Beyond Credit Scoring: Putting Common Sense into Compliance and Risk Assessment

I thought it might be helpful if you were to get to know me better, and also my co-author and co-inventor Dr. Mingyuan (Sunny) Zhang, and what has motivated recent advances we have made to the field of “model-driven decision making.” It was my good fortune to meet and join forces with Sunny, whose broad and deep experience in modeling in a variety of business settings set the stage for our work together, and whose knack for applying appropriate scientific methods to solve business problems has fueled progress in many directions that our research has led us. In a future blog post, Sunny will write a piece that will provide his perspectives. I’m kicking things off this week by sharing with you a bit more about me, my long-standing ambition to make a contribution in the field of credit granting, and the journey that led me to where I am today.

This week’s blog post was composed on a runway at Regan National Airport while I waited for a storm to pass. I reflected on my visits during the past several days in our nation’s capitol. The purpose of the visit was to brief various stakeholders on the new lending system (CCAF) and topics related to it. Those topics ranged from consumer financial literacy and predatory lending, to loan portfolio stress testing and capital adequacy, to hedge funds and pricing of illiquid assets, and also future financial crisis prevention.

Government incentives (e.g. New Markets Tax Credit Program ), regulations (e.g. the Community Reinvestment Act), non-profit microenterprise development organizations, and community development corporations (CDCs) are playing positive roles in providing capital where it is badly needed. A couple of cases in point were recently provided by Comptroller Dugan following his swing through some hard hit communities in Dallas, Texas.

Ideas introduced in our white paper early last year have begun to gain acceptance. That paper, entitled “A Comprehensive Credit Assessment Framework—Overview and Implications for the Subprime Crisis” asserted that a more complete view of the borrower, loan terms, and economic assumptions was needed to ensure that:

1) borrowers were properly evaluated from a credit risk perspective
2) borrower vulnerability to equity erosion was measured relative to loan collateral and their other assets
3) borrower vulnerability to capacity constrictions caused by variable rate contracts and income volatility was properly quantified

As a consequence, every borrower, in every instance, would be matched with affordable loan products--which would have prevented the subprime lending problem that preceeded the larger financial crisis.

This view has been referred to as a 360 degree view of the borrower and the loan transaction. In our white paper, Dr. Zhang and I term these the borrower contour and the transaction contour.

These concepts were further underscored in my testimony last summer before the House Financial Services Committee’s Subcommittee on Investigations & Oversight where the impact of credit scoring on consumers was discussed. In our recently released book, Credit Risk Assessment – The New Lending System for Borrowers, Lenders, and Investors, we demonstrate how this 360 degree view can reconnect all related parties that participate in the lending value chain. The benefits of this added view are significant and cascading in nature. Let me provide you with a couple of “for instances!”

I had a discussion with my son, who graduated from Med School on Sunday, about the complexity of lending these days. His reaction was “It’s not brain surgery! What’s the big deal?” To which I replied “Son, I have just co-authored an entire book on a new approach to lending and trying to cover the bases with a short white paper is like explaining quantum physics in 3 words or less!” My son replied “Fast moving particles, Dad. What’s your problem?!”

So, rising to my son’s challenge, I have put together some sound bites on CCAF! After all, it is not brain surgery!

There has been much in the news lately about stress testing financial institutions in order to see which ones require additional capital to safeguard them in the event of additional economic shocks and negative trends (i.e. declines in real GDP, higher unemployment, further declines in the housing price index, and so on). You may want to check out the April 24 white paper from the FRB: The Supervisory Capital Assessment Program: Design & Implementation for the details.

For most consumer loans, FICO credit score bands are prominently utilized as predictors of default. Interestingly, however, actual bad rates and losses are currently exceeding those of the original development samples for broad ranges of the FICO credit score (including the higher score bands). While some loan level data are used, most loss forecasting and portfolio management is performed on aggregate measures. The current stress testing exercises are no exception. I assert that instead of stess-testing the banks, we need to be stress-testing their borrowers – that's where the cash flows originate for loan repayment!

When Sunny Zhang and I set out to write a book last year on a new lending framework (CCAF), we did not have to re-invent the wheel on primary components. Instead, we leveraged the tried and true guiding principles that were used historically to qualify consumer loans prior to the emergence of credit scoring, namely the 5 C's of Credit. Our idea was to merge the best of science and expert credit judgment to fashion a new way to make lending more effective, transparent, and simple.


