Let’s look at two examples:
- Discretionary income
Most people don’t have large piles of idle cash. They must prioritize essentials like food, shelter, and transportation. What's left is discretionary. People cut back during periods of high inflation — when real wages lag. That impacts industries like casual dining or movie theaters. These sectors are tightly correlated with shifts in discretionary income. - Public policy
We rarely think of public policy as a correlation factor, but it can be huge. Take tax credits for solar panels and windmills. When those incentives are removed or threatened, entire projects stall and revenues plummet. Lending on assets driven by policy incentives introduces political risk — and I generally avoid lending on anything political. Tax credits sit high on that list.
Differentiating risk in complex credits
Complex credits often come with layers of risk. A helpful way to assess them is by separating key risks from trigger risks.
- Key risk is the fundamental threat that causes actual loss. You can’t avoid it, only mitigate it.
- Trigger risk is a condition that could activate the key risk. It may or may not occur, and even if it does, it might not cause harm.
Take commodity lending. The key risks are price fluctuation and collateral control. Trigger risks might include weather events, geopolitical conflicts, or even market rumors—things that might influence price but don’t guarantee impact.
Misdiagnosing a trigger risk as a key risk can lead to poor decisions. For example, imagine a construction loan backed by pre-leased tenants. If a tenant like Party City goes bankrupt 18 months into a 3-year build, reacting as if the whole project is at risk could be a mistake. The developer still has time to backfill, restructure, or adjust. Recognizing the true key risk — the ability to refinance or sell upon stabilization — is critical.
