Trusted Advisor to Banks and Credit Unions

Stress Testing your Commercial Loan Portfolio to Predict Default Risk

Woman chewing on pencil stressed about her bank portfolio

During a recent interview with a contact at the FDIC, I asked some rather pointed questions about commercial loan portfolios and the stress that COVID-19 and other social disruptions around the country may be putting on borrowers.  The conversations drifted to a hypothetical client whose entire commercial portfolio was strictly lending to hotels.  What would that portfolio look like today vs. only 12 months ago?

After a bit of silence, he asked me a pointed question that really spoke to the issue:

Do you know how many of Remedy Consulting’s clients do a regular stress test to their loan portfolios?” 

Since I didn’t know the answer off-hand, he said that he anticipated that for banks under $1B in assets that fewer than 20% conducted a default stress test.

He went on to explain that a stress test might be easiest to understand using our hypothetical bank that only loans money to hotels.   If the underwriting criteria used by the bank to make the loan on a single hotel property included a Debt-Service Coverage Ratio (DSCR) of 1.2, it means that the bank expects the operating income from the hotel to be 20% over the ability to cover the debt plus other expenses of the property.

If the underwriter calculated the 1.2, or 20% profit margin, using the fact that hotel occupancy rates have traditionally hovered between 55-65%, and in a typical economy, that lender would have no problem maintaining a 60% occupancy rate.  

But what happens to that property in an economic situation like COVID-19 when hotel occupancy declines?   With a 10% drop in occupancy, what happens to the profitability of that hotel property?  Does that DSCR drop closer to the 1.0 number that means that the hotel owner can just make their loan payment alongside other operating expenses, but doesn’t really have any profitability?

Let’s say that the DSCR drops below a 1, meaning it is no longer profitable.  If the owner makes the loan payment, there is some chance that they are shorting the property tax payment or something else that may affect the viability of the commercial property.

Stress Testing your Portfolio

So, now, apply that drop in occupancy to every hotel in your portfolio.  Run some “what if” scenarios.

Using the hotel example, if you test for a drop of hotel occupancy from 65%, down to 55%, down to 45%, etc.  and see what that does to each lender’s ability to cover the debt, you will have a strong understanding of which loans are in jeopardy of default.   A quick internet search will get you industry statistics on occupancy, and with that you can quickly build a risk profile around portions of your commercial portfolio to predict what it looks like in various economic scenarios.

Since it is unlikely that you are strictly lending to hotel operators, stress testing your entire loan portfolio becomes a little more complicated when you add in additional lending segments, but once you understand the concept, creating a stress test for your entire portfolio becomes intuitive.  Complete the same type of test for any restaurant loans you have outstanding….at what point does all or a portion of that portfolio get into trouble? Is it when restaurant capacity hits 50%, 40%, 30%?

Look at your commercial loans that are office buildings since more people are working from home and businesses are realizing that they may not need that amount of space or can save a lot of overhead costs with majority of employees at home office.  What if commercial office building rates decline?  At what occupancy rates are your loans safe?

The same holds true for those apartment buildings in downtown areas of cities. What if those apartment dwellers decide to move to the suburbs? What does that do to downtown occupancy rates?  Does a drop in occupancy affect your borrower’s ability to make the payments?

Stress Testing – Why Bother?

Some banks and/or credit unions feel like they are too small to stress test their entire portfolio.  Some do not see the reason to complete the test, since they have little control over the outcome.  Others just don’t want to bring unnecessary negativity to their board of directors when this COVID economy is so unprecedented and unpredictable.

The value of a stress test is that many commercial loans run on a 3-5 year balloon-payment schedule, with a 15 or 30 year amortization period.   So as those loans in your portfolio near maturity and it is time to renew them, a stress test might put you in a position to question the business case of your borrowers outside of the financials. 

The borrower’s tax returns might look good for 6-18 months before loan problems start to show up, so proactively stress testing might get you to ask some questions that you might not have without a test.

Now what? If you run your own commercial loan portfolio stress test, reach out to Charlie and let him know your findings.

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