorates), the value of the collateral also fails. This is just a natural extension of the capitalization approach to valuing income producing property (real or intangible). What may be less evident to credit officers is the high correlation between all three credit supports – cash flow, collateral, and personal guaranty.
We have witnessed that in times of financial stress, for community bank lending arrangements, the correlation between cash flow, collateral value and personal guaranties approaches 1.0. That means that when cash flow fails, collateral value drops and collectability of the guaranty approaches zero.
Given the nature of community bank lending business, this correlation makes sense. Often the personal net worth of the guarantors is reflective of the business providing the direct credit obligation. If the business cash flow is disrupted, collateral value drops and personal net worth of the principles also follows. Again the adage applies, we must concentrate our underwriting efforts on three variables – cash flow, cash flow, and cash flow. Repayment analysis must stress the level and stability of cash flow (even though transcribing numbers from appraisals and personal financial statements is much easier).
Problems with Enforceability and Collection
Lenders may take for granted that they can collect on a guaranty. However, many statutory and procedural constraints can limit the amount for which a guarantor is liable. Some states require simultaneous proceedings against both the collateral and guarantor. The California one-action rule is well known and has hindered many banks in that state, but other states have similar statutes.
Certain state anti-deficiency rules require recovery on the guaranty to occur only after the foreclosure is complete – with obvious hurdles for the lender. While in certain states foreclosure will discharge the entire debt or a judgment against the guarantor will have the effect of reducing the amount of the debt that is secured.
Many bankers argue that the value of the guaranty is the motivation it gives the borrower to perform. We believe that guarantees for incomplete projects (such as construction) are necessary. However, by law completion guarantees are not enforceable, and only money judgments are permitted. Courts will not force servitude on guarantors. If the guarantor does not want to complete the project, the guaranty is unlikely to make a difference.
For completed projects cash flow and collateral value are much more important than personal guarantees. We see strong credits – those with high and predictable cash flow and low LTVs - offered non-recourse loans by various segments of the lending market (banks, insurance companies, and conduits). Banks that have a strict prohibition on non-recourse lending are selecting lesser credit quality for the sake of low-value personal support. Our argument is that at some level of cash flow and collateral every bank must be willing to accept non-recourse credit.
Alternatives to Guaranties
Not all guarantees are the same. Aside from payment and completion guarantees, banks way want to consider limited guarantees or burn-off guaranties. Burn-off guarantees reduce the guarantor's obligation under certain future conditions.
Springing or sliding guarantees can be a very effective way for community banks to negotiate personal support for completed projects. A springing guaranty becomes effective only under certain conditions (for example above a set LTV level or below DSC ratio). The reason that customers negotiate non-recourse structures is because of the credit strength of the borrower and it is difficult for customers to argue that non-recourse is justified if that credit strength disappears in the future, thus making a springing guaranty acceptable. A sliding guaranty toggles back and forth between being effective and dormant based on future preset conditions.
Community banks may also want to consider capital or equity funding agreements. These agreements require the owners to inject funds into the borrower based on predetermined credit deterioration. While these agreements are not guarantees, they serve the same lender-objectives of maximizing recovery.
Those banks that offer non-recourse lending, nonetheless, should insist on carve-outs guaranties (sometimes referred to as bad boy carve-outs). These guarantees are intended to cover a narrow spectrum of events. For example, if the borrower engages in bad behavior (such as fraud, misappropriation of funds, or waste) a guarantor becomes liable for lender's loss resulting from those activities.
We currently see many lenders offering non-recourse loan structures to stronger borrowers. Given the limited value of personal guarantees, we believe that banks should be well served to forgo personal recourse in exchange for superior cash flow and better collateral coverage. Banks that have a blanket prohibition on non-recourse real estate-secured loans are inadvertently undermining the quality of their loan portfolio.
Submitted by Chris Nichols on January 11, 2017