The New Lending System - Putting common sense into compliance and risk assessment

I have literally been on the go for the past couple of weeks getting the word out on CCAF in five cities, the last of which was Orlando, where I spent several days attending RMA’s Annual Conference on Risk Management. Loan underwriting was the focus of much of the conversation, together with upcoming regulatory reforms and the economic outlook, at both the national and state levels.

Next week finds me headed to South America. So, I wanted to catch-up before too much time passed by to let you know what I am hearing and thinking about!

In the community development space, I heard some exciting news while attending a Social Compact Board Meeting. CEO John Talmage shared that Manny Diaz, the outgoing mayor of Miami, has credited their DrillDown as possibly the most significant project of his administration (Social Compact’s DrillDown is powered by SAS technology). The DrillDown of 14 Miami neighborhoods showed that the city has 137,000 more people than the Census projected, as well as a 29% higher income level. At present, Social Compact is also in partnership with the World Bank and local officials to test the potential of DrillDown methodologies in emerging markets in Johannesburg, South Africa and Bogota, Columbia.

Speaking of Colombia, and the credit underwriting space, on November 20, I will actually be delivering a keynote address there at a Risk Management Conference sponsored by Asobancaria, the Colombian Banking Association. The title of my presentation is: Credit Access and Risk Management: A Gap To Close. I am looking forward to giving this speech for two main reasons. First is the opportunity to illustrate how CCAF can transform the way loan underwriting is performed today to allow for greater access to credit for consumers falling outside of the financial mainstream. This new lending system is described in mathematical detail in the last half of my first, and technically-oriented, book, published last year. It is the entire subject of my second, business-oriented, book, published this past spring. The second reason for my excitement, and no less than the first, was the opportunity to visit Colombia and learn first-hand about banker’s key concerns and challenges, and to exchange ideas and perspectives.

You may be wondering what information-led community development and loan underwriting have to do with one another. First, they both benefit from having greater information. In the case of community development, more information can be used to develop greater intelligence that can change the perspective of a community from being one of need to being one of opportunity. Loan underwriting can benefit from the sourcing and use of alternative data that can qualify consumers for a loan on their record of making timely cash payments for rent, utilities, phone, and so on. Technology can collect, integrate and organize this information and put it into a form that is amenable for analysis. It can help us to look deeper, below the surface statistics and typical impressions. Of course, in a more direct way, loan underwriting can provide small businesses and consumers with capital that can enable them to fund necessary purchases and, ultimately improve their financial health and overall economic well-being. That, in turn, has a very positive effect on the community in which they are located.

In my talk on closing the gap between credit access and risk management, I explore the connection between community development and loan underwriting in greater depth. Upon my return, I will post what I learn on my trip to Colombia, and I will share reactions to what I have to say about this important and timely topic.

Stay tuned for more on this subject!

SAS has been conducting research on analytic frameworks that combine expert judgment with best science. We have observed that effective integration of comprehensive views, especially customer-centric ones, with financial performance and the evolving economic and market realities, offers significant competitive advantages.

SAS has actually pioneered a new lending system that, compared with today’s typical loan underwriting systems, is:

1) simpler, yet more accurate,
2) thorough, yet concise,
3) becomes more, not less, predictive over time, and
4) is statistical in nature, yet is transparent and passes various tests of reason by simple inspection.

Moreover, these advances in loan underwriting approaches have the implications for the entire lending value chain.

CCAF (pronounced See-Caf) is short for Comprehensive Credit Assessment Framework. It is a new lending system that affords many benefits, in addition to those stated above, when compared with more traditional loan underwriting systems. Additional benefits include:

ease of understanding
stresses loan affordability
adaptibility and ease of updating
ability to be effectively monitored
is based on proven lending principles
provides adequate controls to limit risk
affords early warning in advance of performance declines

For those who want to learn more, just click on the links in this post to download a copy of the CCAF white paper or to obtain a copy of our book that describes the new lending system. Please share your comments on either, or on this or past blog content. I want to hear your opinions!

I call fact on that! I am in the process of preparing a keynote address entitled Credit Access And Risk Management: A Gap To Close, for an International Banking Conference sponsored by Asobancaria, Colombia's Banking and Financial Entities Association. The conference will take place in late November in Cartagena, Colombia.

