Collateral: Great Expectations vs Sobering Facts

Expectations Often Are Not Fulfilled

 

Ellen Carr has an article in the 10 June FT “Linus from Peanuts has risk lessons for high-yield investors”

Two quotes from that article to set the stage for some additional observations.

When we get the chance to buy bonds with collateral backing them up, we feel, well, more secure.

Secured bondholders anticipate that, if their research fails them and the issuer ends up in bankruptcy court, they are likely to be paid in full before unsecured lenders get a dime.

There is truth in these statements.

But note that in both of the quotes Ms. Carr speaks about “feelings” and “anticipations”.

Sadly these “wishes” don’t always turn into “horses” that bond holders can ride.

Some inconvenient and perhaps even “sobering” facts.

(H/T for the latter phrase to Joseph Blount, President and CEO of Colonial Pipeline).

The nature of the collateral drives its value in a liquidation.

1. Property, plant, and equipment generally are sold for a fairly low percentage of historic cost in collateral realisation, particularly if they are highly specific to an industry. Or are costly to move.

2. As you’d expect items nearer to cash have higher sales values, assuming they are liquid in nature and trade in liquid markets.

3. Holders of collateral in the form of 100% of the shares of capital stock in a subsidiary are effectively junior in legal priority to all other creditors in that subsidiary. Last in the line in the cash waterfall from the subsidiary’s estate.

4. Such shares are generally less liquid than listed shares.

The nature of the corporate distress drives collateral values in liquidation.

1. If one company in an industry is failing but the industry itself has reasonable prospects, the sales price of collateral is likely to be more than if the entire industry is tanking.

2. This will also depend on whether there is existing excess capacity in the industry.

The form of the corporate distress resolution can affect access to collateral.

1. In a US Chapter 11, one may find one’s position changed under the reorganization plan.

2. Realisation of collateral can be legally stopped.

3. The reorg plan may change tenors, rates, and in some cases even the collateral itself.

4. In that regard DIP financing can create a new and higher priority class of secured creditors.

Laws and transaction structures can affect collateral.

1. Be sure that you legally have and can enforce your collateral rights.

2. Be sure the legal structure is sound. Complex structures involving multiple national laws may be fragile. You enforce your collateral rights in the jurisdiction where the collateral "resides".

3. Read the Offering Memo. The deficiencies outlined in points #1 and #2 above are often clearly spelled out in the Offering Memoranda. (See earlier posts on Golden Belt Sukuk and Peking University Founders Group),

4. Be sure you will get a fair shake in courts if you have to enforce your rights. For example, you don’t really want to be a foreign lender in Saudi Arabia. (See Al Gosaibi, TIBC, AlAwal Bank, AlSanea. Or Redec for those with long memories or access to the internet.)

5. Be sure there are no quirks in local law or advantages for well connected individuals. (See Dana Gas posts).

With that as background, let’s take a look at the transactions she mentioned in her article.

What's the Scrap Value of a Cruise Ship?

Royal Caribbean Line: US$ 3.320 billion senior secured notes maturing in 2023 (US$ 1 billion) and 2025 (US$ 2.320 billion)

You’ll find the Indenture here.

Collateral – pages 7-8

“Collateral” is defined as:

1. shares of capital stock in subsidiaries that own the pledged “vessels”

2. 28 pledged vessels

3. the Collateral Account and any “Trust Moneys” within

4. the material trademarks owned by the Issuer and Celebrity Cruises Inc. on the Issue Date, including the Royal Caribbean and Celebrity brand trademarks and (y) all intellectual property rights of the Issuer in and to marketing databases, customer data and customer lists, except to the extent prohibited by contractual obligation existing on the Issue Date or applicable law, rule or regulation.,

You may have read that the book value of the pledged collateral is some US$ 12 billion.

Sounds great!.

That’s roughly four times coverage of the Secured Notes.

But let’s look a bit closer.

First, this collateral is industry specific.

Ask yourself what is the value of cruise related collateral if RCL is failing because it cannot generate sufficient cash to repay its debt.

Then ask how the fact that the cruise industry in general is “facing rough seas” may depress collateral values even more.

A falling tide lowers all boats.

And their related values. And that of their customer lists, trademarks, etc.

Second, note that the US$ 12 billion is based on historic cost.

It’s an old rule of the market that one sells assets at the current market price which may be significantly different than historic cost or book value.

If you are a motivated seller, bidders are more likely to bid low than high. If indeed, they bid at all.

But as they say on late night TV, “but wait there’s more”.

