Credit Risk Stress Scenarios

The "safe" loans were actually the killers. Picture this: You buy a solid apartment building. Cash flows beautifully. Then your floating rate loan jumps from 4% to 8%. Suddenly you're writing checks every month instead of collecting them. This wasn't bad luck. This was predictable horror. The monsters that killed deals in 2024? Unhedged floating rates. Skinny debt coverage. And "hope and pray" refinance plans. But here's the twist— Most investors are STILL making these same mistakes for 2026. Everyone talks about "getting the best rate." Wrong focus entirely. The real killers were the loan structures themselves: SOFR plus thin spreads with no rate cap. When rates spiked, these loans became financial vampires. Sucking cash flow until deals died. Short maturities with refinance dependency. Business plans that only worked if rates cooperated on schedule. Spoiler alert: they didn't. Debt service coverage ratios that looked good on day one. But vanished with a 150 basis point rate move. The scariest part? Covenant traps that triggered cash sweeps exactly when you needed capital most. Here's how we structure debt to survive ANY rate environment: Fixed rates or properly hedged floating. With caps that actually protect you through stabilization. Budget for cap replacement because hoping rates stay low isn't a strategy. Real debt coverage ratios - DSCRs. We underwrite 1.35x minimum at closing. And stress test at 1.25x with rates up 150 basis points AND income down 10%. If it fails this test, we pass on the deal. Five to seven year terms with multiple exit options. Sale, refinance, or supplemental financing. Never depend on one path. Interest-only periods sized to actual stabilization timelines. Then amortization kicks in. No fantasy timelines. Prepayment flexibility. Real reserves. Three to six months of operating expenses sitting in the bank. Whether rates drop in 2026 or stay elevated, your debt structure should protect the plan. Not become the plan. Ask these four questions on every deal: Is the rate properly hedged? What's the debt coverage under stress? When does it mature and what are your options? What triggers the covenant traps? Don't let Nightmare on Loan Street haunt your returns. What's the scariest debt structure mistake you've seen in real estate?

Private credit didn’t replace banks — it entangled them. 👇 ________________________ BACKGROUND: Since 2008, the dominant narrative has been simple: Private credit stepped in where banks stepped out — helped by lighter regulation. But that story is incomplete. Banks and private debt funds aren’t competitors. They’re co-dependent — and the risks are now deeply intertwined. ________________________ HOW BANKS ARE LINKED TO PRIVATE DEBT FUNDS: A great FT piece breaks this down, but here’s the simplified map of how banks fund the very private credit ecosystem that supposedly replaced them: 1️⃣ Upstream – financing the investors ‣ Banks lend to LPs to fund commitments ‣ Banks lend to GPs via subscription lines → All secured by LP capital 2️⃣ Midstream – financing the funds’ assets ‣ "Loan-to-loan" facilities for SPVs at 60–70% LTV ‣ Repo structures: sell loans today, buy them back later ‣ NAV loans → Banks finance the portfolio construction itself. 3️⃣ Downstream – financing the same companies the funds lend to → Banks and private credit funds often finance the same borrower without realising it. ________________________ WHERE SYSTEMATIC RISK EMERGES: Two accelerants turbo-charge the feedback loop: ‣ CLOs → banks buy slices of the very credit risk they once avoided ‣ Significant Risk Transfers → banks hedge loan books with private credit funds And this is where things can get messy — fast: ‣ Borrowers are already highly levered ‣ A closed loop of leverage + shared exposure with almost no visibility on concentration risk ‣ Most private credit loans are floating-rate, amplifying sensitivity to rate shocks ‣ Any downturn (defaults rising or rates staying higher-for-longer) → levered, correlated losses across banks and funds ________________________ So the questions nobody has answered yet: 1️⃣ How much bank capital is truly at risk if private credit hits a stress cycle? 2️⃣ And more importantly — Who actually holds the risk when everyone is financing everyone else? 👉 What do you think? ________________________ 👋 Follow me Andrea Carnelli Dompe' (PhD) for weekly private markets insights 🔔 Tap the bell on my profile and you'll be notified when I post #PrivateMarkets #PrivateDebt #PrivateCredit #Banking #RiskManagement #ECB #FinancialStability

