Credit risk perspective
COVID-19 and its impact on U.S. credit markets
INSIGHT ARTICLE |
The outbreak of the coronavirus provided the exogenous shock to send the longest economic expansion in American history to an end. The robust steps taken by the Federal Reserve over the past two weeks to shore up the front end of the money markets are essential to the free flow of capital and global economic stability, and in our view will help stabilize U.S. credit markets.
The Fed acted as stress in the credit markets became apparent. A clear sign showed up in the Libor-OIS spread, a widely used measurement of stress in banking. It quadrupled to more than 50 basis points from less than 12 basis points when it became apparent that the Fed would need to cut the overnight rate in response to the crisis.
Now, central banks working to establish a floor and provide liquidity so that the magnitude of the crisis can be fully absorbed by financial markets.
A question of liquidity
These dynamics are playing out in the real economy as businesses suddenly contend with a host of new challenges—declining cash flows, supply chain disruptions and government mandates to restrict movement—that pose a threat to their liquidity. The borrowing capabilities of most businesses will be stretched, and opportunities to find additional liquidity will become more challenging.
Without direct access to capital markets, small and medium enterprises are left with few alternatives to fund operations. The primary option is to tap into the lines of credit at their primary banking organizations. But banks at the same time will look to mitigate their own exposure, which will only tighten credit standards.
With the outcome of the current health pandemic unknown, the need for liquidity by businesses—especially those small- and medium-size enterprises—will increase substantially.
Financial institutions should assess all options of their short- and moderate-term liquidity. By understanding the liquidity needs of customers, financial institutions will be able to plan for the increased borrowing demand while mitigating the impact on their own financial statements.
There are five industry segments that warrant heightened attention from lenders:
- Industrial and consumer products—borrowers with exposure to international supply chains should expect to see disruptions in both supply and demand for imports and exports. Industrial products companies with exposure to the aeronautics and energy sectors are likely to experience a more pronounced decline in demand with a longer recovery period.
- Retail—social distancing will reduce foot traffic, which will accelerate as cities order restaurants and bars closed. Consumer discretionary spending will be hurt as employees in the service industry are laid off or furloughed.
- Travel—the majority of U.S. businesses have severely restricted domestic and international air travel, canceling conferences and nonessential trips. This will hurt not only airlines, cruises and travel companies, but also hotels and suppliers to hospitality companies.
- Energy—this sector is being challenged on two fronts: the decline in economic activity stemming from the coronavirus, and the Russia-Saudi production conflict. Clients should be actively monitoring borrowers with exposure to any part of the crude oil supply chain with a focus on those involved in shale production.
- Commercial real estate—nonowner occupied commercial real estate will see some niches affected to a greater degree than others. Retail and strip centers are likely to incur some level of stress as tenants may struggle to make rent payments because of the drop in foot traffic caused by social distancing. Office spaces may also be affected as businesses reassess property needs. Projects in construction or completed, but not yet stabilized, warrant a review of key milestones to determine if extensions are warranted as a result of the market shock.
Institutions should establish processes to identify and monitor their portfolio for borrowers who may be affected by the market shock. This can be accomplished by identifying borrowers with exposure to the industries outlined above and conducting stress testing to identify borrowers susceptible to near-term payment disruptions. Institutions should consider taking steps to help these identified borrowers weather short-term cash flow issues. Approaching these borrowers before they fall into financial distress should allow institutions to limit future troubled debt restructuring modifications.
Lenders with small business exposure should also refer to the SBA Guidance for Businesses and Employers to Plan and Respond to Coronavirus Disease 2019. The program specifics continue to evolve, but they are expected to provide relief to ease cash flow issues as a result of the economic slowdown.