As Rates Continue to Increase, So Does Refinance Risk

This blog was authored by my colleague, Erica Crain, Principal and National Leader for Credit Risk Services at CLA

When with a group of senior lenders and chief credit officers recently, the question was asked – what keeps you up at night? The answer: refinance risk. Simply put, refinance risk is the risk that a borrower will not be able to refinance their existing loan at favorable terms when it becomes due which could negatively impact their ability to repay the debt. In the current environment, the fed funds rate has climbed sharply by 450 basis points over the last year as the Federal Reserve continues efforts to curb inflation. Borrowers would hardly consider these new rates to be “favorable.” Although the underlying credit facility and borrower may be unchanged, the financial outlook is unavoidably impacted. Through the passage of time and economic changes, risk that the borrower may or may not have sufficient cash flow to support debt at a higher repricing is present.

While the concept of refinance risk is easily grasped, assessing the impact of an entire loan portfolio is a greater challenge. Stress testing and sensitivity analysis applied to individual borrowers and to the entire loan portfolio are common exercises for financial institutions. However, for many years, rate shocks within these evaluative exercises were typically capped at a 300-basis point rate increase – which seemed farfetched given the historically low-rate environment and stagnant market rates. And with little expectation of significant change, admittedly, commercial lenders paid little attention to results of the upward 300 basis point scenario. Now, there is a new or renewed emphasis needed for borrowers that are most vulnerable to refinance risk. Loans that appear to be performing as agreed today may not be able to perform with significantly higher interest rates when coupled with already inflated operating costs for many businesses.

There are some practical steps each financial institution should consider in mitigating and monitoring their exposure to loan refinance risk. As a starting point, it is essential to identify those borrowers with a maturity on the horizon that, if repriced at current and/or forecasted interest rates, would fall below an internally established threshold of acceptability for cash flow coverage. Credit stress testing results can point financial institutions to those vulnerable customers. For example, when borrower’s financial results are stressed, if the debt service coverage ratio (DSCR) for the borrower (or property or global relationship) were to fall to a level below the prescribed threshold, the financial institution can formulate plans and discuss proposed changes with the borrower to possibly reposition to address the identified risk. While this is just one scenario for consideration, the point is to identify the most vulnerable customers by geography, loan segment, lender, etc. to assess risk and identify any concerns that could ultimately lead to potential losses and act now to reduce, manage, or eliminate the threat.

Financial institutions should also evaluate adjustments to overall credit underwriting standards that may be appropriate given a changing economic landscape. Policies and procedures should be re-evaluated. Loan structures should be re-visited and requirements for loan approval should be assessed. An example would include requiring a lower loan-to-value (LTV) for collateral if cash flow coverage constricts and the DSCR falls. Additionally, the use of loan covenants or revision of financial loan covenants with prescribed performance requirements could offset some of the risk of reduced cash flow is an option.  

Experts in the industry discuss whether or not there is a hurricane on the horizon or storm clouds. I think we can agree there is change one way or another. Financial institutions have a good track record of navigating turbulent times and these actions to address refinance risk are valuable steps to assess the impact to your financial institution now and for the months/years ahead.