During the course of my research on the high cost of being poor in Latin and South America, I learned that it is estimated that perhaps a billion dollars is maintained under mattresses and in cookie jars where it earns no interest and provides no indication of the thriftiness of the lower income tiers of society. Worse, as many as 85 percent of the population is out of the formal financial banking system, and as a result their in-person cash payment and deposit transactions require long trips, risk of robbery, and long waiting lines, in addition to carrying a high degree of cost (as much as five to ten percent of the actual payment amount for check-cashing, and as much as nineteen percent for US dollar international wire transfers to non-bank customers who receive income supplements from relatives and friends). Bank loans can carry as much as a 17 percent annual interest rate (35-40 percent for credit cards) and the common non-bank alternative sources for loans can charge as much as from 150 to 400 percent interest annually.

In last Thursday's front page article in The Wall Street Journal, Tom Lauricella, Jason Zweig, and Conor Daugherty said that "A year after the U.S. economy was brought to its knees by the bursting of the housing bubble, credit fo consumers is still being ratcheted back." The Federal Reserve reported on Wednesday that total consumer credit outstanding contracted for the seventh straight month (which has not occurred since 1991), falling $12 billion in August. Lauricella, Zweig, and Daugherty go on to point out that some of the decline is due to lenders' exposure on thier real estate loans in particular, and to the reluctance of consumers to borrower given the tightening job market and the loss of their home equity. So, what does this imply? Well, given that historically consumers spending has fueled 70% of the nation's economic growth, coupled with the fact that consumers financed a large portion of thier purchaes through borrowed money and the unemployment rate is headed north of 10% going into 2010, we cannot expect the consumer sector to lead an economic rebound anytime soon. If anything, I would expect consumers to continue to curtail spending and to attempt to increase their savings while de-leveraging to the greatest extent possible. Many find themselves in a larger home than they can afford, or stuck with a second home in a real estate market where liquidity at an acceptable price point has dried up due to the number of foreclosed properties that continue to flood the market (I have heard reports of an additional 3.5 million homes that will go into foreclosure by the end of 2010).

Let's consider the question "What can lenders do to help get the economy back on track?"

As lenders asssess lending opportunities and risks in today's troubled economy, they must consider many factors, and unavoidably all sorts of questions pop into their minds. For example:



Item: Congress is poised to enact new laws and regulations in the wake of the financial crisis and the banking industry is experiencing a great deal of FUD anticipating the outcome.

Item: Banks are struggling to properly assess credit risk so that they can make profitable loans – the demand is there, but they are hesitant to lend.

Item: It’s now the end of another quarter and lenders are looking at one or more of their product lines and finding that they've come up short in terms of revenue, and have mounting losses. “What happened?”

Clearly, the FICO score is too blunt and and too opaque a method with which to manage credit nowadays. With CCAF you can find the answers and take immediate and appropriate action.

Take, for example, the question “How should we tighten (loosen) credit?” which I highlighted in red in the above figure. Let's contrast the curent "state-of-the-art" with the CCAF approach for addressing this question, which is both a natural, and a recurrent, one in the world of lending operations.

In his recent article “How Did Economists Get It So Wrong?” New York Times journalist Paul Krugman takes the reader on a journey from the birth of economics with the publication of Adam Smith’s “The Wealth of Nations” in 1776 to the theories of John Maynard Keynes and finally to today’s salt water versus fresh water schools of economic thought. He concludes that the Keynesian economic theory remains the best framework for making sense of recessions and depressions. Advancing the notion that markets are not perfect, people are not always rational, Krugman quotes H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.” Krugman offers his opinion that the vision of the economic profession therefore will likely not be neat, may seem a bit unclear, but will hopefully be partially right!

Mainstream economists were not the only ones who did not see the freight train coming. We can add many more to that list! Someone quipped that the regulators just needed a dashboard with dials that measure greed. I would offer that if the nation's credit system had been able to leverage thechnology like the Comprehensive Credit Assessment Framework (CCAF, pronounced See-Caf) then we would have seen the handwriting on the wall long before the problem reached such giagantic proportions. CCAF provides early warning on non-delinquent trends and concentrations that precede performance declines. Furthermore, it surfaces loans where the loan products, the collateral, and the borrower are all associated with high risk. Needless to point out, that is a very bad combination!

