We can’t provide Coronavirus tests, but we can test your loan portfolio. Stress test your portfolio to get the answers you need to beat this pandemic.
“Stress testing, hmmm, I seem to remember when we used to talk about that. Didn’t that go away a few years ago?” If this is your reaction when you hear the term stress testing in conversation, then it is worth remembering that while stress testing your loan portfolio may have been pushed to the back burner in the last few years, it wasn’t removed from the stove. And now, more than in the recent past, you should consider moving it to the front burner.
Stress testing can be a valuable tool for your financial institution. You may take a stress testing approach where you do tests to see what happens to your portfolio in general when certain stresses are applied, working with portfolio averages. Or you may take a more detailed approach, stress testing each individual loan and aggregating the results. Or you may even consider alternative approaches such as Reverse Stress Testing, where you apply stresses until you reach a certain result (i.e. how much vacancy can my CRE loans handle before we hit $10MM in losses?). Whatever you choose, it’s important that you set up a method for stress testing, perform stress tests, and the take action based on the results.
First, consider that a large portion of the bank loans are for Commerical Real Estate (CRE). According to an FDIC report from April of 2019, “CRE loans make up at least one quarter of the loan book at more than 60 percent of both community and noncommunity banks.” We don’t need to do the math to know that this is a large amount of money. Now, with the recent COVID-19 virus causing storefronts, restaurants and even office space to close for an undetermined amount of time, it is reasonable to expect that at least some of the tenants in properties aren’t going to be paying their rent. Sounds like now is the time to be running a stress test on your CRE loans to see what happens if vacancy rates go up. Will the property still cashflow if 20% of the current tenants leave? How about 30%? You need to know that, and now.
Second, what about consumer loans like home loans, HELOCs, auto loans and even (gasp!) unsecured personal loans? According to CNBC in 2019, the unsecured personal loan market itself hit an all time high of $138 billion. These loans rely on the cashflows and cash reserves of the borrowers and guarantors. What if one of your borrowers loses their job, or even just temporarily loses their income during this period of quarantine and social distancing (like many in the services industries)? Sounds like now is the time to stress test your consumer loans to determine what type of income reduction your portfolio can withstand. You need to know how a possible reduction in personal income for your borrowers can affect their ability to repay.
Finally, what about the residential real estate market in general? While real estate closings haven’t seen a drastic decline as of the time of this writing, it is clearly a reasonable path of thinking that will tell you that people probably are going to slow down their real estate purchases both due to social distancing and the possibility of reduced/unstable income. Think about this: if you are uncertain when your office and work will return to normal, is buying a new house one of your top priorities? Even if it is your top priority, you’ll still possibly need to find another person interested in buying your current house in order for you to move up. A slowdown in this chain of events can then lead into the new construction market. While new construction has been humming along just fine the last few years, a sudden change in the financial condition of potential buyers will quickly work its way into the new construction market. Sounds like now is the time to be running a stress test on your construction loans, maybe starting with your multi-family projects. If the absorption rate slows down by 50%, what will happen to your portfolio?
We aren’t suggesting panic. We aren’t suggesting to start collections and foreclosures on your portfolio. We are suggesting that you arm yourself in the best way possible for a financial institution… with information. While it may be too late to “get out in front of this” situation, it’s not too late to run stress tests and know what you’re looking at if certain changes in the market do happen. The difference could be that you see the potential issues with your borrowers and loans prior to their other creditors, and you are thus better able to manage through the situation. This is an area where you definitely do not want to be the last one to figure out there’s an issue. You may just end up like a shopper at my local supermarket this past weekend looking for toilet paper, ending up just holding an empty bag.