𝗧𝗵𝗲 𝗡𝗚𝗙𝗦 𝗷𝘂𝘀𝘁 𝗿𝗲𝗹𝗲𝗮𝘀𝗲𝗱 𝘀𝗼𝗺𝗲𝘁𝗵𝗶𝗻𝗴 𝗯𝗶𝗴— for the first time, we now have 𝘴𝘩𝘰𝘳𝘵-𝘵𝘦𝘳𝘮 𝘤𝘭𝘪𝘮𝘢𝘵𝘦 𝘴𝘤𝘦𝘯𝘢𝘳𝘪𝘰𝘴 tailored for 𝘀𝘁𝗿𝗲𝘀𝘀 𝘁𝗲𝘀𝘁𝗶𝗻𝗴, 𝗳𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝘀𝘁𝗮𝗯𝗶𝗹𝗶𝘁𝘆, 𝗮𝗻𝗱 𝗻𝗲𝗮𝗿-𝘁𝗲𝗿𝗺 𝗺𝗮𝗰𝗿𝗼 𝗿𝗶𝘀𝗸. 🔸 This isn't about 2050. It's the next five years, i.e. 𝟮𝟬𝟮𝟱–𝟮𝟬𝟯𝟬. 🔸 This isn't abstract. It's 𝗚𝗗𝗣 𝘀𝗵𝗼𝗰𝗸𝘀, 𝗰𝗿𝗲𝗱𝗶𝘁 𝗿𝗶𝘀𝗸, 𝗶𝗻𝗳𝗹𝗮𝘁𝗶𝗼𝗻, 𝗮𝗻𝗱 𝘂𝗻𝗲𝗺𝗽𝗹𝗼𝘆𝗺𝗲𝗻𝘁. 𝗧𝗵𝗲𝘀𝗲 𝗮𝗿𝗲 𝘁𝗵𝗲 𝘀𝗵𝗼𝗿𝘁-𝘁𝗲𝗿𝗺 𝘀𝗰𝗲𝗻𝗮𝗿𝗶𝗼𝘀: 1.  A smooth transition ("Highway to Paris") 2.  A delayed, abrupt policy shift ("Sudden Wake-Up Call") 3.  Physical risk disasters without transition ("Disasters & Policy Stagnation") 4.  A fragmented world with climate chaos and policy misalignment ("Diverging Realities") These scenarios are a wake-up call for taking short-term climate risks seriously. ➤ Delaying climate action could increase global 𝗚𝗗𝗣 𝗹𝗼𝘀𝘀𝗲𝘀 𝗯𝘆 𝗼𝘃𝗲𝗿 𝟯𝘅, and unemployment spikes by 1.3 percentage points (Sudden Wake-Up Call vs Highway to Paris). ➤ Climate disasters aren’t just regional anymore. Floods, fires and droughts in Asia or Africa can cut European 𝗚𝗗𝗣 𝗯𝘆 𝟭.𝟳%, driven by supply chain exposure. ➤ Credit risk spreads explode in carbon-intensive sectors. In some cases, default probabilities jump by 20–30 percentage points, stressing banks and insurers alike. ➤ Green sectors could lose out if the transition is abrupt, fragmented, or disrupted by physical shocks. 𝗛𝗲𝗿𝗲 𝗶𝘀 𝘄𝗵𝘆 𝘁𝗵𝗲𝘀𝗲 𝘀𝗰𝗲𝗻𝗮𝗿𝗶𝗼𝘀 𝗮𝗿𝗲 𝗮 𝗴𝗮𝗺𝗲-𝗰𝗵𝗮𝗻𝗴𝗲𝗿 ➤ For the first time, compound hazards—droughts, floods, wildfires—are modelled together, showing how climate risk can become systemic through trade, finance, and supply chains. ➤ Monetary policy is now integrated, so climate shocks affect interest rate paths, inflation dynamics, and macroeconomic volatility. ➤ Financial contagion is now factored in. Using advanced modelling, the framework maps how climate-related losses feed into default risk, cost of capital, and sectoral investment flows. ➤ Sector-by-sector and region-by-region outcomes now include asset-level exposure, probability of default, and sovereign bond repricing, offering tools fit for risk management. 𝗠𝘆 𝘁𝗮𝗸𝗲 This release is a step-change in how we understand and model climate risk. These scenarios are critical because they model economic and financial impacts on business over the next five years. A timeline relevant for senior management, boards and shareholders. Because these scenarios capture dynamic feedback loops, sector-specific capital costs, and second-round effects that ripple through the financial system, the risk science is taken to a whole new level. These real-world complexities have been missing from science to date, which is why these scenarios are so critical. #NGFS #NetZero #ClimateRisk _____________ For updates, follow me on LinkedIn: Scott Kelly

