Recently we have received feedback from the NCUA regarding our interpretation of the common ratio Loan-to-Value. I think we first need to ask ourselves what this tool is used for in underwriting. While this seems obvious, it bears stating that we use loan-to-value to measure our collateral position.
NCUA Rules and Regulations 723.21 defines loan-to-value (LTV) as the aggregate amount of all sums borrowed including outstanding balances from all sources on an item of collateral, divided by the market value of the collateral. According to this interpretation, the NCUA is not using LTV as a measurement of collateral, but a measurement of project leverage. Why is that significant?
LTV as a collateral measure tells us how much cushion we have in the event of foreclosure. Our cushion remains unaffected if there are liens behind our senior lien. Say we have a $1 million piece of real estate and a $500,000 first mortgage. Our LTV is $500k/$1 mil. = 50%. Now say there are four additional $500,000 mortgages behind our first, creating a second, third, fourth, and fifth mortgage! No matter what subordinated liens exist, that $1 million property will first serve as collateral for our first $500,000 mortgage, and therefore our LTV position will always be 50%.
However, the NCUA argues all of those liens should be included in the LTV ratio. In this case, if there is actually $2.5 million in debt secured with a $1 million piece of property, it will bring LTV to $2.5 mil / $1 mil = 250%! Yes, the total project has debt of $2.5 million, and the collateral is leveraged 2.5 to 1, but that doesn’t tell us anything about our specific collateral position. Is there danger in a project being overleveraged? Yes, both from a cash flow standpoint and an equity standpoint. But, LTV is not the most effective tool in limiting leverage.
Traditionally, we employ a different ratio to measure project leverage, which is loan-to-cost (LTC). In this case, it is common to lump all the aggregate amount of all sums borrowed including outstanding balances from all sources on an item of collateral. But in this case, you don’t divide by collateral value, but divide by total project cost. I would argue the NCUA would be correct in adding all debt, including subordinated debt, in determining a project’s total LTC.
Why does this matter? Credit analysis is fraught with people using the wrong tool for the wrong purpose, and we need to be careful in understanding what LTV is and isn’t. LTV is the tool we use to measure collateral, but not necessarily the tool we use to measure equity. For this reason, we only care about the LTV of our specific debt. LTC is the tool we use to measure equity, therefore LTC should account for total debt and not just specific debt.
By adding all debt into the LTV calculation, the ratio is misstating what the true collateral position is for specific debt, and it will also misjudge equity in the project. In effect, the present definition fails to characterize both collateral and equity in a meaningful way.