Project sponsors will have to pay a lot more for financings that come to market in the wake of the current banking crisis that is a certainty. However, as a result of the clogged interbank lending market some will also face a price hike on previously agreed loans that they are currently in the process of drawing down or paying back.
This hike in project financing costs stems from a jump in interbank lending rates, as a result of the fallout from the credit crunch, which has forced some banks to invoke the market disruption clause (MDC) present on most project financing agreements. While the wording varies according to each contract, the MDC specifies that on project financings or corporate loans, if banks costs of funding are higher than the dollar Libor (London inter bank offered rate) as set by a number of banks and displayed by Reuters, they can instead set a reference rate based on the average of the banks participating in the syndicated loan (which has to be agreed by around one third to half of the syndicate). Most corporate loans and project financings are fixed based on one-month, three-month or six month Libor rates and the fixing falls due at the end of a fiscal quarter. A number of banks invoked the MDC just prior to end-September this year, because they were no longer able to access interbank funding at the published Libor rates, despite the increase in these rates.
Frozen Interbank Lending
Dollar Libor and interbank rates for many other currencies, including those in the Gulf (MEES, 29 September), have climbed. But the freezing in interbank activity as a result of the credit crunch has meant that actual rates are even higher than published rates, generating discussion about the relevance of Libors use in contracts. Banks are reluctant to lend because they face write-downs from exposure to bad debt as a result of the US subprime mortgage crisis, or do not want to extend credit lines to a peer that may ultimately fail, desiring instead to shore up their cash position. While the outlook is currently unclear, if the recently proposed bailout plans and coordinated injection of liquidity by central banks around the world does not help to free up the choked bank market, as Libor fixing falls due for loans, more banks are expected to invoke MDC.
Looking ahead we dont know what to expect, but there should be more MDC activity because the cost of funding is above the average return on our portfolio, commented one banker in Europe. Another in the Gulf suggests: The number of MDCs is increasing. Ive seen three more across my desk today, noting that MDC has, until now, not been a common occurrence and its recent appearance has left most sponsors scratching their heads. However, the extent of the problem remains unclear, because few banks at present will provide details on the deals subject to MDC, and the extent of the pricing increases. Invoking MDC is a matter of bank policy and the most stricken banks are not necessarily the ones that call it, said one banker, stressing that it has nothing to do with the creditworthiness of the sponsor.
Gulf Sponsors To Weather Higher Prices
In project financing, sponsors pay banks margins which are expressed in basis points over Libor. While the margins are set when the project financing agreements are signed, if MDC is invoked sponsors total costs will increase because the base rate rises. While MDC is a function of the problems that banks are currently facing, deals with low margins could see a greater impact because the bank has less wiggle room to increase its own cost of funding, said one banker. Margins in Gulf project financings had been in downtrend since 9/11 because over the last several years sustained high oil prices made banks, which were awash with liquidity, keen to take on Gulf risk. However, even if they do face MDC, the increase in base rates is unlikely to prove problematic for most Gulf sponsors, given that they are underpinned by strong economic growth and often government support. Most Gulf borrowers have cash that will cover interest charges several times over and they wont go into default, but outside the Gulf if we move away from Libor it could be damaging to some and cause cash flow problems, warned one banker.
Aside from the movement on MDC, MEES soundings indicate that the project finance market has ground to a halt, with most underwriters waiting to see if recent government efforts to support banks proves effective before they launch new transactions (MEES, 22 September). The UAEs Shuweihat S2 is the next mega-deal set to come to market, and this is expected to provide a barometer for pricing. In the absence of the interbank market, banks have to increase interest rates and fees almost twice as much as before, and letters of credit, for example, have gone up fourfold, commented Saleh Jallad, Treasurer at Consolidated Contractors International Company (CCC) and Publisher of MEES.
Under immediate conditions, while banks are still keen to take on advisory roles for projects (given that they typically take a year to come to market) none are prepared to take underwriting positions. Not only are banks not taking on underwriting, but many will not even conduct deals on a best efforts basis because the market liquidity situation is crippling all of us, commented a senior UAE banker. Under best efforts agreements, a bank will give only indicative pricing and attempt to build a book for a corporate deal or project financing, rather than the firm commitment of cash and booking building that characterizes the classic underwriting process. Project sponsors and corporations which desperately need bank support are having to take out shorter term financing in order to weather the current storm, he said, noting that most business is restricted to relationship clients rather than new customers.
MAC Unlikely, Despite Crunchs Severity
Since it started to bite in late summer last year, the credit crisis has already ushered fundamental changes into project finance, pushing up margins from the all-time lows they saw in 2005, 2006, and early 2007, and causing the first reappearance of the market flex clause since 9/11 (MEES, 11 August). The freezing of the interbank lending market, and failure/merger/rescue of a growing list of banks has left many wondering if any currently mandated underwriters around the globe will attempt to use the material adverse change (MAC) clause that is present in most project financings to step away from their commitments. The use of MAC is rare, but its very presence in a contract allows banks to get sponsors around the table and discuss changes in pricing and structure of deals, said one banker, noting that rigorous talks would be taking place between underwriters and sponsors on any open financings that had been scheduled to hit the market this year. It just makes sense for banks and sponsors to talk, because ultimately, no one wants a financing to fail. However, most bankers suggested that any sponsors that can hold off with their financing needs will continue to do so, until market conditions return to a semblance of normality, although pinpointing such a juncture is almost impossible.
Islamic Banks
Although very little activity is expected to resume in the immediate term, future financings are expected to call on alternative sources of funding, as the banking sector returns to full strength. Islamic banks have been unscathed by the bad subprime loans that have hampered their conventional peers, and are expected to play an increasing role in project finance. The activities of Islamic banks are related to the real economy, not the secondary sector like the stock market, so they have fared well, comments Dr Jallad. The Islamic sector is growing rapidly, but is still small relative to conventional banking, despite the latters woes, and they will also need to see a return to smoother interbank market conditions in order to reach top gear in provision of services. Since the credit crunch hit the market, export credit agencies (ECAs) which can lend directly are also stumping up more cash, but many only provide insurance cover, and are dependent on banks to provide the underlying funding. Needless to say, the bond market, which at one point appeared likely to provide increased funding to project finance, has effectively been shut down by the crisis.
Copyright MEES 2008.
