Lending To Contractors - Risk Update for 2014

Lending to Contractors

If you drive a fair bit, you probably agree with us that gridlock is bad, but it is starting to get better. It used to be we used to drive to work only to use the bathroom and then start to commute home. Now, with many of the major Stimulus Package projects coming to an end, we can make it to work and discuss the latest episode of Homeland before having to turn around - And this is a problem.


Not only will we miss sitting in traffic watching the “Expect Delays” sign flash, but without the $100B being put to work and most of the 30,000 projects ending, we can now expect higher probability of defaults on loans to infrastructure contractors, which, as risk goes, are the safest type of contractor to lend to.


Since many banks lend to contractors, we thought we would query the data to highlight current loan probability of defaults, expected probabilities of defaults, best practice tips and things to watch out for.


While you may not lend to large construction companies that were the primary recipients of much of the Stimulus funds, you likely lend to some contractors and their smaller sub-contractors. If you do, the first thing you should know is that loan probabilities of defaults are going up next year an average of 24%. This is a result of several reasons including the ending of many Stimulus programs, higher interest rates and higher expenses (think the Affordable Healthcare Act).


As can be seen in the schedule below, all contractors are not the same. Electricians, for example, have vastly lower default rates than compared to contractors that specialize in drywall. There are several reasons for this, most notably anybody with a pickup truck can become a drywaller or a framer. However, it takes about five years in a journeyman program to become a certified, card-carrying electrician. The education, akin to a college degree, helps produce not only a more committed and professional contractor, but also serves as a barrier to entry (keeping prices up).


Additionally, banks should also make the distinction about which contractor types have to purchase their own materials and which just supply labor. Those contractors that purchase their own materials tend to have more volatility of earnings and have higher risk profiles. As many banks know from the downturn, just because a contractor is good with their trade doesn’t mean they have a handle on finance. Having to deal with substantial materials costs creates an added layer of complexity that many contractors are ill-equipped to optimize.


However, statistically speaking, the largest determining factor to risk is the profile of the builder or the entity paying the bills. Those contractors that work for corporate or municipal builders tend to have lower risk profiles for a variety of reasons including greater background checks, a structured purchase order system, greater required financial position, more experience and other such attributes that tend to produce a more stable cash flow stream. This explains why contractors that specialize in highway projects, schools and larger buildings have a fraction of the risk of single family home general contractors.


Finally, banks can reduce their lending risk by requiring monthly financial information and metrics. For single home family builders looking at revenue per employee, cycle times in calendar days and variance to budget tend to be among the best metrics to foretell problems. Whatever metrics you choose for your particular contractor type, creating an early warning system is important to managing and reducing contractor risk.


Below is the latest information for sub and general contractors utilizing 9 months of data for 2013 and then utilizing our model that regresses probabilities of defaults against material factors such as interest rates (assumed rates are 25bp higher next year), input inflation (8% higher), property values (higher, but slowing) and permits (4% higher). The list is broken into categories and sorted on current probability of default. The end result is the following:


Contractor POD


As can be seen above, not all contractors are the same and more importantly the forward risk is likely going to increase. This means banks need to take the risk into account when pricing, putting covenants in place, structuring and managing credit. Contractors represent one of the higher risk categories of bank lending, on par with restaurants, gas stations and car washes. However, by better management, banks have proven to be able to reduce the probability of default from an average of 70bp to an average of a much more manageable 55bp.


While we are looking forward to our commute speeding up, we are not looking forward to the higher risk associated with contractor lending. Hopefully, this data will give you something to think about the next time you are stuck in traffic. 

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