## The Effect of Deal Structures on Current Expected Credit Loss

Introduction

In a recent paper, we looked at the effect of forecasts on IFRS-9 and Current Expected Credit Loss (CECL) deductions. This paper goes a step further to explore what lenders can do with deal structures to limit the expected losses. This can be viewed in three ways:

Approaches to reduce the CECL deductions

Approaches to reduce the actual risk

Approaches to arbitrage anyone who does not take these features into account

In the previous paper, we looked at several variations on a commercial real estate deal under three forecasts. In this paper, we take the most-risky combination and show the effect of changing the loan structure. The stylized "moderately negative" central forecast used was as follows:

Interest rates, inflation and vacancy rates increase 0.5% per year for three years and then flatten

Capital values and rental rates fall 5% per year for three years and then flatten

The loan is towards the risky end of the spectrum. It is for a Boston office with an LTV of 75%, initial DSCR of 1.35, floating-rate interest, 20-year amortization and a maturity of 5 years. There are four equal leases with a 1% probability of tenant default, one lease expiring in year three, the others expiring after year eight, and all leases repricing to the market annually.

Analysis

Using the Specialized Finance System's cashflow simulation, we quantified the effect of six variations in the financing structure:

Reduced loan amounts

Alternative amortization profiles

Interest rate caps

Sweep amortization (i.e., also taking all excess income to pay-down the loan)

Sweep triggered by covenants on Loan to Value (LTV)

Sweep triggered by covenants on Debt Service Coverage Ratio (DSCR)

The details of each variation are described later. Let us first look at the overall results. The table shows [...]