United States: US Banking Regulators Issue Further Frequently Asked Questions For Leveraged Lending Guidance

Last Updated: November 14 2014
Article by J. Paul Forrester

Keywords: Comptroller of the Currency, OCC, SNC, financial covenants

The Office of the Comptroller of the Currency (OCC) has released its 2014 Shared National Credits (SNC) review (the 2014 SNC review). Highlights (or lowlights, depending on your viewpoint) include (emphasis added):

  • Total SNC commitments increased by $379 billion to $3.39 trillion, or 12.6 percent from the 2013 review. Total SNC outstanding increased $206 billion to $1.57trillion, an increase of 15.2 percent.
  • Criticized assets increased from $302 billion to $341 billion, representing 10.1 percent of the SNC portfolio, compared with 10.0 percent in 2013. Criticized dollar volume increased 12.9 percent from the 2013 level.
  • Leveraged loans comprised 72.9 percent of SNC loans rated special mention, 75.3 percent of all substandard loans, 81.6 percent of all doubtful loans and 83.9 percent of all nonaccrual loans.
  • Classified assets increased from $187 billion to $191 billion, representing 5.6 percent of the portfolio, compared with 6.2 percent in 2013. Classified dollar volume increased 2.1 percent from 2013.
  • Credits rated special mention, which exhibit potential weakness and could result in further deterioration if uncorrected, increased from $115 billion to $149 billion, representing 4.4 percent of the portfolio, compared with 3.8 percent in 2013. Special mention dollar volume increased 29.6 percent from the 2013 level.
  • The overall severity of classifications declined, with credits rated as "doubtful" decreasing from $14.5 billion to $11.8 billion and assets rated as "loss" decreasing slightly from $8 billion to $7.8 billion. Loans that were rated either doubtful or loss account for 0.6 percent of the portfolio, compared with 0.7 percent in the prior review. Adjusted for losses, nonaccrual loans declined from $61 billion to $43billion, a 27.8 percent reduction.
  • The distribution of credits across entity types—US bank organizations, foreign banking organizations (FBOs) and nonbanks—remained relatively unchanged. US bank organizations owned 44.1 percent of total SNC loan commitments, FBOs owned 33.5 percent and nonbanks owned 22.4 percent. Nonbanks continued to own a larger share of classified (73.6 percent) and nonaccrual (76.7 percent) assets than their total share of the SNC portfolio (22.4 percent). Institutions insured by the FDIC owned 10.1percent of classified assets and 6.7 percent of nonaccrual loans.

On the same day, the Board of Governors of the Federal Reserve System (FRB), the OCC and the Federal Deposit Insurance Corporation (FDIC and, together with the FRB and the OCC, US Banking Regulators) also issued their joint Shared National Credits Leveraged Loan Supplement 2014 (the 2014 Supplement) and related Frequently Asked Questions (FAQs) for Implementing March 2013 Interagency Guidance on Leveraged Lending.1

The 2014 Supplement provides additional commentary on the 2014 SNC review and states:

The review also found serious deficiencies in underwriting standards and risk management of leveraged loans. Overall, the SNC review showed gaps between industry practices and the expectations for safe-and-sound banking articulated in the guidance. Thirty-one percent of leveraged transactions originated within the past year exhibited structures that were cited as weak, mainly because of a combination of high leverage and the absence of financial covenants. Other weak characteristics observed included nominal equity and minimal de-leveraging capacity.

Covenant protection deteriorated, as evidenced by the reduced number of financial maintenance covenants, the use of net debt in many leverage covenants, and features that allow increased debt above starting leverage and the dilution of senior secured positions. In particular, transactions that increase leverage without a subsequent increase in cash flow generation (e.g., loans used to pay dividends to equity investors) should be viewed with greater caution. In many cases, examiners questioned the borrower capacity to repay newly underwritten loans if economic conditions deteriorated or if interest rates rose to historical norms. As noted in the 2013 guidance, financial institutions should ensure borrowers can repay credits when due, and that borrowers have sustainable capital structures, including bank borrowings and other debt, to support their continued operations through economic cycles.

Regarding SNC underwriting, the 2014 Supplement notes:

Weakness in underwriting was far more prevalent in leveraged lending compared with non-leveraged SNC loans. Thirty-one percent of leveraged transactions originated within the past year exhibited structures that were cited by examiners as weak, mainly because of a combination of high leverage and the absence of financial covenants. Other weak characteristics observed include: equity cures, nominal equity, and minimal de-leveraging capacity. In addition, covenant protection deteriorated, as evidenced by the reduced number of financial maintenance covenants, the use of net debt in leverage covenants, excessive headroom, springing features, and various accordion features that allow increased debt above starting leverage and the dilution of senior secured positions.

Similarly, the FAQs2 are offered by the US Banking Regulators to "foster industry and examiner understanding of the guidance and supervisory expectations for safe and sound underwriting and to promote consistent application of the guidance."

Footnotes

1 For more information about the 2013 Leveraged Lending Guidance, see our March 27, 2013 Legal Update.
2 We have excerpted certain of the questions and responses from the FAQs regarding non-pass origination, permissible amendments, acceptable refinancing of special mention credits, multiple-tranche facilities, relevance of debt-to-enterprise value, 6x leverage not a "bright-line" test and other matters.

Originally published November 13, 2014

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