We live in a dynamic world and we all understand that. I can’t think of one tax return or P&L that looked exactly the same from one year to the next. We understand that a whole host of factors change every year, and it is a poor assumption to believe that present conditions will remain constant throughout the life of the loan. Therefore, it is important for us to test just how much stress the borrower can endure until the likelihood of default becomes too high.
Where to begin? The most common way you may see a loan stress tested is by shocking the interest rate. The underwriter will examine how the debt service coverage ratio (DSCR) is affected by increasing and decreasing interest rates. The results of this are not surprising, as you would imagine DSCR improves when rates are lowered and deteriorates when rates are increased.
Lowering a rate will never hurt a loan, and testing a loan in this manner is mistakenly a practice that is only meaningful when looking at a bank or CU balance sheet as it relates to cost of funds. Increasing the rate is often arbitrarily done by 1-4%, although again, the results are predictable. A higher rate will result in lower DSCR. A more precise method is simply to solve for the break-even interest rate, which will give you the absolute threshold at which DSCR would slip below 1.00x if all else remained constant.
However, it is a poor assumption that all else will remain constant. The lender should be well aware that sales could drop, cost of materials could increase, and operating expenses could increase too. Realistically, changes in these factors are far more likely to pose a threat to repayment than an increase in interest rates. Therefore, a lender should calculate the maximum decrease in sales, maximum increase in cost of materials, and maximum increase in operating expenses; all as a percentage of gross revenue. Again, these are all break-even indicators and tell us more than providing arbitrary 5%-10%-15% increases or decreases.
For reasons noted above, it becomes clear that break-even analysis provides much more information than stress shocks. Shock analysis, while better than nothing, is sort of a one-size-fits-all approach to stress testing. On the other hand, break-even analysis provides maximum thresholds for all factors examined.
Most importantly, interest rate stress testing should not be the only stress test examined. Revenue, COGS, and operating expenses should also be examined because they are far more likely to impact repayment. Those tests should also be reflected as a percentage of revenue to put into context the size of the overall maximum stress tolerance.
When we can observe there is ample buffers before break-even is reached, we can feel much more comfortable about the ability of the loan to handle changing conditions. When break-even marks are less than 5% in any area, it is a point of concern that needs to be monitored.
One other thing, for those in a reasonable driving distance to Miles City, Montana, do not forget about our upcoming "Basics of Agriculture Lending" on October 8-9. Please contact us for more details.