Lending requires an adequate assessment of risk, understanding of which risks can be managed and which ones cannot, and then having a fair rate of interest paid to the lender from the borrower for that risk. One key tool that lenders have developed over time to gauge risk is the risk rating model. These have ranged from a simple “pass-fail” model to a broader scale ranking, say 1-10, to a larger division of looking at the probability of default for a borrower and then the possible loss to the lender if a default occurs. Models look at many different factors like liquidity, debt service coverage, in ag lending-capital debt repayment capacity, leverage, or loan to value, just to name a few.
In times of normal economic cycles—growth and recessions—these models have served lenders well in putting a rating on risk. These ratings can be tested retroactively to see how accurate the model is and what other factors or changes must be done. But how in the world do you use a risk model to assess risk today? We have seen changes in the economy that are the equal of a tectonic plate movement and everything has changed. It is now time to pick up the pieces after the tornado has hit as now basic economic drivers have shifted and it is unsure if they will shift back.
A few months ago, we would view a hotel located near a major league sporting center as having a huge driver of business from folks attending those games. Now consider that hotel near stadiums in downtown St. Louis or Minneapolis. We do not even know if baseball will be played at all this year and it may, like basketball be played somewhere totally different than the cities the teams represent. It also may be played in relatively empty stadiums. Essentially, this demand driver for rooms has evaporated.
In our community, our favorite Mexican food chain has seen record sales as they figured a way to effectively deliver food curbside and take out when some other restaurants did not. Will these sales continue at this level when other restaurants begin to re-open and people have more alternatives to chose from? Or what about the face mask manufacturer who cannot make enough masks today to continue with the demand? Next year, will we see many people walking around with face masks or will it be back to our pre-mask days? How will this impact demand? How do you determine where reality lies?
What about office buildings? Now that companies have successfully been able to utilize remote workers, will they still have the future need for as much office space as what they did going into 2020? This is just another example of how the new world picture is still a bit fuzzy.
Consider the bounce back in the economy like pulling a rubber band and letting it go. Retail sales took a huge 8.2% drop in March but then rebounded with a sharp 17.7% spike in May. How do you figure out what is reality for your retailer who had sales match up with the national averages? Use the drop, the spike, an average, or something in the middle?
The current COVID crisis is also different form other past recessions, wars, and other economic shocks, as this current crisis has impacted virtually every human being in the modern world. How sudden, the scale, and duration of the stay-at-home orders is making the impact on judging credit qualify difficult to measure. Variations in shelter-in-place will also impact the economic viability and desirability of underlying real estate as areas who have less restrictions will see more growth than areas with stricter lockdown measures or now, destructive riots that destroy communities economically.
The timing of this shutdown that has spanned a calendar quarter end, has made borrowers’ financial information minimally useful as a predictor of future performance. In lending we often look at past history to mark the future. This happens as the lending industry depends upon accurate and reliable credit risk ratings.
This will require the lender to begin to gather and analyze some new information in order to make a sound assessment of credit risk. It is also important to recognize what impact COVID has had on the standard measures of credit risk we have always looked at and whether to discount or pay closer attention to one factor or another. As we move forward, mistakes will be made, and no measurement or model will be perfect. Logic and thought must be present behind each indicator to explain how a certain factor shows or does not show the risk inherent in the credit.
Other than the general concept that those who have sufficient liquidity to retire the entire debt point to low risk, the picture on the rest of your portfolio may not be as clear. Now there are several sources of alternative information that can be used to make near term risk ratings to reflect the actual risk. Some of these may are:
· Information on the borrower, gathered from the customer, guarantor, or sponsors
· Lender’s knowledge of the company, industry, management history, customer base, competitors
· Experience level of the lender’s credit team and other resources available to them
· Any regulatory guidance
· Economic information, models, forecasts
· Publicly available information on the industry
· Information on the specific area or region the business serves
In some of the upcoming blogs, we will look further at some more of this information and how some alternative methods can help better rate the risk in the credit which should drive the credit management needs.