The fixed income markets have been struggling to define and contain counterparty credit risk for the past five years, since the collapse of Lehman Brothers and Bear Stearns. In the secondary loan market for commercial and industrial loans, counterparties sometimes sell and purchase loans by “participation.” The seller or “grantor” of the participation remains the “lender of record” for the loan, and sells to the buyer or “participant” a beneficial, economic interest in seller’s rights and obligations under the loan. The US secondary loan market has been working to mitigate the structural risk of a participant’s default and subsequent failure to pay the grantor future funding obligations due under the loan.
When a participation interest in an unfunded loan commitment has been sold, the contractual obligation to fund the borrower remains with the grantor, as the lender of record under the credit agreement. The participant typically agrees, however, in the participation agreement to reimburse the grantor for any future fundings made to the borrower. In order to reduce credit exposure in these circumstances, grantors of participations may take a security interest in the underlying participation as well as require their participants to post cash and/or securities as collateral.
The Loan Syndications and Trading Association, Inc. (the “LSTA”) previously published a Collateral Annex for Participations (the “C ollateral Annex”) to be used in conjunction with the transfers of loans by participation. Under the Collateral Annex, the participant is required to post collateral as security for any future funding obligations at the time the loan is purchased, subject to adjustments as changing circumstances may require.
On June 28, 2013, the Collateral Annex was modified by the LSTA in response to increasing market concerns with counterparty credit risk. While the original version of the Collateral Annex focused on protecting grantors (mainly brokers and dealers) from defaulting participants (often hedge funds), the unprecedented collapses of Lehman Brothers and Bear Stearns in 2008 caused trading counterparties to take a much harder look at broker/dealer creditworthiness. Additionally, significant delays in the settlement of trades and frustrations with lengthy negotiations over buyer collateral issues led to a call for revisions to the relevant LSTA documentation.
There are three significant changes to the Collateral Annex and the LSTA’s Par/Near Par Trade Confirmation and Distressed Trade Confirmation (collectively, the “Trade Confirmations”) which are highlighted below:
WHEN IS COLLATERAL REQUIRED?
- Unless specifically agreed by the parties in the Trade Confirmation, sellers may, at their sole option, require buyers to post collateral for any unfunded portion of a revolving loan/commitment.1
- Previously, unless otherwise agreed by the parties in the Trade Confirmation, sellers could not require collateral to be posted by buyers for any unfunded portion of a revolving loan/commitment.
- Buyers of participations in revolving loans/ commitments should be particularly aware of this reversal and make sure to express any disagreement or concerns to the seller at the time of trade.
WHO HOLDS THE COLLATERAL?
- Buyers of participations in revolving loans/ commitments, in trying to diffuse and limit counterparty credit risk and restrict a grantor’s use of collateral, may prefer instead to deposit collateral with a third-party custodian or, alternatively, request segregation of the collateral into a “customer account.”
The Trade Confirmations now contain “check the box” provisions, to be agreed by the parties at the time of trade, with respect to:
- whether or not the Collateral Annex applies;
- whether the collateral account can be established with a third-party custodian, as opposed to with the seller; and
- if established with the seller, whether or not such account will be a segregated account in buyer’s name.
HOW MUCH COLLATERAL MUST BE POSTED?
- The definition in the Collateral Annex of “Collateral Shortfall,” which prescribes the formula for calculating the amount of collateral to be posted at any given point in time following the trade settlement date, has been modified by the LSTA in an attempt to more closely reflect the range of current market practices among broker/dealer institutions.
The definition now offers two suggested alternative calculation methodologies, with an important caveat that the alternatives are not intended to be exhaustive:
- Alternative 1 uses a fixed percentage of the unfunded commitments; and
- Alternative 2 considers also the amount the seller would have to pay a third-party buyer to assume the unfunded commitments, as well as the market value of the funded participation.
- In either scenario, the formula is recalculated on a daily basis; if there is a shortfall on any particular day, then the seller may request additional collateral. The shortfall amount will fluctuate in both formulations with the amount of the unfunded commitments and, in Alternative 2, with the market value of the participation as a whole — increasing as the unfunded commitment increases, but decreasing with increases in market value of the participation.
- Sellers of participations in revolving loans/ commitments, with widely varying and constantly evolving institutional credit requirements, should benefit greatly from the flexible approach taken by the LSTA regarding how much collateral is posted. As a result, sellers can customize the Collateral Annex to meet these credit requirements and address specific counterparty credit risk concerns.
We anticipate that the LSTA will continually update and revise their suite of secondary loan trading documents. We will endeavor to continue to provide updates on these developments.