Picture yourself out walking, running, biking or most any other activity with a friend. You hear someone (particularly your friend) shout, “Watch out!” What is your immediate reaction? I know mine would be to stop, look up, look forward, and swivel my head side-to-side. I want to see what peril or danger is in my immediate vicinity. Assuming I see a threat, I would take some type of protective action. Only after looking forward, would I be inclined to look behind me. No need to be distracted by the rainbows and unicorns when there is a lion up ahead.
In past blogs we have cautioned against the temptation to drive looking in the rear-view mirror. We may miss the coming danger or obstacle. Given the present rapid increase in interest rates and historic inflation rate, this may be a good time to practice our forward-looking skills.
In the last blog installment, we looked at the “subtle theft” of collateral value through the increase in real estate cap rates. In summary, as the interest rate environment increases, cap rates increase and collateral value declines (all other things being equal). A much less subtle impact is the deterioration of debt service coverage (DSC) with the increase in interest rates. As responsible lending and credit professionals, I am sure annual credit reviews of our commercial borrowers include a stress analysis of the cash flow. However, how many risk ratings were adjusted given the stressed value of the DSC? More importantly, are we still “watching out” on the cash flow?
Perhaps a simplified example is instructive. The prime rate sat at 3.25% from March 15, 2020, to March 16, 2022, when it increased to 3.50%. Since that time, the Prime rate has increased to 7.0% (as of November 3, 2022). Further increases are certainly coming in the future. Accordingly, any “annual review” of past performance, and likely most recent interim reviews, would be conducted using interest rates that are 3.75% lower than current rates. That margin is likely to increase at the next Fed meeting on December 14 where another rate increase is expected.
Assume you have a mid-grade pass credit with a DSC of 1.25X with $100,000 of total debt service (EBITDA = $125,000) of which $30,000 of the debt service is interest. If interest cost doubles from $30,000 to $60,000 due to the increase in interest rates and all other EBTDA are the same, DSC will drop to 0.96. Debt service increases to $130,000 on EBITA of $125,000 (increase in interest reduces earnings by same amount). While this assumes all the debt was floating rate, the analysis can be adjusted based upon the debt schedule to account for fixed versus floating rate. It would also be important to consider what portion of the fixed rate debt will come due in the next 12 to 18 months. How will the new interest rate environment compare with current loan rates?
Items Worth Noting
While the above analysis is simplistic, a couple of things are worth noting. First, the above situation assumed a reasonable debt service coverage to begin with. Many of the portfolio clients may have 2021 debt service coverages in the 1.05 to 1.10 range. With this thin coverage, these clients are operating in a watch credit range given the higher rates. Further, even the original example with sub-breakeven debt service assumes that earnings are flat in an economic environment with over 8% overall inflation and selective components well over 15%. Accordingly, it is unlikely that underlying profitability has remained stable.
Adjust Risk Ratings?
This should raise the question for our credit and lending partners. When is it appropriate to make an adjustment to a risk rating in advance of receipt of year end financials that will confirm what you already know? Philosophically, we at Enlighten Financial would advocate being proactive with downgrades and conservative with upgrades. Moving a credit to a watch status would appear prudent in cases where the underlying financial performance is suffering. Debt service coverage is further threatened by increases in interest rates that have already occurred (even though not necessarily apparent in interim financial statements) and those that are scheduled or likely in the near future.
The team at Enlighten Financial can assist you in targeted portfolio reviews to identify higher risk portfolio clients. We assist in assuring that risk assessments are up to date and assist in developing strategies for vulnerable clients. It’s not too early to “watch out!”
Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.Tags: Enlighten Financial, Watch Out