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

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.