Science1 publisher3 min readPublished
A George Mason study prices lender forbearance at 11.6% of the loan amount
Stephen Karolyi and three co-authors compared borrowers who had just tripped a loan covenant with those who came close, then read the enforcement decisions that followed as a revealed price for keeping the client.
The Scientist · Science desk
What happened
- Stephen Karolyi of George Mason University and three co-authors published a study in the Journal of Financial Intermediation on how lenders decide whether to punish a borrower who has breached a loan covenant.
- The team assembled loan packages initiated between 1990 and 2016 and computed covenant slack, a quarter-by-quarter estimate of how close each borrower stood to breaching its terms.
- Identification rests on comparing borrowers who had just tripped a threshold with borrowers sitting very close to it but not over, so differences in borrower quality are less likely to explain the gap.
- Across the sample, the reward from enforcement had to be worth 11.6% of the loan amount before lenders would impose fees or renegotiate, and the authors treat that as the limit of forbearance.
Compiled by The ScientistSomething wrong?How this is made
Why it matters
- constraint The figure bounds forbearance only at the moment of confrontation, so it cannot be used to price the relationships inside a loan book whose covenants are never tripped.
- decision What the estimate means for a lender turns on the denominator, since the same share of a loan that dominates a portfolio is a different call from that share of a small one.
- capability The value a bank places on a borrower relationship can be estimated from public disclosures and reported financial ratios, without asking a loan officer what a client is worth.
- exposure A borrower the market already covers closely, with several financing options open to it, should expect less slack on the same breach than an opaque one.
The 11.6% is a threshold. It is how large the payoff from cracking down had to be before a lender was willing to crack down [11]. The payoff is specific: when a lender imposes fees or renegotiates, the breaching borrower usually takes steps to cut its own default risk [13][23]. Leniency gives that up, and discipline risks the borrower taking its next loan somewhere else [6]. On the bargaining position, Karolyi said, "The lender has the upper hand in this negotiation because the alternative outcome is that the loan is recalled" [14].
Covenant slack, computed quarter by quarter from contract terms and borrower financials, gives every borrower a distance to its threshold in every quarter [5]. Borrowers just over the line are then set against borrowers just short of it [8]. "When we model two borrowers at similar distance to the threshold, we can be safer in assuming that changes in their outcomes have less to do with differences in borrower quality and more to do with the covenant violation itself," Karolyi said [9]. "On one side, the lender has to make a choice whether or not to enforce. On the other side, they don't have that choice" [10].
Actual enforcement comes from borrower 8-K filings, where fees imposed by lenders show up [7]. The 11.6% is a single figure standing for whatever the lender expects to earn from that borrower later [12]. Earlier work had established that relationships give lenders information they use to cross-sell and to reduce uncertainty, and had left the value of that information unmeasured [18]. This study prices the total, without dividing it among the services Karolyi has in mind when he describes the alternative, arm's-length lending, "where each transaction carries its own narrow cost-benefit analysis, without consideration for other services that are being provided or could be provided in the future" [19].
Because the estimate is a share of principal, it scales directly: $11.6 million per $100 million of loan [21]. Karolyi will not call that large or small. "Whether you'd consider the premium large or small depends upon the size of the loan compared to the bank's overall portfolio," he said [16].
Every loan in the sample arrived at or near a breach. "These are all loans that end up in a situation where a borrower is at least close to breaching a covenant threshold, which is not uncommon but certainly not always the case," Karolyi said [17]. The loan packages span 27 years of originations [20]. Within that sample the pattern ran as the authors expected, with the higher premium going to borrowers who were more mysterious to the wider marketplace and to those with fewer financing options [15].
What to watch
- Whether the authors or others split the 11.6% into specific later revenue, such as fee income or follow-on loan volume, which would test the cross-sell reading.
- An estimate drawn from loans that never approach a covenant threshold, which would say whether forbearance is priced the same away from the enforcement margin.
- Extending the sample past 2016 to see whether the premium moved as syndicated loan markets changed.