Even more important, CCAF would not have allowed the risky loans to be made in the first place because it does not put riskier borrowers purchasing over-priced homes into the riskier loan products. This is because CCAF integrates borrower payment history with borrower capacity, borrower capital, borrower equity in the property being financed, and borrower and property vulnerability to future market and economic scenarios.

In the first chapter of our latest book that describes a new lending system for borrowers, lenders, and investors, we trace through the suspected causes and perpetrator of the financial crisis to 3 roots as depicted below:




Credit Risk Assessment: The New Lending System for Borrowers, Lenders & Investors, Clark Abrahams & Mingyuan Zhang, copyright 2009, SAS Institute, Inc. Reprinted with permission of John Wiley & Sons, Inc

CCAF addresses all three root causes in the following ways:

1. It is fully transparent, unlike credit scoring models. Its classification and qualification of borrowers is open and immediately verifiable by logical inspection, i.e. the categorization of the borrowers by the 5 C's of Credit correlates with their risk score. No one can look at a scorecard and tell if it is correct -- not even FICO !!

2. It is comprehensive and uses common sense -- CCAF does not rely on models to determine what is important in granting a loan and it does not have static weights like a scorecard -- in fact it adjusts its score based on all relevant factors viewed simultaneously! It is not a one-size fits all approach. The expression "To the boy with a hammer, the world is a nail" comes to mind when I think of the FICO credit brueau score and how much it contributes to the problem of inadequate risk assessment.

3. CCAF promotes a balanced approach to lending that emphasizes affordability, rather than:

A) the lowest monthly payment for a loan amount sufficiently large to put the borrower at considerable risk if everything doesn't go according to plan, or

B) the highest return for the lender associated with somewhat less suitable loan products for the borrower's core need.

Sadly, we are now witnessing the fallout from unchecked greed, namely:

i) borrower's homes in foreclosure
ii) lenders having higher loan loss reserves and owning more property in their OREO portfolio
iii) investors holding ill-liquid investments with accompanying negative returns.

The cover story of the October 2009 RMA Journal explores the principle of risk homeostasis -- the notion that excessive faith in mechanisms aimed at risk-prevention actually encourages riskier behavior. Rick Nason, author of the article, asserts that:

"Risks in the financial services industry are constantly changing and evolving. Risk systems must change and evolve as well. Faithful adherence to what has worked in the past is a blueprint for extinction in the future."

When I was on Capitol Hill last year testifying as an expert witness before the House Financial Services Subcommittee on Investigations and Oversight, I asserted that we needed to move away from the "secret sauce" models of the past that relied on "substitutes for common sense." I came away with the impression that most observers felt that the FICO score and the heavily relied upon credit bureau data for consumer credit qualification have served the country well, and that there was no real need for moving to a new system. That was in July of 2008, two months prior to the financial system near meltdown in September. These days I am finding much greater interest in a new lending system (termed CCAF) and far greater acceptance of the assertion that the FICO score is an incomplete risk measure -- one that does not nearly take into account sufficient breadth of information to accurately reflect a consumer's creditworthiness.

In our latest book on the new lending system, my co-author Dr. Mingyuan (Sunny) Zhang and I began each chapter with an apropos quote. For our chapter on the borrower and loan affordability, we chose the following quote: "What the people cannot understand, they must accept on faith." We have sought to make the case that a new lending system is needed that will bring lending models closer to reality through the bonds of common sense and a sound and proven structural basis -- one that will afford consistent and comprehensive model visibility to all market participants, from borrowers to lenders to investors. Be assured that blind faith is not a requirement for the newly proposed lending system! We believe that "more disclosure is better," and that the vast majority of borrowers and investors would agree that we need to put the era of blind faith in FICO credit scores and reporting agency ratings of loan-backed securities behind us.

Adoption of CCAF (pronounced See-Caf) would significantly strengthen our risk management systems dealing with loan underwriting, loan portfolio management, loan collections and recovery, loan securitization, and investor reporting for loan-backed investments. While this would undoubtedly foster much greater faith in risk management systems, I do not believe it would encourage riskier behavior. Much to the contrary, it would effectively curb, possibly eliminate, ill-advised product choices and disproportionately large loan magnitudes based on such categories of factors as borrower income and capacity, borrower liquid capital reserves, historical collateral price levels, down payment percentage -- all of which act in concert with one another. As a result, regardless of whether the actors are well-intentioned, the types of behavior that led to the unaffordable combination depicted in the table below would no longer pose a threat, because they would result in a declined loan application!













