Pub. 6 2016 Issue 3

While our economy is still in recovery mode, many borrow- ers haven’t had a full return to pre-recession profit and may still struggle if anything significant were to impact income. On a $1 million interest-only loan, a 200 basis point increase is $1,667 per month, or $20,000 per year. This may not be that big of a deal for many borrowers, but consider the following: A borrower has $100,000 of cash available to service debt. On an interest-only line of credit of $1 million and 5 percent interest, this gives the borrower a debt service coverage ratio of 2.0 to 1.0. Now, using the same scenario above, assume rates rise by 100 basis points and 200 basis points. The debt service cover- age ratio drops to 1.67 and 1.43, respectively. These are still acceptable coverage ratios. What if we take a scenario where a borrower is at 1.30 for their debt service coverage, meaning in the above example they generate $65,000 of cash available to service debt. Then, a 100 basis point increase drops the debt service coverage ratio to 1.08. While above 1.0, it’s below what most financial institu- tions would desire because it leaves little cushion for anything to go wrong. At 200 basis points, the debt service coverage ratio drops to 0.93 to 1.0, which means the borrower will be unable to service the debt and runs the risk of default. How many acceptable credits do you have today that will be troubled debt restructuring candidates after a 200 basis point increase? Similarly, if we use an example where a borrower has a $1 million term loan with a five-year maturity based on a 30-year amortization with $100,000 of cash available to service debt, then the borrower maintains a positive debt service coverage ratio, even with a 200 basis point increase. However, when the debt service coverage ratio starts at 1.25 in the base case and at a 200 basis point increase in interest rates, the debt service cov- erage ratio falls to 1.01 to 1.0 with less than $700 of cushion. Granted, most term loans aren’t going to reprice immediately, but as these loans mature they may no longer qualify for financ- ing at many institutions. So what can your institution do? First: Institutions need to analyze their balance sheets to determine if they have this type of interest rate exposure and the extent of the exposure they have. Second: Begin performing stress testing or scenario testing of your assumptions. Include stress testing on borrowers’ debt service coverage ratios, to determine at what level your borrow- ers begin to face an economic hardship because of an increase in rates. Run scenarios—such as not repricing the portion of your loan portfolio with relatively low (1.25 or less) debt service coverage ratios, because they will be unable to reprice with- out a rate modification—as rates increase. Or a scenario with loan runoff due to charge-offs for customers being unable to meet their debt obligations. Determine which have the great- est potential impact on your institution and spend more time ensuring those assumptions are valid or safeguards are put in place to minimize the impact. Third: Institutions may want to revisit their lending practices to determine which have a greater impact on your interest rate risk and whether it’s at an acceptable level based on the institu- tion’s risk profile and loan mix. We may not be able to determine when or how much interest rates will increase, but you can and should know the impact of rate increases on the ability of your borrowers to continue servicing their debt, and evaluate this in the context of your institution’s risk appetite. w Katherine Hart worked in the banking industry for 10 years prior to joining Moss Adams in 2005. She provides internal audit, consulting, auditing, accounting, regulatory compliance, and SEC reporting services to financial institutions. You can reach her at (503) 478-2257 or katherine.hart@mossadams.com. 9 ISSUE 3. 2016