Commercial Loan Origination

--by Kelly Kent

When reviewing offers for prospective clients, lenders often deal with a significant amount of missing information in assessing the outcomes of lending decisions, such as:

• Why did a consumer accept an offer with a competitor?
• What were the differentiating factors between other offers and my offer, i.e. what were their credit score trends?
• What happened to consumers that we declined? Do they perform as expected or better than anticipated?
• What were their credit risk models?

While lenders can easily understand the implications of the loans they have offered and booked with consumers, they often have little information about two important groups of consumers:

1. Lost leads: consumers to whom they made an offer but did not book
2. Proxy performance: consumers to whom financing was not offered, but where the consumer found financing elsewhere

Performing a lost lead analysis on the applications approved and declined, can provide considerable insight into the outcomes and credit performance of consumers that were not added to the lender’s portfolio.

Lost lead analysis can also help answer key questions for each of these groups:

• How many of these consumers accepted credit elsewhere?
• What were their credit attributes?
• What are the credit characteristics of the consumers we're not booking?
• Were these loans booked by one of my peers or another type of lender?
• What were the terms and conditions of these offers?
• What was the performance of the loans booked elsewhere?
• Who did they choose for loan origination?

Within each of these groups, further analysis can be conducted to provide lenders with actionable feedback on the implications of their lending policies, possibly identifying opportunities for changes to better fulfill lending objectives. Some key questions can be answered with this information:

• Are competitors offering longer repayment terms?
• Are peers offering lower interest rates to the same consumers?
• Are peers accepting lower scoring consumers to increase market share?

The results of a lost lead analysis can either confirm that the competitive marketplace is behaving in a manner that matches a lender’s perspective.  It can also shine a light into aspects of the market where policy changes may lead to superior results. In both circumstances, the information provided is invaluable in making the best decision in today’s highly-sensitive lending environment.

 

There are a lot of areas covered in your comment: efficiency; credit quality (human side or character in an impersonal environment); and policy adherence. 

We define efficiency and effectiveness using these metrics:

• Turnaround time from application submission to decision;
• Resulting delinquencies based upon type of underwriting (centralized vs. decentralized);
• Production levels between centralized and decentralized;
• Performance of the portfolio based upon type of underwriting; and
• Turnaround time from application submission to decision

Due to the nature of Experian’s technology, we are able to capture start and stop times of the typical activities related to loan origination.  After analyzing the data from 160+ financial institutions of all sizes, Experian publishes an annual small business benchmark report that documents loan origination process efficiencies and inefficiencies, benchmarking these as industry standards.  

Turnaround Time

From the benchmark report, we’ve seen that institutions that are centralized have consistently had a turnaround time that is half of those with decentralized environments.

Interestingly, turnaround time is also much faster for the larger institutions than for smaller.  This is confusing because the smaller community banks tend to promote the close relationship they have with their clients and their communities. Yet, when it comes to actually making a loan decision, it tends to take longer.

In addition to speed, another aspect of turnaround is consistency.  We all can think of situations where we were able to beat the stated turnaround times of the larger or the centralized institutions.  Unfortunately, these tend to be isolated instances versus the consistent performance that is delivered in the centralized environment.

Resulting delinquencies based upon type of underwriting/Performance of the portfolio based upon type of underwriting

Again, referring to the annual small business lending benchmark report, delinquencies in a centralized environment are 50% of those in a decentralized environment. 

I have worked with a number of institutions that allow the loan officer/relationship manager to “reverse the decision” made by a centralized underwriting group.  The thinking is that the human aspect is otherwise missing in centralized underwriting.  When the data is collected, though, the incremental business/portfolio that is approved by the loan officer (who is close to the client and knows the human side) is not profitable from a credit quality perspective.  Specifically, this incremental portfolio typically has a net charge-off rate that exceeds the net interest margin -- and this is before we even consider the non-interest expense incurred. 

Your choice: is the incremental business critical to your success…or could you more fruitfully direct your relationship officer’s attention elsewhere?

Production levels between centralized and decentralized

Not to beat a dead horse, but the multiple of two comes into play here too.  As one looks at the throughput of each role (data entry, underwriter, relationship manager/lender), the production levels of a centralized environment are typically double that of a decentralized.

It’s clear that the data point to the efficiency and effectiveness of a centralized environment

-- by Kelly Kent

The title of this edition, ‘The risk within the risk’ is a testament to the amount of information that can be gleaned from an assessment of the performances of vintage pools.

Vintage pools offer numerous perspectives of risk. They allow for a deep appreciation of the effects of loan maturation, and can also point toward the impact of external factors, such as changes in real estate prices, origination standards, and other macroeconomic factors, by highlighting measurable differences in vintage to vintage performance.

What is a vintage pool?

By the Experian definition, vintage pools are created by taking a sample of all consumers who originated loans in a specific period, perhaps a certain quarter, and tracking the performance of the same consumers and loans through the life of each loan.

Vintage pools can be analyzed for various characteristics, but three of the most relevant are:

* Vintage delinquency, which allows for an understanding of the repayment trends within each pool;

* Payoff trends, which reflect the pace at which pools are being repaid; and

* Charge-off curves, which provide insights into the charge-off rates of each pool.

The credit grade of each borrower within a vintage pool is extremely important in understanding the vintage characteristics over time, and credit scores are based on the status of the borrower just before the new loan was originated. This process ensures that the new loan origination and the performance of the specific loan do not influence the borrower’s credit score. By using this method of pooling and scoring, each vintage segment contains the same group of loans over time – allowing for a valid comparison of vintage pools and the characteristics found within.