Third, Collateral Cap – pages 8 and 99

That’s not a sartorial accessory for the collateral,

But a way to deal with indentures in existing bonds which limit the amount of “new indebtedness” that RCL can incur.

So what is a collateral cap?

Let’ turn to the Indenture for the legal meaning of this term.

First, the amount of the collateral that is available to the secured creditors solely is limited.

“Collateral Cap” means, on the Issue Date, $1,662.0 million, as it may be increased pursuant to Section 4.13.

Second, on page 99 there is an explanation as to what happens to amounts above the “cap”.

In no event shall Collateral Proceeds in excess of the Collateral Cap or any other limitation on the extent of Collateral Proceeds contemplated by the Security Documents be applied in accordance with this Section 6.10, and such excess amounts shall be returned to the Issuer, any Guarantor or any other obligor of the Notes, as their interests may appear, or as a court of competent jurisdiction may direct.

So in the best case the collateral will not repay more than roughly 50% of the outstanding debt.

Any proceeds from the collateral sales over US$ 1.662 billion would go to RCL’s “estate” to be shared by all creditors.

Thus, the secured note holders are not going to be repaid in full before the unsecured creditors get a dime in the event that the collateral needs to be realised.

There’s more.

As is typical the Indenture permits certain liens against the collateral that have legal priority to the secured note holders’ position.

Once one takes possession of collateral like a vessel, one incurs maintenance and costs associated with berthing, including any required crew salaries and expenses, plus insurance until the sale. These out of pocket costs would then represent a deduction from the proceeds of any realisation.

Admittedly An Extreme Case
But Who Is Going to Want to Buy Stores Now?

Macy’s US$ 1.3 billion 8.375% senior secured notes maturing 2025

The notes are secured by first liens/deeds of trust on real estate.

If Macy’s hits the wall to use a technical financial term, does that perhaps indicate that retail is in real trouble?

I’d argue that it does.

Macy’s is indeed a different “fish” than say Sears or K Mart.

If a name like this is in trouble, then the sector is in trouble.

Who then is the expected buyer of these real estate assets or as we might more realistically call them “empty stores”?

Dollar General? Maybe if the price is a dollar?

What is their value in alternative uses? 

Amazon fulfillment centers? Homeless shelters? Schools?

If you’re interested, Fitch assigned this issue a BB+ rating.

That is below investment grade, a good indication that full repayment is not assured.

KHCB: Credit Metrics Part 3: Collateral Coverage

Post Foreclosure Sales Prices May Be Less than Appraisal Values

We ended the last post on KHCB’s credit metrics with some theological speculation.

Since AA’s province is finance and not theology, let’s look at collateral coverage.  Maybe KHCB is so collateral “rich” that classifying some loans past due 180 days as unimpaired makes perfect (credit) sense.

As outlined above, KHCB’s collateral position is not sufficiently “robust” to compensate for other weaknesses in its lending portfolio discussed in earlier posts.

1. Collateral is concentrated in real estate. That poses at least two problems. Illiquid assets like real estate are difficult to sell quickly and/or at full price, exposing lenders to loss.  Real estate is interest-sensitive. With real estate 85% of collateral, KHCB is particularly vulnerable to increases in interest rates. 
2. Compounding this problem, KHCB’s real estate collateral is primarily located in a single, very small market—Bahrain—, magnifying the inherent risks of taking illiquid assets as collateral. 
3. KHCB also seems to be relying on real estate to collateralize non-real estate loans thus increasing the bank’s overall exposure to real estate.  This appears to contradict GFH’s stated goal of reducing “land-based” exposure.   

Now to the detail.  

Key areas for investigation: 

1. Percent of portfolio collateralized and trends in collateralization.
2. Types of collateral.  

General introductory notes:

