The Warehouse Line Covenant Squeeze
Mid-sized bank Northbridge lends $40M to a regional grain distributor under a borrowing-base facility secured by inventory and receivables. The base formula advances 80% of eligible receivables under 60 days and 50% of eligible inventory, less a $5M availability block. The borrower has $30M receivables, of which $6M is over 60 days and $2M is owed by a single customer now on credit watch. Inventory is $18M, but $4M is slow-moving seed stock that the bank's field examiner values at 30 cents on the dollar. The borrower has drawn $21M. A covenant requires availability of at least $3M at all times. The relationship manager wants to waive the covenant and increase the advance rate to 85% to support a seasonal purchase, arguing the borrower has never missed a payment.
1. Compute current availability and determine whether the covenant is breached. Show your work.
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Eligible receivables: $30M less $6M over 60 days = $24M. The $2M watch-list customer is typically ineligible under a standard concentration or credit-watch exclusion; if excluded, eligible receivables fall to $22M. Eligible inventory: $18M less $4M slow-moving = $14M, but the examiner's 30-cent valuation means the realistic collateral value of that excluded stock is irrelevant since it is already excluded. Applying advance rates: receivables at 80% of $22M = $17.6M; inventory at 50% of $14M = $7.0M. Gross base = $24.6M. Less $5M availability block = $19.6M borrowing base. Drawn $21M means availability is negative $1.4M - a covenant breach and an overadvance of $1.4M.
Even if the watch-list customer is included, base = 80% of $24M ($19.2M) + $7.0M = $26.2M, less $5M = $21.2M, leaving only $0.2M availability - still below the $3M covenant. The conclusion is the same: the borrower is in breach on either reading. The key judgement is that the covenant is tested on availability, not on payment history.
2. The RM proposes raising the advance rate to 85% and waiving the breach. Assess this proposal as a credit officer.
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Raising the advance rate to 85% on $22M of eligible receivables adds $1.1M of availability (from $17.6M to $18.7M), which would bring availability to roughly negative $0.3M - still short of the $3M covenant and still an overadvance. The proposal does not solve the problem; it merely disguises it. More importantly, increasing the advance rate raises loss-given-default on collateral that is already deteriorating: $6M of receivables are stale and $2M sit with a watch-listed obligor, so the effective dilution and default risk is rising, not falling.
A credit officer should reject the waiver as framed and instead require: (1) a paydown or reserve sufficient to restore at least $3M availability, (2) a field exam and receivables aging refresh, (3) a reserve against the watch-list customer, and (4) if seasonal support is genuinely needed, a tightly monitored overadvance with a hard maturity, a cash dominion sweep, and a fee. The RM's 'never missed a payment' argument is a lagging indicator; collateral quality is the leading one.