Credit Risk Assessment: The New Lending System for Borrowers, Lenders & Investors, Clark Abrahams & Mingyuan Zhang, copyright 2009, SAS Institute, Inc. Reprinted with permission of John Wiley & Sons, Inc.

Yesterday, the conference coordinator for an external event where I soon will be speaking asked me if the new lending system I have been advocating would surpass the FICO Credit Score. In our latest book, published in April 2009 by John Wiley & Sons, Sunny Zhang and I make the case that we need a new singular measure of creditworthiness. In our view, the FICO Score is an incomplete, inaccurate and out of context risk measure that focuses only on how consumers have paid their credit obligations in the past without regard for prevailing, and anticipated, circumstances, their income, savings, and a host of other factors. More specifically:

FICO is a one-size fits all technology that is also a black box, i.e. consumers are not told what characteristics are included in their score and how many points they were assigned for each of those factors. Consumers do not even know how specifically to improve their FICO Credit Score! While it is true that credit scoring is more consistent that a purely judgmental system of credit granting, it is rooted in models that attempt to identify statistical correlations between “substitute factors” and poor loan performance. Many of those substitute factors have no direct logical connection to loan default or are viewed out of context, in stark contrast with such factors as capital and capacity. Consequently, when we experience significant change, such as the current economic downturn, FICO scores become irrelevant (i.e. what used to be predictive no longer is).

CCAF (pronounced See-Caf) is rooted in common sense and the basic guiding principles of credit granting, namely the 5 C’s of Credit – Character, Capacity, Capital, Collateral, and Conditions. CCAF first classifies borrowers holistically before assessing their risk. Hence, their CCAF score is in the proper context, and it considers all relevant factors. Furthermore, an importantly, CCAF is transparent in that borrowers can decipher how they rated on each of the factors considered during the evaluation of their loan application, and how they can boost their creditworthiness.

I was so thankful that the question was raised, comparing CCAF to FICO. Yes, the FICO score falls far short of meeting today’s credit market demands for greater relevancy, accuracy, and transparency throughout the lending value chain, i.e. borrowers-to-lenders-to-securitizers-to-investors! Replacing FICO with CCAF would enable borrowers to better balance product options and loan affordability, lenders to more effectively balance loan volume and quality, and investors to better balance risk and return. CCAF adoption will help prevent future financial crises and can also help deal with the fallout, namely loss mitigation and foreclosure avoidance.

In our research for our book, Sunny and I concluded that a couple of root causes of the current financial crisis were inadequate risk assessment and lack of transparency. The secret sauce, narrow, and historical-behavior based FICO Score is used pervasively throughout our credit system, and it was most certainly one of our critical risk measurement antennae that was fully extended when the financial time bombs and loan default missles hit our financial system. It appears that at least one other of our critical risk measurement antennae was, at the same time, severely retracted, namely common sense! CCAF adoption will provide a far more powerful and much needed risk antennae for borrowers, lenders, investors, and regulators and it will automatically go a long way to fully extend the common sense antennae!

Generation after generation has believed that homeownership is a core requirement to accumulating wealth, is integral to the fabric of the American way of life, and perhaps even our saving grace. In Thomas Sugruea’s August 14th piece for the Wall Street Journal entitled “The New American Dream: Renting,” we learn that “for millions of Americans at risk of foreclosure, the home has become something else altogether: the source of panic and despair.”

I recall the days I worked at Fair Isaac and Co., where I developed scorecards for installment and revolving credit products. Back then, and over the years, renters always got fewer points than those who owned their residence or were buying. Interesting. I often wondered why it was fair, and unquestioned, that credit scoring penalized credit applicants just because of their choice of lifestyle.

I grew up in rental housing – my parents always rented homes and apartments. My Dad always said “If something breaks or wears out (like the garbage disposal, furnace, air conditioner, a leak in the roof, etc.), then it is somebody else’s headache,” and he was compulsive about his financial affairs – very insurance-minded and he never paid a bill late in fifty years! According to the credit models, my Dad was higher risk because he rented!