1. Note 34 page 72 (IFRS) and Note 4.10 page 93 (Basel Pillar III) are the sources for this post.
2. I have relied primarily on the Pillar III note as the IFRS note really doesn’t provide the same level of detail.
3. However, both have an apparently erroneous and misleading statement regarding collateral coverage of the portfolio.  This error appears only as a number in the Pillar III Note 4.10.  Note 34 spells out the error:  “The average collateral coverage ratio on secured facilities is 107.80% at 31 December 2015 (31 December 2014: 109.49%).”  
4. As Pillar III Note 4.10 shows this ratio was determined by taking the value of all collateral and dividing it by outstanding exposure. 
5. Two problems with that.
6. First and foremost, Pillar III Note 4.10 shows that BHD 106.5 million is unsecured.  The key point here is that if a loan is unsecured, then by definition it has no collateral.  Consequently, unsecured loans should be excluded from measures of collateral coverage.  That of course would apparently make the ratio higher at 148%.  Note that the data for “Other” and “Unsecured” is switched in both the Arabic and English versions of the 2015 AR as evidenced by data in prior years’ annual reports.   
7. Second, unless this collateral is pledged to all secured facilities the 148% coverage ratio is meaningless.
8. As a concrete example, suppose you take a $1mm loan from Bank Arqala (“BA”), assuming you can pass our stringent credit process, and pledge The Trump Tower in NYC.   Our fine bank has collateral worth let’s say a $1 billion, if not multiples more.  But TTTNYC only secures your loan.  If BA makes loans totaling $999 million to other borrowers, the average collateral on the portfolio is not 100%.  One loan for $1 million is over collateralized.  It’s also important to remember that BA like any other bank can only collect what you owe on your loan when it sells (realizes) the collateral you pledged.   If you owe $1.1 million in P&I, BA can take and sell the Trump Tower but only keep $1.1 million not the untold billions TTTNYC is really worth.  The bank must return the rest of the proceeds from the collateral realization to you.  

Collateralization Levels
	2015	2014	2013	2012	2011
Unsecured	106.5	105.2	55.9	47.9	40.3
Total Gross Exposure	408.7	361.8	306.0	286.3	217.3
% TGE	26.1%	29.1%	18.3%	16.7%	18.5%
Partially Secured	25.0	17.9	9.9	10.8	12.2
% TGE	6.1%	4.9%	3.2%	3.8%	5.6%
% TGE –All Unsecured	32.2%	34.0%	21.5%	20.5%	24.1%

Comments on collateralization levels: 

1. As is clear, KHCB has been expanding its unsecured portfolio.  It was at 18.5% in 2011 and 26.1% in 2015.  However, percentages don't convey the full extent of the change.  Unsecured loans have gone from BHD 40.3 million to BHD 106.5 million.  Why is that important?  Because over the period capital has not increased by 2.5x.
2. In general, but not always, uncollateralized lending is riskier than collateralized.  Tenor (maturity) of the loans would also affect risk.  That info is not available. 
3. Note the partially secured amounts are net after deducting the partial collateral shown in Pillar III Note 4.10 for “cash” and “other” collateral at face value (no haircut by AA).   

Types of Collateral: 

1. Pillar III Note 4.10 discloses that 85% of KHCB’s collateral is real estate. 
2. Three observations.
3. First, real estate is illiquid and may be hard to sell, unless one is holding a security interest in a piece of land in central Tokyo.  There’s probably not comparable land in Bahrain.  Additionally, it’s well known that with the right nautical partners one can create perfectly good land in Bahrain from the sea as GFH and Arcapita might testify.  Cash or marketable securities would be much more liquid and provide much more protection.  That’s why KHCB advances on average only 60 fils against each dinar of real estate collateral.
4. Second, real estate is interest sensitive.  As market rates rise so do cap rates (the interest rates used to determine the value of the property). As a consequence, property values decline.  That could be a problem as the US raises interest rates and currency pegged-Bahrain follows along.  The main consequence is likely to be eroding collateral values. Borrowers are shielded from rising rates by the fixed rates on their existing loans--absent covenants in the loan agreements that allow the bank to raise borrower’s interest rates.  Thus, borrowers’ ability to repay should not be affected directly, though general interest rate could indirectly stress their ability to repay by reducing overall economic activity in the Kingdom.   Potential buyers of “seized” collateral are likely to require financing.  If rates on new loans are higher than currently, the sale of real estate will be more difficult, perhaps requiring KHCB to make loan term concessions or reduce the price of seized property being sold.  That leads nicely into the next point. 
5. Third, when looking at an institution’s exposure to real estate risk, one needs to look at more than the purpose of the loan or the business of the borrower. If a bank makes a loan for a new airline, but secures it with real estate, it has an indirect exposure to real estate along with the direct exposure to the airline.  If the loan is being made because the real estate collateral “compensates” for shortcomings in the airline’s creditworthiness, then the exposure to real estate is more “direct”.
6. Some 55% of KHCB’s exposure (based on outstanding exposure not collateral values) is secured by real estate, which tempers KHCB’s management’s statement at the bottom of the chart in Pillar III Note 4.3.6 page 88: “The Board approved internal cap for real estate exposure at 40% of total assets. The Bank’s real estate exposure as of 31 December 2015 and 2014 are within the policy limit.”   Not exactly.  Assuming collateral is taken because it is needed to support extension of credit, then KHCB’s real estate exposure is larger than 40%. 
   

All in all a poor fit for GFH’s announced strategy.