Bank Loans

Bonds are generally long-term loans and more often than not are issued publicly by the bor­rowing company. It is now time to look at shorter-term debt. This is not usually issued pub­licly and is largely supplied by banks. Whereas the typical bond issue has a maturity of 10 years, the bank loan is generally repaid in about 3 years.[1] Of course, there is plenty of varia­tion around these figures.

In the United States, bank loans are a less important source of finance than the bond mar­ket, but for many smaller firms, they are the only source of borrowing. Bank loans come in a variety of flavors. Here are a few of the ways that they differ.

1. Commitment

Companies sometimes wait until they need the money before they apply for a bank loan, but about 90% of commercial loans by U.S. banks are made under commitment. In this case, the company establishes a line of credit that allows it to borrow up to an established limit from the bank. This line of credit may be an evergreen credit with no fixed maturity, but more commonly, it is a revolving credit (revolver) with a fixed maturity. One other com­mon arrangement is a 364-day facility that allows the company, over the next year, to borrow, repay, and re-borrow as its need for cash varies.[2]

Credit lines are relatively expensive; in addition to paying interest on any borrowings, the company must pay a commitment fee on the unused amount. In exchange for this extra cost, the firm receives a valuable option: It has guaranteed access to the bank’s money at a fixed spread over the general level of interest rates.

The growth in the use of credit lines has changed the role of banks. They are no longer simply lenders; they are also in the business of providing companies with liquidity insurance.

2. Maturity

Many bank loans are for only a few months. For example, a company may need a short-term bridge loan to finance the purchase of new equipment or the acquisition of another firm. In this case, the loan serves as interim financing until the purchase is completed and long-term financing arranged. Often, a short-term loan is needed to finance a temporary increase in inventory. Such a loan is described as self-liquidating; in other words, the sale of goods pro­vides the cash to repay the loan.

Banks also provide longer-maturity loans, known as term loans. A term loan typically has a maturity of four to five years. Usually it is repaid in level amounts over this period, though there is sometimes a large final balloon payment or just a single bullet payment at maturity. Banks can accommodate the precise repayment pattern to the anticipated cash flows of the borrower. For example, the first repayment might be delayed a year until the new factory is completed. Term loans are often renegotiated before maturity. Banks are willing to do this if the borrower is an established customer, remains creditworthy, and has a sound business reason for making the change.

3. Rate of Interest

Most short-term bank loans are made at a fixed rate of interest, which is often quoted as a discount. For example, if the interest rate on a one-year loan is stated as a discount of 5%, the borrower receives $100 – $5 = $95 and undertakes to pay $100 at the end of the year. The return on such a loan is not 5%, but 5/95 = .0526, or 5.26%.

For longer-term bank loans the interest rate is usually linked to the general level of interest rates. The most common benchmarks are LIBOR, the federal funds rate,40 or the bank’s prime rate. Thus, if the rate is set at “1% over LIBOR,” the borrower may pay 5% in the first three months when LIBOR is 4%, 6% in the next three months when LIBOR is 5%, and so on. The nearby box describes how LIBOR is set and its relationship to the Treasury bill rate.

4. Syndicated Loans

Some bank loans and credit lines are too large for a single lender. In these cases, the borrower may pay an arrangement fee to one or more lead banks, which then parcel out the loan or credit 40The federal funds rate is the rate at which banks lend excess reserves to each other.

line among a syndicate of banks.[4] For example, in 2017 JPMorgan, Citigroup, Mizuho Bank, and Goldman Sachs arranged a syndicated loan facility for Sprint Communications. The pack­age consisted of a $4.0 billion term loan and a $2.0 billion revolving credit facility. The term loan had a seven-year maturity and was priced at 2.5% over LIBOR. The interest rate on the revolving credit facility was 1.75% to 2.75% over LIBOR.[5] In addition, Sprint was required to pay a commitment fee of .25% to .45% on any unused portion of the revolving credit.

The syndicate arrangers serve as underwriters to the loan. They price the loan, market it to other banks, and may also guarantee to take on any unsold portion. The arrangers’, first step is to prepare an information memo that provides potential lenders with information on the loan. The syndicate desk will then try to sound out the level of interest in the deal before the loan is finally priced and marketed to interested buyers. If the borrower has good credit or if the arranging bank has a particularly good reputation, the majority of the loan is likely to be syndicated. In other cases the arranging bank may need to demonstrate its faith in the deal by keeping a high proportion of the loan on its own books.[6]

Bank loans used to be illiquid; once the bank had made a loan, it was stuck with it. This is no longer the case so that banks with an excess demand for loans may solve the problem by selling a portion of their existing loans to other institutions. For example, about 20% of syn­dicated loans are subsequently resold, and these sales are reported weekly in The Wall Street Journal.[7]

5. Security

If a bank is concerned about a firm’s credit risk, it will ask the firm to provide security for the loan. This is most common for longer-term bank loans, more than half of which are secured.[8] Sometimes the bank will take a floating lien. This gives it a general claim if the firm defaults. However, it does not specify the assets in detail, and it sets few restrictions on what the com­pany can do with the assets.

More commonly, banks require specific collateral. For example, suppose that there is a sig­nificant delay between the time that you ship your goods and when your customers pay you. If you need the money up front, you can borrow by using these receivables as collateral. First, you must send the bank a copy of each invoice and provide it with a claim against the money that you receive from your customers. The bank may then lend up to 80% of the value of the receivables. Each day, as you make more sales, your collateral increases and you can borrow more money. Each day, some customers also pay their bills. This money is placed in a special collateral account under the bank’s control and is periodically used to reduce the amount of the loan. Therefore, as the firm’s business fluctuates, so does the amount of the collateral and the size of the loan.

You can also use inventories as security for a loan. For example, if your goods are stored in a warehouse, you need to arrange for an independent warehouse company to provide the bank with a receipt showing that the goods are held on the bank’s behalf. The bank will generally be prepared to lend up to 50% of the value of the inventories. When the loan is repaid, the bank returns the warehouse receipt, and you are free to remove the goods.[9]

Banks are naturally choosey about the security that they will accept. They want to make sure that they can identify and sell the collateral if you default. They may be happy to lend against a warehouse full of a standard nonperishable commodity, but they would turn up their nose at a warehouse of ripe Camembert.

Banks also need to ensure that the collateral is safe and that the borrower doesn’t sell the assets and run off with the money. This is what happened in the great salad oil swindle. Fifty- one banks and companies made loans of nearly $200 million to the Allied Crude Vegetable Oil Refining Corporation. In return, the company agreed to provide security in the form of storage tanks full of valuable salad oil. Unfortunately, cursory inspections failed to notice that the tanks contained seawater and sludge. When the fraud was discovered, the president of Allied went to jail and the 51 lenders were left out in the cold, looking for their $200 million.

6. Loan Covenants

We saw earlier that bond issues may contain covenants, which restrict companies from taking actions that would increase the risk of their debt. For publicly issued bonds, these restrictions are often mild and are generally incurrence covenants. In other words, they might say that the company may not issue more debt unless the interest cover is greater than five times. In the case of privately placed debt, such as the Sprint syndicated loan, the covenants are generally more severe, and include maintenance covenants. For example, these may say that the com­pany is in violation if interest cover falls below five times regardless of whether that is a result of taking on more debt or is simply caused by declining earnings.

Since privately placed debt keeps the borrower on a fairly short leash, it is quite common for a covenant to be breached. This is not as calamitous as it may sound. As long as the bor­rower is in good financial health, the lender may simply adjust the terms of the covenant. Only if covenants continue to be violated will the lender choose to take more drastic action.

Covenants on bank loans and privately placed bonds are principally of three kinds.[10] The first and most common covenant sets a maximum fraction of net income that can be paid out as dividends. A second set of covenants, called sweeps, state that all or part of the loan must be repaid if the borrower makes a large sale of assets or a substantial issue of debt. The third group places conditions on key financial ratios, such as the borrower’s debt ratio, and interest coverage ratio, or current ratio. For example, the Sprint loan requires the company to maintain a specified debt ratio and interest cover.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.

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