The ABC of vigilance against non-performing loans

Today’s tumultuous market backdrop of rising rates, inflationary risk and extreme levels of volatility paint a bleak picture for lenders and investors. As a result, nations across the globe are grappling with high levels of public and corporate debt and high credit growth from increased yield levels. To add to the potent mix, banks are experiencing low profitability against this backdrop while facing increasingly stringent regulatory pressures. Many lenders are rightly concerned that these influences playing out simultaneously have created the perfect storm, a storm that will ignite an influx of non-performing loans. 

At Mount Street, one of the most frequent questions we have been receiving is “Are you seeing any NPLs yet?”. While we are not – and we do not expect to see them quite yet – we are certain they are on the horizon. The trajectory is clear, and there has never been a time to be more vigilant.

In our view, high gilt yields, high inflation (though not as high as the current levels) and high interest rates are not as transitory as some may have hoped. We certainly expect these market factors to persist well into, and perhaps throughout, 2023. We are also seeing valuations of real estate assets starting to drop, with evidence so far showing 10-15 percent downward adjustments. We reiterate the word “starting”. The lagging nature of this indicator, corroborated by anecdotal evidence, suggests that asset sales have re-traded with up to a 20 percent discount.

The effect on the market is illustrated by the speed of decline of new debt origination, something that, as loan servicers, we are well placed to observe. The effect is also evident in the roll-over of loans that have reached the end of their term and been extended due to a lack of parties willing to refinance. In fact, for most market participants, it seems that only the very lowest risk loans, by which we mean core assets with 50 percent loan-to-value, are seen as attractive at the moment.

Given this, asset surveillance and diligence are more crucial now than ever. One of Mount Street’s main responsibilities is to manage risk for clients, and key to this are our asset surveillance and asset diligence teams. The approach that we recommend our clients take is threefold: acting with vigilance when assessing the value and risk of the asset, the borrower, and the capital of a loan – or the ABC of vigilance.

A is for asset

It is usual to conduct due diligence and a review of capex and business plans at origination, but less usual for this to be checked during the lifetime of a loan. It is also unusual for ESG audits to be carried out at this stage.

The value of the asset and its desirability in the market both reflect on the risk of a loan. An asset that suffers from underinvestment becomes tired – rental rates drop, vacancies increase and last longer, and the maintenance and replacement capex increases. The current focus on ESG and energy can exacerbate this, especially on buildings where EPC rating improvements are likely to be required. Our rough estimate is that the de-carbonisation spend needed to get UK commercial real estate to meet government decarbonisation targets is in excess of £100 billion ($123 billion; €113 billion) between now and 2030. This is missing in many of the capex plans that we review.

Our suggestion is to undertake an annual light-scope due diligence review examining ESG, capex (spent and to be spent) and the business plan. With this, we can track the condition of an investment and ensure it remains good collateral for the debt invested in it.

B is for borrower

Borrower reporting is crucial to ongoing risk management. Lenders will generally monitor covenant compliance and trends, but at Mount Street we interrogate and test all aspects of reports to ensure full compliance with facility agreement terms. We never accept a compliance certificate at face value and run a parallel model across our loans to verify borrower calculations before uploading the results to provide an ongoing covenant trend analysis. This due diligence is crucial to determining the full landscape risks. 

There are other warnings that we look to pick up. For example, a real estate loan can be covenant compliant, but achieved rental levels and weighted average lease terms and/or occupancy may have been tracking downwards for some time, which can indicate issues within the asset that may not be picked up in the covenant results. An increased level of rental arrears, lease churn and reduced surplus funds can also be useful risk indicators. 

We also verify that what has been reported as net income matches what has been received in bank accounts. Mismatches can be due to delays in timing of receipts, but we also find payment mechanics not operating as per the terms of the facility agreement and too little income flowing through to the lender’s charged accounts. Given we are likely to see an increase in distressed borrowers, it’s important that lenders are in full control of underlying asset income and can potentially trap cash if required. 

Our asset surveillance team runs and reports regular stress tests against the loans we manage, both on an income (and valuation) level, but also versus market interest rates, margins and current hedging costs. This can be valuable in an environment where refinancing is increasingly selective, allowing early conversations with borrowers to deal with issues, rather than waiting for maturity and finding out a loan won’t be able to repay. 

C is for capital

Access to capital – both in terms of cash and equity value in assets – has always been important, but has been brought into sharper focus for borrowers and lenders given the state of today’s debt markets. On a general basis, lenders are lending at lower LTVs, while margins, rates and hedging costs are all higher. Understanding how well capitalised borrowers are at both underwriting and particularly at loan maturity is crucial given lenders are often requiring loan paydowns, reserve top-ups, cash traps and expensive rate protection before agreeing to extend facilities. 

We also expect to see equity capital become increasingly selective. While general lending standards have been much higher and more conservative since the GFC, credit enhancement via guarantees, reserves or cross-collateralisation have not featured highly in a competitive lending environment, and there are likely to be deals where valuation pressure will mean it makes more sense for borrowers to walk away rather than recapitalise. The forensic deal analysis and up-to-date market knowledge that third-party solutions providers can deliver are invaluable in understanding which loans may be negatively affected and providing help in getting ahead of potential problems, so it’s pertinent that lenders ask their advisers what they are seeing in the wider market.

Jim Gott is head of asset diligence, asset surveillance and ESG at Mount Street, a provider of solutions to the credit, structured and asset-backed finance markets