Credit risk

Interest, inflation and credit risk uncertainty

In March 2022, the Federal Reserve approved its first interest rate increase since 2018. The 0.25% rise is due to inflation being at its highest level since the Reagan administration. The recent increase is the first of a possible six increases during the year. After keeping rates artificially low for the past two decades, the central bank has declared the ability to raise rates “more aggressively” if needed. Federal Reserve Chairman Jerome Powell said: “If we conclude that it is appropriate to act more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will.”

The next meeting is scheduled for May and many of the biggest banks expect the outcome to be a half-percentage increase. The Federal Reserve was unwilling to show its hand; however, if a 50 basis point increase does not occur in May, it is considered likely to occur at future meetings this year.

The Federal Reserve is walking a tightrope in its attempt to quell soaring inflation without plunging the economy into a recession. The other elephant in the room is the looming deadline of September 1, 2022, when federal student loan payments will no longer be suspended unless another extension is granted. This is important because the disposable income previously circulating in the economy will now be used to pay down approximately $1.5 trillion in student loan debt.

It’s no secret that banks are in the risk business, but it can best be defined as the calculated risky business. Significant time and resources are spent on underwriting loan opportunities to inform loan committee members of the strengths and weaknesses of potential opportunities. Are current economic factors still factored into credit analyzes and decisions? There are plenty of people in the banking workforce who weren’t in the industry the last time inflation levels were this high, as it was 40 years ago. An inexperienced analyst may have been in grade school the last time the fed funds rate was above 5% – the fact is, these are generational economic events and institutions may consider adjust their underwriting standards accordingly.

Stress tests

The first consideration is to stress test the impact of rising interest rates on cash flow. Stress-testing interest rate risk not only affects short-term lines of credit, but also commercial real estate investments. In the current environment of rising rates, it would be prudent to predict future amounts of interest rates. For example, if a borrowing entity has a one-year working capital line of credit in the amount of $2,000,000 with an interest rate of 3%, its interest expense for the year would be $60,000. However, next year, when the same line of credit is renewed, if rates increased by a modest 150 basis points, the interest charge would be 50% higher. Leveraged companies that rely on short-term debt would see the greatest short-term effect.

A similar increase in debt service will occur for commercial real estate, although more slowly as loans change in price. This is a widely adopted best practice for testing occupancy risk and its impact on cash flow. However, with interest rates rising, it is just as important to focus on interest rates. For this example, consider a $5,000,000 loan for the purchase of a standard office building. If the amortization is over 20 years and the interest rate resets after five years, the initial annual debt service requirement would be approximately $362,000. After 60 months, if the interest rate were to drop to 6%, the annual debt service for the remaining four years would be approximately $422,000. In the absence of prudent rent increases, the debt coverage ratio from the original 1.20 would fall to 1.03.

The two examples above clearly illustrate the real economic impact that rising rates will have on a borrower’s cash flow. These variables should be considered before making a credit decision. It may be worth considering temporarily increasing the minimum debt service requirement or maintaining a secondary requirement for cash flows that your institution is comfortable with. That way, if rates continue to rise, current issues will hopefully still have enough projected cash flow when the interest rate revalues.

Elasticity of goods and services

The likely rise in short-term interest rates will affect future cash flows, but another immediate concern is inflation. When will consumers change their consumption habits and no longer accept rising costs? How elastic are the goods or services provided by the borrower? Are the concentration limits appropriate and well documented for the industries most sensitive to inflation risk?

The combination of inflation and the reinstatement of student loan repayments will result in less disposable income. A consequence of tight monthly budgets is a reduction in consumer spending. These considerations should be taken into account when taking out new loans. These warnings may sound extreme as we were in the midst of the longest pre-pandemic economic expansion in US history, and despite the challenges of COVID-19, overall credit quality remains strong. However, certain factors, as noted above, could negatively impact a borrower’s ability to repay their loans over time.

As it becomes more expensive to borrow, the demand for loans may flatten out. Conversely, an institution’s desire for growth may increase in search of increased margins. The dilemma becomes finding harmony between loan growth and risk. As new opportunities arise, considering the above recommendations will hopefully create balance. After all, financial institutions are not in the business of risk, they are in the business of calculated risk.

For more information on potential credit risk factors, contact your advisor or submit the Contact Us form below.

Sources

Reuters: ‘Fed will raise rates more aggressively if needed, says Powell’
The Wall Street Journal: “Following the Fed’s lead, banks are changing their forecasts for big rate hikes”