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

Saturday, September 20. 2008

A New Day Must Dawn in Credit Granting

A credit score based on credit bureau data is incomplete, a flawed concept when it is used in isolation to measure a borrower's creditworthiness. How can you predict whether or not someone will pay a loan without considering all of the relevant facts?

The credit bureau score is the most prevalent means for determining how high an interest rate to charge the borrower if the loan is approved. It is also the main mechanism for pricing loan risk by financial engineers who create loan pools for sale to investors, by portfolio managers who are responsible for monitoring loan quality, and by buyer's/sellers of whole loans and bid portfolios of credit card loans, auto loans, etc. What is needed is a more comprehensive approach (namely CCAF) to better capture the risk associated with individual loans held on the lender's balance sheet and also the vast pools of loans, whose cash flows may be restructured and sold to investors on Wall Street.

Had CCAF been in place, and fully utilized for subprime mortgage underwriting (to make the risk transparent to both the lender and borrower), for limiting risk concentrations in loan portfolios, and for structuring pools of loans to sell to investors (which is absolutely critical for market liquidity), we would not be facing the current massive market bailout the Treasury Secretary, Fed Chairman, and leaders of Congress are struggling to hammer out this weekend.

I intend to drive this point home during my talk and the Innovator's Summit in San Francisco next week. This is a story that needs to be told and I intend to do just that. Sunshine is the best disinfectant. My words will, no doubt, sting a bit in certain quarters (the proponents of the status quo). But with the facts known, perhaps we can end the finger pointing and make progress in solving the root problem, namely, out-dated and sub-optimal credit risk management that extends from loan origination, servicing, sale, restructuring through to final disposition!

The American people and our government must say “Enough!” A new day must dawn in credit granting. Innovative, transparent and effective solutions are needed -- not spin and the cloak of secrecy, coupled with a "business as usual" mentality.

Posted by Clark Abrahams in credit scoring at 10:36 | Comments (2) | Trackbacks (0)

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I don't think banks want a fair system. My take on this might seem cynical, but I suspect it's got some truth behind it.

Why would banks want to change the system? I suspect they like arbitrarily charging people more for loans if they can get away with it. If I pay a credit card bill late just because I'm focused on other things and forget, then that is an great opportunity for a bank to screw me by claiming I'm a credit 'risk'. Never mind that they make ridiculous profits with late fees. Why would a bank give up the opportunity to rip me off no matter how arbitrary the reason? Note: Evidence of banks intent to make money this way is their blatant marketing of no-interest balance allowances that suddenly incur increased rates for a late payment. It's trickery and 'gotcha!' all rolled up into entrapment.

The credit scoring system is designed to reward the cold greed and implicit collusion of a system where the bankers make money if they all quietly keep the system of unfair ratings ongoing. If the system was truly fair, almost everyone would have a higher score, and the remainder would have lower scores. The banks could no longer profit from high interest for genuinely low-risk borrowers. On the flip side, those who generate loans could no longer get away with earning commissions on loans for people who are actually not credit worthy.

I believe the banks like this system. Maybe the system is inefficient. So what? If inefficiency increases costs for the industry, that helps them make money. They maintain the same profit *margin*, but they actually make more than they would with a fair and more efficient system.

Bruce

#1 Bruce on 2008-10-01 09:15 (Reply)

Fantastic article Bruce! I have often wondered why the banks get away with these ridiculous fees associated with credit score only snaphots.
The credit score system is very antiquated and needs to be addressed. Probably 6/10ths of Americans don't even understand how their score is determined and make decisions that actually hurt their score and think that they are helping it the majority of the time.

#1.1 Jennifer Horn on 2008-10-12 09:15 (Reply)

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About Clark Abrahams

Clark Abrahams is Chief Financial Architect at SAS where he leads business and product development. He has over 30 years of experience in the financial services industry. Along with co-author Mingyuan Zhang, Clark has written two books that re-think credit risk management and granting access to credit:

Fair Lending Compliance: Intelligence and Implications for Credit Risk Management