Client Briefing, 21 April 2009
The last six months have been an extraordinary period of time in the financial sector as lenders' relationships with many of their customers have become increasingly strained as the cost of credit (across almost all sectors) increased, providing that credit was even available.
The inter-bank lending markets, which some previously had thought had an almost limitless capacity, virtually disappeared and we moved into a phase where the market focussed on stronger banking capital ratios, a heavier emphasis on interest rate risk in the banking book and more conservative credit assessments.
In the asset finance and corporate lending sectors, this has led to many lenders activating the so-called "Market Disruption Event" (MDE) clauses in their loan documentation. Over the last six months, the use of these provisions is well documented and they have been utilised across the globe by a vast spectrum of lenders.
In a Nutshell
There has been considerable opinion on the operation and applicability of the MDE clause, as the speed of the decline of the credit markets has suddenly transformed what many had previously considered to be a boiler plate provision into an operational headache.
Applying and invoking an MDE was complicated by the fact that lenders tend to employ a variety of legal advisors to prepare their documentation and so MDE provisions can vary significantly from deal to deal, even within the same lender's portfolio. In addition, some borrowers negotiated their documentation to limit the effects of any market disruption, which in the buoyant credit markets of the past appeared commercially acceptable.
Generally an MDE clause operates in loan documentation, where the borrower pays its lender interest comprising three parts; (a) a cost of funds equivalent which, in floating rate loans, is often linked to some prescribed inter-bank rate of a selected interest period (i.e. 3 month LIBOR); (b) the margin; and (c) any additional costs (such as additional regulatory costs).
The most common form of MDE clauses allow a lender to invoke market disruption when there is a disruption event and then to change the cost of funds component to a mutually agreed rate. The usual reasons that permit a lender to invoke market disruption are that:
a. by reason of circumstances affecting the inter-bank market generally, adequate and reasonable means do not exist for ascertaining the selected interest rate;
b. the rate at which deposits in the desired currency are being offered to the lender in the inter-bank market would not adequately reflect the cost to the lender of making the loan; or
c. by reason of circumstances affecting the inter-bank market generally, deposits in the desired currency are not available to it in sufficient amounts in the ordinary course of business.
There are added complications of calling an MDE in syndicated transactions, particularly as the agent bank needs to ensure that it complies with all of its duties (not least the duty of confidentiality) and the fact that any lender invoking such an event will need to consider the consequence of doing so to its reputation and perceived standing amongst its peers.
The Difficulty of Invoking MDE's
Initially, lenders were cautious when invoking these provisions particularly given the large number of commercial, operational and legal consequences that they faced, not least the risk to their reputation.
While the credit markets appeared to be recovering, the gap between the quoted inter-bank rates and the rate at which many commercial banks funded in the market have continued to persist.
This has made it more difficult for lenders to manage the relationship with their customers and, in particular, explain to those customers the consequences of invoking MDEs, particularly when viewed against the lowering of interest rates by the Federal Reserve and many other central banks.
Notwithstanding the difficulties, where applicable, many lenders have called MDEs and the majority of borrowers have had no choice but to accept increased cost for their existing loans, though many borrowers view such cost adjustments as temporary.
What Next?
Invoking the MDE clause is only the first step, as an alternate mechanism for setting the costs needs to be found and agreed. Initially, many lenders were of the view that this disruption was temporary and that eventually the credit markets would ease as liquidity returned.
In some cases, lenders have only been able to obtain overnight or tomorrow night financing (with nothing of longer tenor being either economically viable or available). Consequently, any increased cost to the borrower was uncertain. Many MDE clauses provide that the lenders and the borrowers should negotiate in good faith to resolve such problems and consequently, many lenders agreed alternate rates of financing that were short term in nature (such as 1-month LIBOR) in the hope that when that period expired the MDE would cease and lending would revert to normal, such that lenders would be able to obtain matched funding.
This approach was also more palatable to borrowers who could agree to paying the additional cost of funds for a short term in the hope that LIBOR would again become representative of their lender's cost of funds in the inter-bank market.
Unfortunately, the markets have not reverted to their previous state and the problems of the MDE continue and further complications are on the horizon, particularly if the case is that markets have structurally changed such that the current market conditions are no longer unusual.
From the perspective of many lenders who are trying to return to relationship banking, some mechanism needs to be put in place which gives confidence to their customers (whilst also giving them certainty of cost), while also protecting the lenders from having to disclose to the borrower their own cost of funds in the market. Administratively, agent banks in syndicated deals would also prefer for lenders to agree on an alternative benchmark so that there can be less debate over whether they have taken, or are taking the most appropriate action.
For borrowers, some certainty of cost and a degree of transparency is desired. If an MDE clause has been agreed, and the documentation has been signed, the borrower has to acknowledge that the lender is entitled to activate the clause, but the borrower needs to know that what they are paying is fair and often lenders do not want to disclose the evidence that their funding costs have increased.
There is some confusion in the market as many lenders look to find other publicly available information or indexes that are appropriate for using as reference rates for their funding costs. Borrowers, while reluctant, would also like to find an acceptable alternative to LIBOR and this has led to discussions over possible alternate sources for interest rates such as using indexes of credit default swaps and blended rates quoted by specialist inter-bank brokers.
As these ideas are relatively new, the extent to which they will be successful will not be clear and lenders will need to be careful to ensure that they do not inadvertently give up their rights to call MDEs by placing their absolute faith in an alternate pricing mechanism which could itself be further disrupted.
The Future
Given the current uncertainty on the determination of interest rates, there is value from an operational and relationship banking perspective, in ensuring that any new loan documentation provides as much clarity as possible for borrowers in relation to MDEs so that borrowers are not caught unaware and also so that it is clear whom the burden of the increased costs falls on and the degree of transparency that can be expected by the borrower. At one extreme, the entire actual cost could be passed on to the borrower (though that would require full disclosure of its funding costs by the bank and would most likely mean interest rates being calculated retrospectively, rather than in advance). Alternately, the borrower may choose a fixed reference rate and leave it to the lender to manage the interest rate risk on its funding, whilst providing the lender with the benefit of limited disclosure.
This change to the credit markets may be temporary and it is conceivable that liquidity could return thereby allowing pricing to return to its previous levels. However, the difficulties that many lenders are having suggests that the reality is more likely to be that the credit markets now are far more risk-based in their approach to inter-bank lending and borrowers who borrowed from lenders that now appear weaker could be forced to pay more as a consequence of the perceived weakness of their lender and, ultimately, affect the competitiveness of poorer rated lenders in the market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.