The Federal Reserve's proposed 2026 stress test scenarios are out, and the narrative has shifted significantly from the 2025 test. While both test a peak unemployment rate of 10%, the underlying risks are different. Here are the key changes in the Severely Adverse Scenario: Commercial Real Estate (CRE): The 2026 proposal features a much harsher 40% decline in CRE prices, up from 30% in the 2025 test. This is now a clear point of emphasis. Market Volatility (VIX): The 2026 scenario is triggered by an "abrupt decline in risk appetite". This is reflected in a peak VIX of 72, higher than the 65 peak in the 2025 test. Residential (HPI) & GDP: The 2026 scenario is less severe on other macro fronts. It models a 29% drop in house prices (vs. 33% in 2025) and a GDP decline of 4.8% (vs. 7.8% in 2025). The biggest narrative flip is in the Global Market Shock (GMS): 2025 GMS: Was a deflationary shock, featuring falling Treasury yields and lower commodity prices. 2026 GMS: Is an inflationary (stagflation) shock, with persistently high inflation, sharply rising Treasury rates, and higher commodity prices. In short, the 2026 proposal shifts the focus from a broad-based recession (2025) to a financial-market-led shock with a specific focus on CRE vulnerability and an inflationary GMS.

Day 26: "The Role of Asset-Liability Management (ALM) in Navigating Rising Interest Rate Environments". 🌐 🚀 ⌛ In today’s dynamic economic landscape, rising interest rates pose significant challenges for financial institutions. With central banks around the world tightening monetary policy to combat inflation, banks, insurers, and other financial entities are facing increasing pressure to manage the risks associated with fluctuating rates. Asset-Liability Management (ALM) plays a pivotal role in ensuring financial stability and optimizing performance during such periods of uncertainty. Why Rising Interest Rates Matter ⚡ 🌎 📊 Rising interest rates affect the balance sheets of financial institutions in several critical ways: 1. Interest Rate Risk: 🏦 🎢 Higher rates impact the value of assets and liabilities differently, leading to mismatches that can reduce profitability or equity value. 2. Liquidity Risk: 🏦 🎢 Maintaining sufficient liquidity becomes more challenging as borrowing costs increase, and customer behavior changes. 3. Margin Pressure: 🏦 🎢 A narrowing of net interest margins (NIM) may occur if liabilities reprice faster than assets. To navigate these challenges effectively, robust ALM strategies are indispensable. Key Functions of ALM in a Rising Rate Environment⚡ 🌎 📊 1. Managing Interest Rate Risk 🏦 🎢 ALM teams employ various strategies to assess and mitigate interest rate risk: Gap Analysis: 💵 🌎 Identifies mismatches between asset and liability maturities to evaluate sensitivity to rate changes. Duration and Convexity Matching: 💵 🌎 Aligns the durations of assets and liabilities to minimize the impact of rate shifts. Interest Rate Hedging: 💵 🌎 Utilizes derivatives such as interest rate swaps, futures, and caps to hedge against adverse movements in rates. 2. Scenario and Stress Testing 🏦 🎢 ALM leverages scenario analysis to model the impact of rate changes across a range of potential market conditions. Stress testing prepares institutions for extreme scenarios, such as sharp and unexpected rate hikes, ensuring they remain resilient under adverse conditions. 3. Optimizing Liquidity Management 🏦 🎢 In a rising rate environment, ALM ensures institutions maintain adequate liquidity. 4. Capital Management 🏦 🎢 Rising rates can impact regulatory capital ratios, especially for institutions holding long-duration fixed-income assets. ALM helps optimize capital allocation and ensures compliance with capital adequacy requirements. Case Study: ALM in Action⚡ 🌎 📊 Scenario: A mid-sized bank faces a rising rate environment, with liabilities (deposits) repricing faster than assets (fixed-rate loans). Outcome: The bank mitigates margin compression, maintains liquidity, and ensures regulatory compliance, safeguarding its profitability. #InterestRates #Markets #MarketRisk #Risk #Riskmanagement #Traded #Quant #Finance #QuantitativeFinance #ALM #Liquidity #Rates

The Federal Reserve released its 2026 stress test results on June 24, 2026, and the headline is reassurance: the largest U.S. banks could absorb nearly $708 billion in losses in a severe recession and keep lending. A few numbers that stuck with me: - 32 banks were tested this year (up from 22 in 2025). - Under the "severely adverse" scenario, the aggregate CET1 capital ratio falls from 12.8% to a low of 11.2%, still miles above the 4.5% regulatory minimum. - That 1.6-point decline is the smallest in seven years. The scenario itself was no joke: unemployment hitting 10%, GDP down 4.6%, home prices down 30%, commercial real estate down 39%, and equities down 58%. Where do the losses come from? Overwhelmingly from lending. Of the ~$708B, roughly $625B is loan losses, and credit cards alone account for $203B, or 29% of the total, at a 17.1% loss rate. Commercial & industrial loans add another 22%. What I find most interesting is the spread across banks. A custody-focused firm like Charles Schwab sees its capital ratio actually rise under stress, while card-heavy and consumer lenders take the deepest hits. Business model is destiny in an exercise like this. One caveat worth flagging: the Fed has frozen current capital buffer requirements until 2027 while it reviews proposed changes to make the models more transparent and less volatile. So this year's results are informative, but they don't immediately reset how much capital banks must hold. Net takeaway: the system looks well-capitalized, but the concentration of projected losses in consumer credit is a reminder of where the real-world pressure points sit. Full report: https://lnkd.in/gazGjBXD #Banking #FederalReserve #StressTest #RiskManagement #FinancialServices #CreditRisk

Coming Soon: The Next Great Vintage of Opportunistic Credit JP Morgan's latest tally of stressed and distressed credit in U.S. markets exceeds $200B across High Yield and Broadly Syndicated Loans. That figure does not include private credit, which I expect to be just as large as HY and BSL combined. When you add Direct Lending to the equation, we are looking at ~$500B+ requiring some form of capital solution in the years ahead. Opportunistic Credit is the flip side of the primary market for HY, BSL, and Direct Lending. When waters are calm, spreads are tight, and new issues flow freely; in this case, there is typically less activity in Opportunistic Credit. That calm is ending. The Morningstar LSTA Leveraged Loan Index has fallen from 98 to 94.5 as the distressed ratio of BSL is 8% and rising. Approximately 12% of private credit borrowers are now generating negative cash flow, with 25% operating with interest coverage below 1.0x. These are not hypothetical stress scenarios; this is the current fundamental backdrop companies must contend with. This statistic rises to ~33% when using actual EBITDA, rather than pro-forma adjusted EBITDA which on average has been adjusted higher by 20%. Capital Solutions will be needed for growth and for turnaround situations across the credit landscape. With the exception of the energy sector, which is performing exceptionally well for obvious reasons, all other 20 industry sectors have issues brewing as JP Morgan shows below. Capital allocators should give special consideration to Opportunistic Credit as I believe this coming vintage will prove particularly rewarding.

