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Stressing Out

Posted on March 22, 2022 Published by

“Take your time, don’t live too fast. Troubles will come, and they will pass.” (Lynyrd Skynrd, “Simple Man”)

While this may be a great lyric for an iconic rock song, it does not give me much comfort as I look around at the current financial environment. In fact, I am stressing out! Just filling my gas tank is pushing me over the edge!

In our previous October and November 2021 blog posts, we looked at a variety of inflation measures and how they look at price changes for consumers and small and medium-sized businesses.

Uncertainty

Last month we looked at the certainty of interest rate increases by the Fed as part of overall monetary policy to control inflation. What is abundantly clear is that interest rate increases are coming, but the number and size is uncertain. With the addition of soaring increases in oil prices, we are in for a rocky road ahead in 2022 and 2023.

As year end 2021 financial statements begin to arrive, lending teams begin the annual review process. This includes updating of risk ratings. There is significant danger in drawing conclusions based upon “driving while looking in the rearview mirror”. These annual credit assessments need to be forward-looking. The past year was impacted by government subsidies and stimulus that (hopefully) will not be repeated. COVID restrictions certainly impacted demand in many industries. Some of those restrictions may have resulted in positive impacts while others were far more dire. And we can’t forget the impact of social unrest in our larger cities.

Stressing Out

As credit professionals, we can attempt to “normalize” last year’s operating results by taking into consideration “extraordinary” circumstances. However, the job cannot stop there; we should look into the future even though the crystal ball may be cloudy. For lack of a better term, operational cash flow analysis will need to be “stressed”. This will accurately assess the risk profile.

If a borrower is limping along under a low interest rate environment, what will be the impact of a 1% to 2% increase in interest rates to the cash flow? While the impact will be felt most immediately on borrowers with short-term or floating rate debt, fixed rate debt that is facing repricing in the next year or two should also be stressed.

Interest rate stress is an obvious issue to our borrower’s cash flow. But inflation issues also need to be considered.

Continued Inflation Issues

The simplest example may be utility costs. With the significant increase in oil and gas prices, utility costs can be expected to increase dramatically. This may not be as significant as interest rate increases for many borrowers. But if the borrower is a manufacturer or other large energy user, a 30% to 50% increase in utility costs will be a meaningful number. If your borrower is a trucking company or maintains a fleet of vehicles, 50% fuel cost increases need to be considered in the projected cash flow.

A question that will need to be considered when discussing projections for 2022 and 2023 is the ability of the borrower to increase prices to their customers to cover the increased expenses. Price elasticity (the change in demand for a product in relationship to a change in price) is likely to be rather limited in many small to mid-size businesses. This will require your borrower to make adjustments in operating expenses to cover the expense increases in areas they cannot control. Analyzing breakeven sales and/or gross profit margins will help determine what level of “cushion,” if any, exists in the borrower’s cash flow.

Real Estate Considerations

Other more subtle impacts of higher interest rates may include the impact to real estate values. With increase in overall interest rates, cap rates will increase as well. Unless rents have increased, the higher cap rate will reduce the value of the income producing property. At the overall macro level, increased interest rates could also result in lower real estate demand and/or lower prices as affordability is reduced with higher debt costs.

There should be no doubt that upcoming annual reviews and risk rating assessments may be some of the most challenging in many years. The rising tide that raised all boats is now in retreat and will leave many ships grounded. Conducting “stress testing” of customers in the loan portfolio can highlight riskier borrowers and reduce “surprise” future downgrades. The team of professionals at Enlighten Financial can assist in performing stress testing of the corporate portfolio. We can suggest credit monitoring strategies to provide early problem identification. As the classic Boston song goes: “All I want is to have my peace of mind”. We can help and try to save you from Stressing Out.

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm. They focus 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. This leads 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.

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— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
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— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection