Every now and then, a topic will become in vogue with regulators. It can make them more excited than my dogs when I have some rib bones left over from a BBQ. One topic in recent years has been stress testing loans or the loan portfolio. Sometimes, the examiners will ask if stress testing has been done but not give any advice as to what kind of stress testing should be performed. I have heard from several institutions that these questions we recently made by their auditors.
Putting a loan under “stress”, is to change some of the variables of the loan or the financials of the company and see how those changes will impact the performance of the credit. These items should be done at the initial loan underwriting, at some term loan reviews and also during exam or audit time.
For individual loans, one of the most common ways to stress the credit is to imply a higher interest rate on the loan and measure how the loan will perform. Will the company be able to make debt service? How much free cash is left over? Clearly, this stress is not applicable for a fixed rate loan. The lender may not have the same need to stress the rate on a loan that has a locked rate for a reasonably long period of time, as compared to a variable rate loan..
Common interest rate stressors would be to increase the by 100 or 200 basis points. Some large institutional lenders will impose an artificial interest rate upon all their loans to see how they act. Recently, this rate was between 6-6.5% for most commercial real estate loans in the capital markets. That is, all loans would have a rate of 6.5% imposed on them to measure their debt coverage. If the credit would pass the minimum threshold for DSCR, the credit was acceptable.
Another way to look at as individual credit is to check changes in the LTV with changes in the cap rate. An increase in the cap rate will result in a decrease in the value and a subsequent increase in the LTV. Increasing a cap rate to a more normal market rate could show a possible loss and the extent of the loss if the loan were to go bad.
A third way to sass a loan is to reduce top line revenues that will result in a decrease of net operating income and subsequent impairment of the firm's ability to make its obligations Some options here would be to use an average of a growing firm’s NOI over several years or take the worst year's performance of the several years that are reviewed. In some cases, a percentage drop in the NOI will be used. If the firm is able to produce an adequate DSCR, the loan is deemed to be good.
This option is tricky. Just an across the board reduction of a certain percentage of gross income will not necessarily equate into the same drop in the bottom line money available for debt service, owner’s profit and capital improvements. The same percentage reduction in the top and bottom line assumes that all expenses for the firm are variable, when actually only some of the operating expenses will be variable, some a fixed and some are a mixture.
Another factor in stressing a loan is to look at the balance sheet of the firm and the guarantors. We recently looked at a loan that would be considered marginal if the rate or the revenue were stressed. Yet the company and the owner had a year’s worth of payments in cash. This cash helps mitigate any surprises in the cash stream.
Some creditors will do a “breakeven-analysis”. This measures how far the cash flow available for debt service can fall or how high rates can rise until a DSCR of 1:1 is reached. The larger the gap between the actual performance and breakeven limit, the safer the credit.
It is valuable to stress the loans during underwriting. It also may be valuable to stress test loans at term loan review time. I would suggest utilizing a possible combination of the methods listed above and use it thoughtfully. Follow sound logic behind the stress testing and you will not only be able to please the auditor, you will also be managing the credit better.