Fast forward to the present, in the wake of the financial crisis and credit crunch and we see that professional organizations are also publicizing the importance of the 5 C's of Credit and the return to more of a balance between models and the common sense approach to lending. I could not help but notice that the most recent edition of the RMA Journal has a feature story on the 5 C's of credit, authored by Dev Strischeck, SVP and senior credit policy officer at Atlanta-based SunTrust Banks. Dev makes the point that one of the 5 C's, character, deserves more scrutiny from lenders, in that it focuses on the borrower's willingness to repay the loan. I agree with Dev and believe that actually the other 4 C's also deserve greater attention! Financial executives have shared with me over the past months that they think more emphasis should have been put on the second C of Credit, or the third C of Credit, and so on.

Capacity and capital relate to the borrower's ability to repay the obligation. A key issue relative to the financial crisis was loan affordability. Assessment of the borrower's ability to make the required payments is key. A borrower who is willing, but not able, to repay is going to end up defaulting on thier obligation. The collateral is also a factor, for example in the mortgage market many homes had inflated prices that left borrowers upside down when home prices plunged and wiped out their equity position (and some of the lender's equity interest as well). Lending put too much reliance on past performance and historical economic conditions. Economists sometimes say that stability breeds instability, recognizing the cyclical nature of financial markets. That takes us to the 5th C, conditions. Borrower vulnerability to future conditions must be assessed by considering future debt-to-income and loan-to-value ratios under worst case conditions. Depending on the loan product terms (e.g. fixed/variable pricing) or collateral valuation volatility, borrowers may have varying vulnerability. Some may have low exposure due to strenths in the 5 C's of Credit, while others may be particularly vulnerable to changes in earnings, capital, debt, collateral, or some combination of them.

The 5 C's of Credit provide primary components that should be included in any lending system. CCAF actually includes a sixth factor that encompasses all other primary concerns or guiding principles, such as cash flow analysis, or any other C's of Credit! CCAF provides exactly the sort of solution framework that is needed to address the changing landscape in today's consumer and small business lending environment.

Clark raised a good point in his last blog that the stress testing should be addressed below loan portfolio level to borrower and loan levels. One of the important lessons learned from the subprime and financial crisis is that the financial risk model s failed to incorporate “possible” extreme events imposed by the exotic loan products and borrower’s loan affordability. As a result, significant losses could not be captured by the model outcomes. This is an issue related to “stress testing”, which is one of the important risk management tools used to evaluate the potential impact of unlikely but possible set of events in order to meet the capital adequacy requirements.

Traditionally, more than 80% of stress tests have been conducted at portfolio (most for trade portfolio and much less for loan portfolio) level by considering variables such as a sudden and significant change in interest rate or other economic factors. It has mainly focused on sensitivity analysis side of the stress testing based on historical performance data to predict the distribution of outcomes. What is missing here is a holistic scenario-based stress testing that includes more relevant risk factors and scenarios at the loan level and borrower’s credit behavior levels (such as borrower’s risk profile and loan affordability) in a proper context.

The key to an effective stress testing is to design a testing scheme that incorporates a set of more complete and relevant risk factors and all “possible” thresholds. Thanks to CCAF’s holistic approach, this process can be very thorough and yet straight-forward. CCAF 's handle-based segmentation process can readily help you identify which factor and their associated scenarios should be included in stress testing in an appropriate business and economic context. With CCAF, it is hard to miss any important scenarios and the scenarios generated by CCAF will go beyond what historical data can surface! I believe this kind of capability for stress testing should be soon reflected and addressed in the requirements by supervisory agencies to assess the financial system’s vulnerability.

I opened this morning’s newspaper to find that the IMF is now projecting the world economy will shrink by 1.3 percent in 2009, over two and a half times what they had projected just 3 months ago! It has been 6 decades since we last saw the global economy shrink at all and the consequences will be severe, with millions more unemployed, and trillions of dollars of lost business.

A big factor in this forecast is the lengthening of the time required to stabilize the world financial markets and the difficulty in getting consumers and businesses the access to credit that they need. The solution to credit access is a re-engineering of the current loan underwriting and pricing systems that are obviously no longer working as advertised. Lenders can only make good decisions on loans after they first have put the borrower qualifications and transaction terms in the proper context, which includes not only past history but possible future outcomes based upon all of the givens. A comprehensive credit assessment framework (CCAF) is need to accomplish what is needed to effectively underwrite loans. If we move quickly, we may be able to turn the tide sooner than the experts think will be required.

Trust in the system is the key, and there is no longer confidence that the FICO score and other supposed indicators of credit worthiness that have the predictive values that they are supposed to possess. It doesn’t take mountains of credit bureau data to make a loan. In a future blog I will explain why only a few credit bureau characteristics are needed. Credit bureau data has been way over-rated in importance because, in the absence of equally, or more, relevant information, it attempts to pick up the slack!

