In any economic downturn banks will look very closely at their customers’ performances and in particular their customers’ loan covenants.
In this blog, I will be focussing in on one particular covenant which will almost inevitably be affected in the case of all borrowers: the Loan to Value covenant.
The LTV is the ratio of a loan to the value of an asset, usually a secured asset, expressed in percentage. LTV covenants tend to stipulate that the amount outstanding under the loan must not be greater than a certain percentage of the property value. A typical LTV covenant will provide that the borrower is responsible for ensuring that the total drawn down funds do not exceed a specified percentage of the value of the property acting as security for the loan.
The purpose of an LTV covenant is of course to ensure that banks have adequate security throughout the life of the loan. They can often be tested as frequently as the lender requires, by appointing a qualified surveyor to carry out a valuation of the secured property.
So why is LTV likely to become critical? The answer lies in the impact any economic downturn can have on these covenants.
The drastic measures implemented to curb the COVID-19 pandemic are already resulting in economic disruption. Experts estimate that the UK economy could crash by at least 15% over the coming months, with the country at risk of tumbling towards its deepest recession in almost 100 years.
Economists forecast the UK economy as entering “a recession of unprecedented scale and depth”. Some suggest that we will move beyond recession into something deeper and longer-lasting: a depression. If these forecasts turns out to be accurate, the UK economy would suffer a greater hit than during the financial crisis 12 years ago and even the Great Depression that followed the 1929 Wall Street crash.
Whilst there is huge uncertainty over the depth of the coming recession and the speed of the subsequent recovery, the Financial Times’ analysis of the most reliable data published so far certainlyindicates that unemployment is surging and public finances are sliding sharply into the red. Covid 19 has already caused Britain’s fastest economic contraction on record.
A downturn of this magnitude is inevitably going to have a very significant effect on property values, whether over the shorter term, or for a longer period. Against this backdrop, banks will be looking closely at their customers’ performance, and in particular at the loan to value or “LTV” covenant.
Typically, before 2008, banks were relatively relaxed about the level of LTV they required. LTV levels of over 80% were common. In a rising market, high LTVs present little risk, as the value of the underlying asset rises steadily, and so, assuming the lending does not increase, the LTV will always drop.
However banks and borrowers alike were caught out when the property bubble burst in 2008. Property prices plummeted, causing many LTVs to rise sharply and often, through no fault of the borrower, the level of borrowing became greater than the value of the asset, often described as “under water”.
LTV covenants are especially tricky covenants for borrowers because the measure of whether or not the LTV has been breached is often not within the borrower’s control. In the last recession, many borrowers were held in default by their banks despite never defaulting on payments under their loans, because, with the drop in property values, they had inadvertently breached the LTV covenant.
Lenders are typically permitted to treat any breach of the LTV covenant as a borrower default and can then demand early repayment of the loan. However, in practice, banks instead opted to use covenant breaches as an opportunity to renegotiate more favourable terms.
As a team, we have specialised in banking issues, acting for borrowers, since 2008. During that time we have seen a number of instances of banks using an apparent drop in LTV to hold customers in default, in circumstances where the bank had not actually instructed a qualified surveyor and instead had used someone unqualified and “in house”; had not obtained a proper survey; and where the survey they relied on specifically said “not to be relied on for security purposes”. On occasion the supposed survey was almost literally written on the back of a fag packet. On other occasions, the bank was never able to produce the supposed survey upon which they maintained they were relying. However, despite such blatant wrongdoing, banks were in this way able to pressurise customers into providing personal guarantees, or additional security, or into agreeing new and very unfavourable lending terms. Banks even pressurised directors of customer companies in to granting personal guarantees shortly before proceeding to liquidate the company.
We would like to think that lessons have been learned in the aftermath of 2008. However, if your bank relies on a property valuation to hold you in default of a LTV covenant, there are a few immediate questions you need to ask.
Firstly, check that your bank has actually run a proper covenant test. Is there a survey the bank are relying on? Has it been carried out by a firm of surveyors you have heard of? Can the bank provide you with a copy of the survey?
Secondly, ask yourself whether valuations conducted in the present circumstances could ever be considered accurate and reliable. The Royal Institute of Chartered Surveyors has indicated that surveyors may need to include ‘material valuation uncertainty’ declarations in their advice and reporting. A survey without such a declaration should immediately be challenged, and you should also think about challenging any survey carried out in the current climate as potentially inaccurate and unreliable.
You should always think about instructing an independent surveyor to carry out a separate valuation, as this could be a powerful negotiating tool if there is a difference in opinion between the surveyors.
In a practical sense, the current lockdown makes it very difficult, if not impossible, for surveyors to conduct site visits. Desk-top valuations are an alternative to physical inspection. However, these should certainly be challenged if they are being used to enforce an apparent breach of an LTV covenant, so look out for this in any survey you have been shown.
I have focussed so far on ways to challenge steps which your bank may seek to take. However, before you reach the stage of needing to challenge what your bank is doing, it is absolutely worth establishing an early line of communication with your bank as soon as you can. In the wake of 2008, and the avalanche of criticism the banks have faced as a result of their treatment of their customers, banks may be more wary of taking peremptory action without at least being seen to engage with the customer.
If you’re struggling to establish an avenue of communication with your bank, it can be very useful at that stage to engage your MP or MSP. Many have been extremely helpful to our clients, as their constituents.
Finally, don’t hesitate to get in touch with us if you are grappling with any of these issues. We are happy to help and this is our area of expertise. Sometimes, it can be as simple as helping you to draft a letter to the bank (and our input can remain “behind the scenes”), whilst on other occasions, clients have welcomed having someone to visibly act as a buffer between them and their bank. It’s very much an individual decision for each client to make and we can walk you through your options.