Political interest to minimize the risk of loan failure
Banking crises generally lead to high losses for depositors. Since governments often feel obliged to cover part of these losses, there is a strong political interest to minimize the risk of bank failure through regulation. The basic idea is that regulatory authorities act on behalf of the depositors. But the goal of bank regulators is not only to protect depositors, but also to provide a stable environment for banks to operate in. In order to be allowed to take deposits, any authorized bank has to hold adequate capital. Generally, capital requirements depend on the size and type of risk associated
A cushion for depositors and creditors
Banks generally have to hold adequate capital against all risks that arise from their business. This capital is intended to provide a cushion for depositors and creditors, if the bank is confronted with unexpected losses. Thus, the probability that a bank is not able to repay its liabilities is minimized. Since 1988, the Basel Capital Accord defines the minimum capital requirements for all banks. The agreement was put forward by the Basel Committee on Banking Supervision, an organization founded in 1974, following the severe crises of Bankhaus Herstatt in Germany and Franklin National Bank in the US to improve cooperation
The generation of revenues and cash flows with credit
While the focus of industrial and utility companies is primarily on the generation of revenues and cash flows, for financial institutions the management of assets is of paramount importance. Traditionally, banks’ income statements and asset composition have been the primary focus of attention when assessing their credit strength. However, the high complexity of businesses and financial products has shifted the focus towards risk management. Off-balance sheet items and funding issues have become more important, therefore common metrics of credit risk are not able to reflect the complete risk profile of a bank. We would argue that the analysis of banks
A chance of keeping the operative credit going
If one assumes that there is a chance of keeping the operative business going a valuation on the basis of sales multiples or EBITDA multiples is appropriate. In this case EBITDA is multiplied by an average market multiple and again all senior debt is subtracted before dividing the remaining value by the total amount of outstanding bonds. The discounted cash flow analysis also assumes that the company is a going concern and the computed value serves as a starting point to estimate the value of outstanding bonds. These three methods will result in three different company values and, hence, should
The valuation of a distressed credit
The valuation of a distressed company should be done according to the following methods: Liquidation value Sales multiples and EBITDA multiples Discounted cash flow analysis. In liquidation valuation, it is assumed that the underlying business is not viable and will be liquidated in parts. The analyst has to assign the most likely realizable values to accounts receivables, inventory and PP&E. Generally it happens through a haircut to the book value of those positions.The liquidation often takes a long time to execute and in many cases all cash positions as well as all debt obligations are not disclosed immediately. From the
A successful turnaround with payday loans
Companies which are likely to achieve a successful turnaround will have the following attributes: Balance sheet restructuring through, for example, a rights issue or convertibles Rebalancing of debt instruments towards more long-term debt The equity price recovers and keeps a positive trend New sources for working capital are available Operating income is generated during restructuring Sales growth is positive and the operating margins are at least constant (remember that in the short term, restructuring efforts will cause operational dislocation) Administrative costs and production costs can be kept under control Streamlining of operations The focus remains on the core business and
It is difficult to identify all credit variables
It is difficult to identify all variables, which lead to the default of a specific company. The monitoring of the company’s ratings is not a good way because the rating agencies tend to react with a lag of sometimes a couple of months when the financial situation of a company deteriorates. Aand BBB companies can reach the spread levels normally seen at the CCC level. Some points, which might be an indication for upcoming financial distress are as follows: A new accounting firm or banking relationship is in place Amanagement conflict escalates and is discussed publicly Members from top management
The risk of an imminent loan rating downgrade
Especially lower investment grade (A-BBB) companies that have the risk of an imminent rating downgrade due to negative industry trends and firmspecific problems should include this clause in the covenant package. In the case of a downgrade the bond investors would receive a higher coupon payment (e.g. 25 bp per notch and rating agency). This way the companies can demonstrate their commitment to the current rating and the bondholder gets a fair compensation in the case of a downgrade. Options pricing theory is applied to compute the value of the coupon step-ups and the swap spread is adjusted accordingly. The
Breaching one of the credit covenants
If a company is in danger of breaching one of their covenants or has to renegotiate a bank facility in order to stay in accordance with existing covenants, the credit spreads will widen immediately because major problems are anticipated in the future. Use of proceeds from bond offering: Another important point which should be considered in the evaluation of a new bond issue is the use of proceeds, because for bond investors there is a major difference between, for example, the refinancing of outstanding debt (bonds and bank debt), CAPEX, general corporate purposes, acquisition financing or the financing of a
Optional redemption of credit
The issuer may redeem all or part of the notes at a specified price and time. This means that, for example, a company issues a bond with 10-year maturity and has the option to call the bond after 5 years. This option represents value to the issuer because depending on future interest rates and the required risk premium a company might considerably reduce financing costs by calling the outstanding bonds. Furthermore, most high-yield bonds have an equity claw-back clause in their indenture. This means that an issuer may redeem up to 35 percent of the aggregate principal amount of notes