In addition, the so-called “stress testing” that is going on at the institutional level needs to be pushed down below the loan portfolio level where most loss forecasting models operate to the loan level. With CCAF, loans and borrowers can be stress-tested, which is, after all, where lenders derive their revenue and also where they experience losses. CCAF would provide early warning before delinquencies and losses surface because it looks at what borrowers cash flows, savings, and liquidity nets out to versus the narrow view of their historical payment pattern, which continue to be given far too much weight.

My co-author and co-inventor, Dr. Mingyuan (Sunny) Zhang, has some thoughts on stress testing that he is going to share with you in next Tuesday's installment. I will be in Washington, DC that day attending a Board Meeting for The Social Compact. Be sure to keep a lookout for Sunny's blog!

If you are a borrower, would you like to know the factors that are used to qualify you for a loan, and precisely what actions you could take to improve your credit standing? Would you like not to have to wait for years to see your past payment performance issues fall off the radar screen? Would you like your information to be put into the proper context, before it is used to decision/price your loan request?

If you are a lender, do you get tired of replacing credit scorecards that have a half-life of one year? Would you prefer to have a system that is adaptive and gets more predictive, not less predictive over time? Would you like to avoid surprises relative to loan portfolio performance, and have greater transparency and a view into the true credit risk dynamic at work in your lending operation and applicant/borrower base? Are you of the opinion that credit scores do not capture the complete picture of the borrower, despite that fact that they are so important in classifying who is sub-prime or who will get preferential treatment?

If you are a secondary market player that packages loans for sale to investors, would you like to know how to better construct loan pools and price the risk that they truly represent?

If you are an investor, would you like to have additional information beyond the agency rating on your investment, that will clue you in on how uncertain the cash flows are that relate to both your principal and your investment return?

If you have a positive response to one or more of these questions, then you would definitely benefit from CCAF!! (Note: CCAF is pronounced See-caf and it stands for Comprehensive Credit Assessment Framework which is explained in our latest book)

Making a loan – sounds simple enough! If this country can put a man on the moon, you would think that we should be able to make loans without melting down the world financial system. Given recent experience, maybe not. The obvious upshot is that making a loan must be more complicated than we think!

OK, but if that is the case, are the complications inherent in the transaction of making a formal IOU between a lender and a borrower, or have we made lending a whole lot harder that it needs to be? I know I am treading on sacred ground here – challenging the status quo. Add to that the fact that when a lot of money changes hands, folks want to get their piece of the action. Well, who wants to grab that porcupine? The short answer is all of a sudden a whole lot of folks, including Congress. There is legitimate outrage surrounding the greed, lack of accountability, lack of transparency, and overly complicated transactions and processes that have come to be embraced by the Financial System Establishment.

I don’t know about you, but I yearn for simpler times – when we had a handful of guiding principles in lending called The 5C’s of Credit. Let me outline, simply, how an alternative system might work.

You might think that a book about a revolutionary new approach towards lending would be a big yawn, except for risk management geeks, and you would be DEAD WRONG! So, who should care?

Short Answer:

Borrowers who, in the wake of the global financial crisis, want to know how they should be evaluated for a loan versus how they actually are and who question why they should have to pay more for the same loan than someone else?

Lenders who are questioning the effectiveness of the FICO credit score (that lacks context and is based partially on consumer choices and substitutes for common sense) and who are looking for a better way to make affordable loans.

Investors who want to know how uncertain the cash flows are stemming from loans that back their investments and how that uncertainty is reflected in the rating of the security.

Regulators who didn’t see this mess coming in time to head off a near meltdown of the entire global financial system and desperately need greater transparency, accountability and early warning (in advance of the customary and obvious delinquency and loss trends).

Conclusion:

Everyone can benefit from reading this book, which unpacks the financial crisis, exposes the root causes, and goes on to illustrate through a wealth of connected and detailed examples how we can fix this mess and avoid repeats!

House Financial Services Committee Chairman Barney Frank’s bill could thin out the playing field and leave all consumers with fewer choices. Stacy Kaper wrote a front page article in the March 31, 2009 edition of the American Banker that pointed to some of the issues surrounding this proposed legislation that was introduced less than 2 weeks ago and may be put to a vote shortly after the Easter recess.

I believe I need to get a copy of our latest book on the new lending system to Chairman Frank as I fear that in the absence of a comprehensive framework that can support the desired reform, we may witness a well-intentioned piece of legislation that will create a new lending standard that will apply universally to borrowers, irrespective of their qualifications. So, what’s wrong with that, you may ask? Well, I have a few observations, and an opinion or two, on that front (as you may have guessed)!