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

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.