Loan Clauses That Bite
by Marcus Fedder

A guide to potentially dangerous covenants in common MFI loan agreements

Marcus Fedder is a former investment banker who has also worked with the World Bank and as Treasurer of the EBRD. He is now a partner in a hedge fund and advises an MFI on treasury issues.

As the financial crisis hits developing economies, clients of microfinance institutions (MFIs) are feeling the effects. MFIs that have enjoyed stable and largely default-free operations for years are likely to be hit by three concurrent negative developments, which could ultimately result in a decrease in profits:

1. Deteriorating credit standing of their borrowers, resulting in:
    - increase in Portfolio at Risk over 30 days (PAR 30)
    - increase in client defaults
    - increase in the cost of monitoring and collections
2. Dwindling external funding
3. In some cases, rapidly depreciating domestic currency

While many MFIs are well-positioned and have enough liquidity, equity capital, and shareholder support to withstand the worsening environment, some will face challenges in meeting their own debt obligations.

MFIs should carefully re-examine their own loan documents and analyze the covenants and events of default that are built into these agreements. In many cases, if an MFI breaches any of the covenants (mentioned below), a loan can be called and become due immediately. Though lenders are unlikely to call loans automatically, borrowing MFIs should be aware of this possibility and should proactively engage with their lenders.

This article highlights covenants sometimes found in MFI loan agreements and the potential consequences and dangers that MFIs face in agreeing to them.

Positive ROE

Some lenders require MFIs to demonstrate a positive year-end return on equity (ROE), in some cases a minimum of 5%. In times of crisis, it is quite possible that MFIs may have a negative ROE.

The danger: MFIs facing an ROE covenant may be tempted to take actions such as putting off crucial investments in infrastructure, firing expensive but important staff, or reducing equity in order to try to meet the ROE requirement.

Recommended approach: While these steps are likely to increase the MFI’s ROE, they are also likely to cause damage to long-term stability. A better course of action may be for the MFI to request an amendment or waiver of the ROE covenant before the MFI fails to meet this ROE requirement, entitling the lender to call the loan.

PAR 30

Some loan agreements stipulate that a loan will be due if PAR 30 rises above a fixed percentage, for example 5%. This may be reasonable under normal conditions. Today, however, a number of MFIs are likely to see PAR 30 rise close to or above such levels as loan servicing becomes a lower priority for micro-borrowers struggling to meet basic needs.

The danger: Once again, it is likely to be highly counterproductive for MFIs to attempt to address this problem by “playing with numbers”, for example:

• Increasing the number of new loans so that PAR 30 decreases in the short-term
• Swapping PAR 30 loans with another MFI

Recommended approach: Neither of these methods will remedy the core issue: an increasing number of problem loans. A better course of action would be for the MFI to raise this issue with its lenders before failing to meet this PAR covenant, and to request a waiver or amendment of this PAR covenant to bring it in line with the actual PAR the MFI expects to see over the coming year.

Clauses to change the currency of a loan

Some loans stipulate that in the event of a devaluation of the local currency in which the MFI operates, the lender may take unilateral action, such as converting the loan to a different currency.

Recommended approach: As any currency conversion of existing loans may pose serious asset and liability management - and potentially regulatory - issues for an MFI, it is advisable that MFI management begin negotiating the terms of such a conversion at an early stage in order to avoid problems.

Conclusion

In these difficult times it is crucial for lenders, MFI management, and shareholders to work in concert. MFIs are likely to survive this crisis if they:

• Communicate clearly and early on with lenders, and
• Do not attempt to circumvent covenants in ways that undermine their institution in the long term.

All experienced bankers are aware of tricks that can make a financial statement look better. However, debt swaps and fast growth in the number of new loans will not pass unnoticed. Debt swaps will certainly be treated as a red flag that the borrowing institution may be hiding problems rather than addressing them. Lenders expect to hear that during troubled times MFIs are tightening disbursement criteria, performing due diligence on delinquent clients, restructuring delinquent loans against additional collateral so that these loans are more likely to be repaid, and so on.

As with any bank, sufficient equity and liquidity are crucial for MFIs. Early negotiation for back-up lines of credit and additional equity to provide a cushion may be crucial factors that allow MFIs to weather the storm. Proactively dealing with issues before they arise – either in the initial negotiation of loan agreements or, failing that, before onerous covenants are breached – will most likely save MFIs and ultimately help the microfinance borrowers.

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Posted: 05 Jun 2009

Related Documents:

Commercial Loan Agreements: A Technical Guide for Microfinance Institutions
This guidebook introduces borrowing microfinance institutions to important provisions of a standard commercial bank loan agreement.