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Providence Financial









MONTHLY NEWSLETTER:  SEPTEMBER 2005 ISSUE

WHAT IS A CREDIT ENHANCEMENT?
BY BRENT VAN ALFEN, PROVIDENCE FINANCIAL COMPANY, INC.


There is an old saying that “almost” only counts in horseshoes. Everywhere else “almost” is not good enough. If your team almost won a game, it lost. If you almost made your airplane flight, you missed it. If you are driving too fast and almost stopped in time, you got in a wreck. If your school applied for a loan and almost got approved, it was turned down. A charter school I have worked with was turned down on their financing requests several times for reasons that I won’t go into here. Their director is very experienced in business and knew how to apply for financing. After the school retained me to see what I could do, I went back to one of the sources that had already turned down the credit request made by the school. I restructured the request with a credit enhancement, and it was immediately approved.

A credit enhancement is anything that will improve the quality or strength of a request for financing. A lender usually requests an enhancement when he/she thinks a potential loan is close to being strong enough to approve but not quite. It is then advisable to offer a consideration that will put it “over the top.” A borrower is well advised to offer a credit enhancement if they are turned down on a request, but they feel they are close to an approval. Better still, a borrower should go to the prospective lender with a proposed enhancement already in place as part of the credit request if they think the request is somewhat marginal. This is sometimes a subjective judgment that comes from experience, but if in doubt, make your request as strong as possible the first time; because it is harder to reverse a decision that goes against you than it is to get a positive decision the first time.

What are some possible credit enhancements? They can be many things and are highly situational to the project in question. I will suggest a few here for your consideration.

Under certain fairly narrow circumstances, a school can get rated as part of a bond underwriting transaction in an effort to lower the interest cost on their debt. This applies to large transactions and schools that are very strong credits. In this case, the credit enhancement, which is getting rated, is used for the purpose of getting a better interest rate rather than getting approved. Getting rated is a slow process and costs considerable money; but under some circumstances, it is worthwhile.

A credit enhancement is anything that will improve the quality or strength of a request for financing.

Additional security such as real estate can be pledged in an effort to get a credit approved. This gives the lender more collateral to liquidate if the loan goes bad. Lenders will be interested in this only if the rest of the proposal looks like it is close to being acceptable. This is the case because liquidating assets is not fun, and it is very uncertain as to what sale value you can get. Additional security is not always a solution.

Some lenders, especially banks, will often ask for personal guarantees from those in key positions in the school. As I said last month, “Never, never, never do this.” Enough said!

Some schools have banded together in pools to get financing. In the pools that I have seen, the schools have not actually pooled their assets but they have pooled cash reserve accounts from all of the schools. These accounts are made available to secure the schools that may become weak. The theory here is that not all of the schools are likely to fail and the pooled reserves will be ample to secure any potential losses arising from one or two failures. If reserves are drawn upon, the other schools pay into the reserve account until it is replenished. This is a very expensive enhancement but it was necessary in earlier years when charter school financing was just getting established. Today, these pooled schools are getting nervous about their weaker “Siamese” siblings and are trying to find a way out of the pools.

One excellent, but difficult to get, credit enhancement is a bank letter of credit. With this enhancement, a bank writes an irrevocable, direct pay letter of credit in behalf of the school’s bondholders. A bond issue is underwritten at a very attractive rate, usually at BMA Index or Libor and floats with those reference rates. A letter of credit fee is paid to the bank also. These are difficult to get because the bank takes on the same risk in issuing a letter of credit as they do in making a loan, but they get a fraction of the profit. When this can be arranged, the interest rates are exceptional. It is a great situation for a borrower.

If you have been turned down on a loan request, or if you want to see about getting a better interest rate, maybe I can help. ?
For information contact Brent Van Alfen, President, Providence Financial Co., Inc.
801-299-8555, brent@providencefinancialco.com