In March, 2013, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corp. jointly issued their Interagency Guidance on Leveraged Lending, finalizing draft guidance initially proposed in March, 2012. The agencies issued the Guidance because of concern on their part that bank lending standards are deteriorating as banks seek yield in the current low interest rate environment. An annual interagency review released in September, 2013, as well as recent articles published in the Wall Street Journal and by Bloomberg, indicate that regulators remain concerned about deteriorating lending standards and suggest that banks may in the future be subject to increased scrutiny with respect to their lending practices.
At the same time, there is a nascent but observable trend toward banks making loans, including syndicated loans, to municipalities and other public agencies. Banks that used to focus on providing liquidity facilities and letters of credit, and more recently "direct purchase" products, to highly-rated issuers are now looking in some cases to make sizeable loans to lower-rated municipal entities such as cities emerging from bankruptcy, public transit and development agencies, and other types of public agencies.
Given these facts, an obvious question for many banks is how to apply the guidelines when making loans to public entities. Generally speaking, leveraged loans are frowned upon from a regulatory standpoint and banks would prefer to find that their lending activities do not constitute leveraged lending. Leveraged loans require enhanced underwriting standards for individual credits and may result in a bank being required to hold more capital or to pay higher FDIC deposit insurance premiums. Unfortunately, the Guidelines were drafted with private/corporate borrowers in mind and neither the Guidelines themselves nor any subsequent interpretations say anything about how they might be applied to public agencies.
What is a "leveraged loan?" According to the Guidelines, leveraged lending commonly includes some combination of the following features:
- Proceeds used for buyouts, acquisitions, or capital distributions;
- Transactions where the borrower's total debt divided by EBITDA (earnings before interest, taxes, depreciation, and amortization) or senior debt divided by EBITDA exceed 4.0X EBITDA or 3.0X EBITDA, respectively, or other defined levels appropriate to the industry or sector;
- A borrower recognized in the debt markets as a highly leveraged firm, which is characterized by a high debt-to-net-worth ratio; and
- Transactions when the borrower's post-financing leverage, as measured by its leverage ratios (for example, debt-to-assets, debt-to-net-worth, debt-to-cash flow, or other similar standards common to particular industries or sectors), significantly exceeds industry norms or historical levels.
Public finance professionals will see immediately that neither these criteria nor the other provisions contained in the Guidance can be applied in any straightforward way to loans to public agencies. Cities and counties do not have EBITDA, net worth or other metrics against financial ratios are customarily calculated. Public agencies do not borrow to make acquisitions or capital distributions because they do not make acquisitions or capital distributions.
Nonetheless, recent informal responses from regulators indicate that they do intend the Guidelines to apply to loans made to public agencies and that it is up to banks and other financial institutions to interpret the Guidelines and adjust their underwriting and other standards and procedures accordingly. Essentially, banks are being asked to translate from, say, Spanish to Portuguese, while being given little assistance other than an encouraging pat on the back.
To date, banks have reached different conclusions, necessarily on a somewhat ad hoc basis, as to how to apply to guidelines to loans made to public agencies. Banks generally look at their own underwriting standards which, according to the Guidance, "should be clear, written and measurable, and should accurately reflect the institution's risk appetite for leveraged lending transactions," in a somewhat holistic manner to determine whether a particular loan has risky features that might make it subject to treatment as a leveraged loan. Such features may include inherently weak borrower credit quality, light covenants and documentary protections, PIK interest ("capitalized interest" in public finance terms) as opposed to current payment of interest, operational risk of the borrower, heavy reliance on the enterprise value of the borrower, or any of a number of potential red flags.
Compliance and regulatory counsel at banks may want to work with their public finance coverage bankers to develop a more nuanced understanding of the many types of public agencies that exist and the different ways in which they should be analyzed from a credit perspective. For example, it would be worth considering the following questions with respect to many prospective public agency borrowers:
- Does the entity exist indefinitely (e.g. a state, city or county) or for a finite period of time (e.g. certain development entities)?
- Does it have the power to tax and, if so, under what circumstances?
- Is it eligible to file for federal bankruptcy protection?
- To what extent are its operations subject to political control/risk?
- If it is an operational entity, such as a public university or a water or wastewater enterprise, what are its projected revenues and expenses and how much control does it have over either?
- If it is something other than an operational entity, such as a development authority created for a specific project, on what basis should its financial position and creditworthiness be evaluated?
- What are its long-term pension and OPEB liabilities, if any?
- What does its overall debt profile look like and what are its future capital needs?
- What is its current and projected cash position?
These are all familiar concepts and credit evaluation criteria in the public finance industry, and of course there are many more that could be added. Unless and until the regulators provide additional guidance on how to apply the Guidelines in the public finance space, banks should continue to use their best judgment and consult with both their internal banking teams and outside counsel and advisors in navigating this somewhat bumpy landscape.
Justin Cooper is a partner at Orrick, Herrington & Sutcliffe LLP, and chair of Orrick's housing finance group.