That just doesn’t make sense, but that is not the only characteristic in credit models today that doesn’t make sense! I testified last year about “proxies for common sense” during a Congressional Hearing on what consumers should know about their credit score. I have been told by credit scorecard developers that the characteristic “Own/Rent” is a proxy for wealth and stability. Instead of scoring consumers on proxies for their stability, capital and capacity, why not categorize them based on the facts?

That is what the Comprehensive Credit Assessment Framework (CCAF) is about. Please be on the lookout for the next post, where Sunny Zhang will highlight the advantages of CCAF over today’s typical credit scoring-based underwriting systems.

In a piece for the American Banker today, entitled “GAO: Poor Data, Oversight Stymie Fair-Lending Laws ,” Stacy Kaper reports on the Government Accountability Office (GAO) report just released by House Financial Services Committee Chairman Barney Frank. The reports concludes that HMDA data alone are not sufficient to determine if lending discrimination is present – not a startling revelation to those of us who have been working in this area for many years!

I recall a presentation entitled “HMDA Data Analysis: Interpreting the Pictures Painted by Public Data” that Sunny Zhang and Fiona McNeill and I put together and presented at a major industry conference back in 2005. The talk centered on what conclusions could be drawn from the HMDA data alone and how it should be interpreted. While Sunny, Fiona and I recognized back then the incompleteness and limitations of HMDA data, we also promoted a universal performance indicator, which can be used to immediately convey the ‘exposure picture’.

Fair Lending Compliance: Intelligence and Implications for Credit Risk Management, Clark Abrahams and Mingyuan Zhang, Copyright © 2008, SAS Institute, Inc. Reprinted with permission of John Wiley & Sons, Inc.

This singular indicator decomposes into different perspectives on lending activities based upon the FFIEC peer HMDA detail data. Using this patent-pending methodology, fair lending analysis can readily be extended to include non-public data that spans borrower risk (i.e. credit scores, loan-to-value and debt-to-income ratios), channel, transaction, market, and collateral information, as is suggested in the GAO report released yesterday.

Quoting the American Banker article, “The GAO found that each federal regulator uses a different approach to analyze HMDA data to identify outliers and examination documentation varies.” Nothing like some good old fashioned inconsistency among our government agencies to add some additional challenges for the lenders! The report goes on to say that “the evidence suggests that lenders regulated by FDIC, the Federal Reserve, and OTS are more likely than lenders regulated by OCC and NCUA to be the subject of referrals to DOJ for being at potentially heightened risk of fair-lending violations.” That simply makes no sense.

These GAO findings raise serious questions about the effectiveness of regulatory oversight. SAS can help the regulators achieve greater consistency by providing analytical frameworks that foster systematic and consistent approaches for regulatory compliance testing and risk assessment. Frameworks portray “how it all hangs together” and they are sorely needed as Congress considers financial modernization and new regulations to better insure the safety and soundness of the financial system that forms the bedrock of our economy.

Compliance with the Federal Reserve Board’s new Regulation C changes is currently a number one priority for every mortgage lending institution. SAS Fair Banking Solution helps lenders prepare to meet the Federal Reserve Board’s Regulation C changes that take effect on Oct. 1, 2009. The SAS R&D Team got the necessary changes to customers early on to ensure they would not have any difficulties or time pressures. SAS Fair Banking affords the flexibility for customers to make the necessary adjustment to their processing in the most effective and efficient way possible.










The FRB’s revisions were designed to reduce the regulatory burden on mortgage lenders by better aligning the Home Mortgage Disclosure Act’s (HMDA’s) above-pricing thresholds with those of the Truth-in-Lending Act’s (TILA’s). Testing of loan origination data based upon the FRB’s new higher-priced mortgage thresholds has already been successfully completed for the SAS Fair Banking compliance solution, months in advance of the October 1 deadline.

In the September 2009 issue of the RMA Journal, the 5 C’s of Credit have again achieved center stage as “the banking world’s long-established tools for credit analysis,” to quote the author, Warren Stell. In the article, Mr. Stell makes the case for qualitative, in addition to quantitative, analysis that leverages the 5 C’s of Credit with a future-oriented focus. At the close of his article, he quotes Richard Fischer, president of the Federal Reserve Bank of Dallas, who commented to The Wall Street Journal on the causes of the credit bubble: “Finally … there was the ‘mathematization of risk:’ Institutions were ‘building risk models’ and relying heavily on ‘quant jocks’ when ‘in the end there can be no substitute for good judgment.’” Mr. Stell concludes that “Good judgment is the lender’s trump card, augmented with qualitative and quantitative analytical tools such as the Cs of credit …” which he advocates now ought to include Change.