Most quants are uncomfortable with “made-up” scenarios, but the risk factor approach provides a useful compromise between art/fundamental judgment and science. Instead of historical factor returns, we can specify hypothetical factor returns: ▪️ Current risk factor exposures x Hypothetical factor returns It is common practice to specify shocks to one or two factors, and then propagate these shocks to the other factors. Essentially, we use the betas (sensitivities) between factors. Suppose we shock the equity risk factor by -20%. To propagate this shock to credit spreads, we multiply -20% x the beta between credit and equity (preferably using a stress-regime beta). We can also adjust the propagated shocks for the differences in means (expected return) between factors. This approach also allows shocks to non-financial factors, such as GDP and inflation, as long as we can estimate the stress betas between the non-financial and the financial factors. If we don’t propagate shocks, we assume, very mistakenly, that the other factors would remain stable under stress. For example, if we shock the equity factor in isolation, we assume credit spreads, currencies, rates, etc. would remain stable. Given the high correlations across risk assets, for most portfolios, shocking individual factors in isolation (i.e. without propagation) may underestimate exposure to loss. [From the book Beyond Diversification. This is not investment advice.]

As indicated on the European Central Bank Blog a few days ago, 𝗖𝗹𝗶𝗺𝗮𝘁𝗲 𝗖𝗵𝗮𝗻𝗴𝗲 is no longer “the Tragedy of the Horizon" as Mark Carney put it, but an 𝗶𝗺𝗺𝗶𝗻𝗲𝗻𝘁 𝗱𝗮𝗻𝗴𝗲𝗿. In the next five years, extreme weather events could already put up to 5% of the euro area’s economic output at risk, according to the new short-term scenarios of the Network for Greening the Financial System (#NGFS). Integrating climate risk into credit risk management involves assessing and quantifying the potential financial impacts of climate change on lending and investment decisions. This includes both physical risks (like extreme weather events) and transition risks (like policy changes). By incorporating these factors into credit risk models, financial institutions can better understand and manage their exposure to climate-related financial risks. In the UK, integrating climate-related risks into credit risk assessment is a growing priority for financial institutions and regulators. The Bank of England is actively working on incorporating climate risks into its monetary policy operations and is encouraging firms to enhance their climate risk management capabilities. The deadline for responding to the UK Prudential Regulation Authority's (#PRA) consultation on its updated climate risk management expectations is July 30, 2025. This consultation paper, CP10/25, focuses on enhancing how banks and insurers manage climate-related risks. The PRA's key findings as to areas for improvement by banks included: (1) scope to expand the range of loan portfolios subjected to a climate risk assessment, to pick up impacts on underlying collateral, refinance risk and ability to repay; (2) enhancement of data granularity and working towards embedding climate risk in loan-level credit risk assessments; and (3) expanding the range of climate scenarios considered, to better identify borrowers and sectors implicated by climate risk Climate risks can impact the probability of default (#PD) and the loss given default (#LGD) on loans, 𝗽𝗼𝘁𝗲𝗻𝘁𝗶𝗮𝗹𝗹𝘆 𝗹𝗲𝗮𝗱𝗶𝗻𝗴 𝘁𝗼 𝗵𝗶𝗴𝗵𝗲𝗿 𝗰𝗿𝗲𝗱𝗶𝘁 𝗹𝗼𝘀𝘀𝗲𝘀 for lenders. Climate risks can also affect the value of collateral, particularly in sectors heavily exposed to climate change impacts.  This compilation addresses this important topic highlighting the latest research and insights covering both credit risk integration and accounting implications of climate change. #riskmanagement #climaterisk #transitionrisk #physicalrisk #ECL #IRB #probabilityofdefault #creditrisk #lossgivendefault #recoveryrate #impairment #defaultrisk #riskassessment #riskmanagement #riskmeasurement #granularity #dataquality #stresstesting #scenarioanalysis #financialstability #globalwarming #climatechange #emissions #netzero #loanportfolio #borrowerdefault #creditloss #information #research #knowledge #resources #futurerisk #emergingrisk #novelrisk