Interest, Inflation, & the Uncertainty of Credit Risk
In March 2022 the Federal Reserve approved its first interest rate increase since 2018. The 0.25 percent bump is in response to inflation being at its highest level since the Reagan administration. The recent hike is the first of possibly six increases over the course of the year. After holding rates artificially low for the past two decades, the central bank declared the possibility of raising rates “more aggressively” if necessary. Federal Reserve Chair Jerome Powell said, “If we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
The next meeting is scheduled in May and many of the largest banks are expecting the outcome to be a half-percentage increase. The Federal Reserve was not willing to show their hand; however, if a 50-basis-point increase does not happen in May it is considered likely to occur in future meetings this year.
The Federal Reserve is walking a tightrope in its attempt to quell the spike in inflation without sending the economy into a recession. The other elephant in the room is the looming September 1, 2022, deadline when federal student loan payments will no longer be paused, unless another extension is given. This is significant as previously disposable income that was circulating through the economy will now be earmarked for repayment towards the approximately $1.5 trillion in student loan debt.
It’s no secret that banks are in the risk business, but that may be better defined as the calculated risk business. Significant time and resources are spent underwriting loan opportunities to inform loan committee members of the strengths and weaknesses of potential opportunities. Are current economic factors always being considered in analysis and credit decisions? There are many individuals in the banking workforce that were not in the industry the last time inflation levels were this high because it was 40 years ago. An inexperienced analyst may have been in elementary school the last time the fed funds rate was above 5 percent—the point being that these are generational economic events, and institutions may want to consider adjusting their underwriting standards accordingly.
The first consideration is stress testing the impact of increased interest rates on cash flow. Stress testing interest rate risk is not only relevant to short-term lines of credit, but commercial real estate investments as well. In the current rate rising environment, it would be prudent to forecast future interest rate amounts. 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 percent, its interest expense for the year would be $60,000. However, next year when the same line of credit is renewed, if rates have increased a modest 150 basis points, the interest burden would be 50 percent higher. Leveraged companies reliant on short-term debt would see the biggest near-term effect.
A similar increase to debt service will occur on commercial real estate properties, albeit more slowly as loans reprice. It’s a widely adopted best practice to stress test occupancy risk and its impact on cash flow. However, with interest rates climbing, there is equal value in stressing interest rates. For this example, consider a $5,000,000 loan to purchase a standard office building. If the amortization is over 20 years with the interest rate repricing after five years, the initial annual debt service requirement would be approximately $362,000. After 60 months, if the interest rate jumped to 6 percent, the annual debt service for the remaining four years would be approximately $422,000. Absent prudent increases in rent, the 1.20 debt coverage ratio at origination would fall to 1.03.
Both examples above clearly depict 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 a worthwhile exercise to consider temporarily raising the minimum debt service requirement or maintaining a secondary requirement for cash flow stresses that your institution is comfortable with. That way, if rates continue to increase, current originations will still hopefully have sufficient projected cash flow when the interest rate reprices.
Elasticity of Goods & Services
The likely bump in interest rates in the near term will affect future cash flows—but another immediate concern is inflation. At what point will consumers alter their spending habits and no longer accept the increase in costs? How elastic are the goods or services the borrower provides? Are concentration limits appropriate and well documented for industries more susceptible to inflation risk?
The combination of inflation and reinstated student loan payments will result in a decrease of disposable income. A consequence of tightened monthly budgets is a reduction in consumer spending. These considerations should be addressed as new loans are underwritten. These warnings may seem extreme because we were in the midst of the longest economic expansion in American history prior to the pandemic, and despite the hardships of COVID-19, overall credit quality remains strong. However, there are factors as noted above that could have a negative impact on a borrower’s ability to repay their loans over time.
As it becomes more expensive to borrow, loan demand may flatten. Conversely, an institution’s desire for growth may surge in pursuit of increased margins. The quandary becomes finding a harmony between loan growth and risk. As new opportunities are presented, considering the recommendations above will hopefully create a balance. After all, financial institutions are not in the risk business—they’re in the calculated risk business.
For more information on potential drivers of credit risk, reach out to your advisor or submit the Contact Us form below.