THE REAL RISK

While most of us are aware of the most obvious reasons for loan default (not paying back the money), a more common risk of default comes with the breach of covenants.  Many borrowers are routinely in default without even being aware and are putting themselves in harm’s way. Personal guarantees are the primary cause of such defaults.

Personal guarantees generally include a requirement that updated personal financial statements be provided by each guarantor on an annual basis. Beyond the hassle factor for whoever is charged with the collection of these documents is the reality that at least one of the partners will invariably fail to submit financials on time. That is a technical default.  While your local banker who has always serviced your account may turn a blind eye, that can change in an instant when the bank gets acquired or a regulator comes in to inspect documentation.  Many loan documents don’t have a “cure period,” so turning in late financials doesn’t automatically end the default. 

While the idea that a bank would call the loan based on this type of technical default sounds farfetched, CMAC has witnessed a spate of such actions by banks who may be looking for an excuse to remove or improve a loan that was added through acquisition or that does not meet its current portfolio standards.  

Personal guarantees are just one of the many technical defaults to be aware of. Others such as loan-to-value (LTV) or Debt Service Coverage (DSC) ratio also trigger defaults. Consider the case of a doctor-owner in Fort Myers, Florida who was cited for a breach when his property’s value declined below the specified LTV in the documents.  The bank used this technical default to terminate the loan.  Of course, the borrower could not come up with funds to immediately pay, so the bank offered a new loan at a much higher rate.  In this way, the bank was able to legally increase the yield on a long-term client.  

Another common technical default is not meeting the specified DSC ratio.  Even with the most lenient DSC of 1.0x (every penny made that year can be distributed) may be inadvertently broken if a practice estimates net income when making year end distributions. 

It is important not to leave yourself unnecessarily exposed to technical defaults.  It’s like having your head on the chopping block: even if you trust the person wielding the axe above you, it’s an uncomfortable situation.