We concur with his assessment and in our latest book we quoted Benjamin Franklin, who said “There is no substitute for Common Sense,” as a lead-in to the second chapter, which makes the case for a comprehensive credit assessment framework that is rooted in the 5 C’s of credit! It is not surprising that we are on the same wavelength with yet another RMA feature article in the space of 5 months.

In our book, we cover, in detail, how the new system we propose will greatly improve the vast majority of loan underwriting systems in operation for consumer and small business lending today. I have been receiving considerable positive feedback on the book from a wide variety of stakeholders since its publication in April.

I encourage you to check out the latest edition of SAS.com magazine.

In the Industry Outlook Section (pages 4-5) Sunny and I share our thoughts on the current financial crisis -- its cause, what can be done about it, and how we can prevent reoccurrences.



Essentially, we propose that what is needed is a new form of lending system (Comprehensive Credit Assessment Framework, or CCAF -- pronounced See-Caf). "WHY?" you might ask. The answer, in a nutshell, is that there a number of flaws in the current lending systems that need to be addressed, such as:

1. Current risk assessment models are inaccurate

a. Failure to consider all relevant factors simultaneously
b. Over-reliance on past performance

2. Modeling approach is unrealistic

a. Purely data driven and overly relies on quantitative methods
b. A black box and hard to interpret
c. One size fits all
d. Risk rating is performed prior to segmentation

3. Models are static with limited life

a. They become less accurate over time
b. Model re-development and model validation processes are very tme-consuming

CCAF is a brand new system, based on a holistic analytic framework that addresses the entire lending value chain , which is depicted in a figure from our recent book below:



CCAF creates loan-level transparency for securitization investors, which provides them with the ability to have a 360 degree view of all risk components of each loan which relate to borrower payment performance, stability, capacity, and capital, in addition to loan collateral and the vulnerability of both borrower and collateral to future market and economic conditions.

CCAF affords:

1. A far broader range of outcomes being considered
2. A transparent process that captures the business reality for borrowers, lenders, and investors
3. An adaptive system that actually becomes more predictive over time

Please do check out our latest published article and let us know what you think!

In her recent blog, Law Professor Ann Graham shared with her readers some of my thoughts on this subject of "generalizing"and provided some good comments of her own on the credit granting process. I contend that in the area of credit granting, most generalizations are no good. An example of a generalization in the judgmental days of credit granting (from page 187 of our first book) was "Never lend to beauticians, bartenders, or barbers." In the age of credit scoring, generalizations have emerged among credit professionals in various lines of business. A couple of examples, say in automobile lending, are:

1. The notion that the FICO score captures 40% of the information value for a credit applicant in determining the likelihood that they will pay as agreed on their loan. As a consequence, a lot of weight may be put on the FICO score for risk-based pricing whereby a customer who normally pays cash for his/her car and who does not maintain a credit balance on thier credit card may be charged more than someone who uses credit to the extreme and lives on thre edge--but has not failed to make a payment yet.

2. The notion that a ten percent increase in the payment-to-income ratio above some pre-determine threshold will make an applicant twice as likely to default on their car loan. Would you think a higher payment-to-income ratio would affect a borrower who lives paycheck-to-paycheck with little savings more than a borrower who has little other debt and a high savings rate?

These generalizations lead to flawed credit policies, bad loan decisions, and alienated customers. As these examples point out, the problem is not the use of judgment or the use of credit scoring or statistical analysis. The problem is the fact that sweeping gereralizations are just plain inaccurate, whether they are rooted in opinion or from a model that was developed on historical loan performance data. Our new lending system avoids the pitfals of generalizations due to its unique handle-based segmentation feature which first seeks to classify borrowers comprehensively before passing judgment on them.

In the absence of complete information and consideration of all relevant factors, credit granting practiced today is, in effect, generalizing. We assert that this was a major contributory factor to the financial crisis, economic downturn and credit crunch that consumers are feeling the brunt of these days. We cover this topic in great depth in our second book.