Loan underwriting using the LTV

Healthcare entrepreneurs need to invest capital for assets that generate revenue and serve customers. Often these assets are financed using debt. Familiarizing oneself on how lenders scrutinize the debt used to purchase an asset, and determine/monitor its value is important to a borrower. Let's take a dive into a common underwriting metric lenders use and borrowers want to understand. 

The risk of default

While entrepreneurs wait anxiously to learn if they're successful in their loan application, lenders must remain anxious throughout the entire loan maturity period. Lenders need to predict and monitor the likelihood that the borrower will default at any time during the lending period. Since most entrepreneurs take loans with maturity periods of years or decades, lenders need to be vigilant throughout the loan period.

There are many measures of risk, and each has its place in entrepreneurship depending on the context in which the risk can manifest. In the debt financing environment, a common measure is the loan-to-value (LTV). 

Loan-to-value (LTV)

Lenders calculate and monitor LTV throughout the loan period. The LTV conveys how much debt financing is needed (the loan, L) to purchase an asset (its value, V). Often, the asset financed through debt is the security (collateral) against the debt. Not surprisingly, lenders favor making loans to purchase assets whose value is greater (or far greater) than the loan amount. How does that happen?

The threshold iLTV is the maximum default risk a lender is willing to accept at  t = 0. The acceptable iLTV depends on the macroeconomic environment, the borrower's personal loan history, and the asset itself. Most lenders suggest an iLTV of 0.75 or less. 

The iLTV is 0.75, which conveys a particular default risk at t = 0. If the value of the asset remains unchanged during the loan period, the LTV will fall as the balance of the loan (the outstanding loan balance, OLB) decreases. 

This graph is an ideal scenario for a lender. As the loan progresses toward maturity (t = 120), the LTV (default risk) falls. The rate of decline can be accelerated if the underlying asset's value *increases*. Land is an asset that often increases in value, but non-property assets that generate increasing cash flows for a business can also increase in value.

A loan secured by a decreasingly valued asset

More often and of concern to lenders, the underlying asset value decreases. When that happens, the LTV (default risk) at any period progressively increases. Depending on the rate of devaluation (green < red < purple in the graph), the risk of default multiplies.

Strategic default

Lenders continuously monitor the LTV, especially if the macroenvironment suggests that assets are falling in value. Borrowers also monitor the LTV, especially if the outstanding loan balance (OLB) far exceeds the value of their asset (high LTV). When a borrower and/or lender realize the loan is truly *underwater* (OLB >> asset value at multiple (+/- consecutive) time periods), strategic default becomes a real possibility. The borrower may intentionally walk away from the loan - surrendering the underlying asset rather than continuing to make loan payments.

Some believe borrowers who employ strategic default should face greater reputational consequences than if they involuntarily defaulted. While this philosophy has merit, those reputational consequences (including the big hit to a borrower's credit worthiness) are realized in the long term. in the short term, a lender suffers additional costs when one (in)voluntarily default on the loan.

Let us know how you use the LTV to monitor your default risk, or if you know someone who has employed a strategic default and at what LTV did they pull the trigger.