Once vintage pools have been defined and created, the possibilities for this data are numerous...

Much of the discussion on Capitol Hill revolves around sufficient risk-based capital and the derivation of how much tier 1 capital and/or common equity capital is appropriate. Most of our solution offerings and consulting services address various aspects of risk management, from targeting prospective customers, through loan origination and risk-based pricing, to ongoing relationship management and portfolio monitoring. We have been addressing risk management with our clients long before the recent financial and economic crises. We are both ready and able to assist new and existing clients in many ways: to effectively and efficiently address the management of credit and other risks and to develop strategies that offer optimal risk-based profit performance. We are always monitoring regulatory developments and, as always, will strive to assist our clients with new best practices to operate as effectively as possible under any new regulations affecting risk management policies, processes and governance responsibilities.

We have talked about: the creation of the vision for our loan portfolios (current state versus future state) – e.g. the strategy for moving our current portfolio to the future vision. Now comes the time for execution of that strategy.

In changing portfolio composition and improving credit quality, the discipline of credit must be strong (this includes in the arenas of commercial loan origination, loan portfolio monitoring, and credit risk modeling of course). Consistency, especially, in the application of policy is key. Early on in the change/execution process there will be strong pressure to revert back to the old ways and stay in a familiar comfort zone.  Credit criteria/underwriting guidelines will have indeed changed in the strategy execution.

In the coming blogs we will be discussing:

• assessment of the current state in your loan portfolio;
• development of the specific strategy to effect change in the portfolio from a credit quality perspective and composition;
• business development efforts to affect change in the portfolio composition; and 
• policy changes to support the strategy/vision.

We have talked about: the creation of the vision for our loan portfolios (current state versus future state) – e.g. the strategy for moving our current portfolio to the future vision. Now comes the time for execution of that strategy.

In changing portfolio composition and improving credit quality, the discipline of credit must be strong (this includes in the arenas of commercial loan origination, loan portfolio monitoring, and credit risk modeling of course). Consistency, especially, in the application of policy is key. Early on in the change/execution process there will be strong pressure to revert back to the old ways and stay in a familiar comfort zone.  Credit criteria/underwriting guidelines will have indeed changed in the strategy execution.

In the coming blogs we will be discussing:

• assessment of the current state in your loan portfolio;
• development of the specific strategy to effect change in the portfolio from a credit quality perspective and composition;
• business development efforts to affect change in the portfolio composition; and
• policy changes to support the strategy/vision.

More to come.

The problem in the 2005 to 2007 home lending frenzy was not just granting credit to anyone who applied. It was giving loans to everyone at essentially the same price range regardless of normal credit risk scrutiny.

While “selling” financial services may be largely an art form, appropriate risk-based pricing is more of a science.

Although the financial press seemed to have discovered sub-prime lending in the last year or so, such high-risk lending isn’t new at all. It has been (and is still being) done since finance and money were invented. And, importantly, sub-prime lending has been done profitably by many lenders all along.  The secret to their success, not surprisingly, has always been risk-based pricing -- even if they didn’t call it that until recent times.

Sub-prime funding has been available in many forms and from many sources. Providers range from venture capitalists to pawn shops. It includes pay-day lenders, micro loans, tax refund loans, consumer finance companies, and even dates to Shakespeare’s merchant of Venice.

We often hear complaints that the effective rates (prices) on loans from such sources are unfairly high and predatory. The cost of that credit is high, but so is the risk of that credit. Without these kinds of sources, and their high rates, there would not be any credit granted from for-profit sources to high-risk borrowers. 

Listed firms that regularly provide pay-day loans or cash advances to sub-prime borrowers have very high gross margins and very high credit charge-offs, compared to banks. They also have much higher risk-based capital (or equity) positions that range from 40 percent to 60 percent of their average assets. This risk-based capital burden is much higher than the 8 to 10 percent found at commercial banks. So the sub-prime lenders have a significantly larger capital cushion than banks. Most of these financial results and ratios are examples of successful risk management where the credit risks are identified, managed, priced and backed by sufficient capital.

Then…along came the rose-colored greed of the housing bubble that resulted in aggressive building and selling of homes, loan originations to all (no-down, no-income, no-assets, no-problem mortgages), securities packaging and attractive ratings, and global leveraged investing -- all by prime-oriented entities and all at prime-oriented prices. Well, obviously, it didn’t work.

Risk-based pricing of mortgages would have dissuaded many home buyers to begin with… but what would we have done with all of those shiny new homes? Realistic credit models (that took into account a full credit cycle and a huge proportion of sub-prime credits) would not have rated mortgage-backed securities as AAA. Regulators that were still focused on earnings correctness (the last major snafu) should have been looking into realistic net asset values. And highly compensated investment bankers, with 30-to-1 leverage ratios, would not have gone overboard with intuitively dodgy investments. Few of these players took risk management seriously.

The new danger is that banks are doing the whole thing in reverse. They are tightening lending standards -- which is, of course, a euphemism for shutting off credit. The danger has nothing to do with so-called credit standards. It’s the general over-reaction of shutting off credit to all borrowers, again, without regard to relative risk. The latest Federal Reserve Board survey of senior loan officers paints a picture of rapid tightening to record levels.

We feel that credit standards should always improve AND that loan pricing should always proportionately reflect risk-adjusted rates and terms. Opening the flood gates and then slamming them shut is a very pro-cyclical behavior pattern on the part of bankers that doesn’t reflect a measured approach, borrower-by-borrower, using reasonable risk management at the client relationship level.

Whenever an industry encounters problems, the natural tendency is to play the blame game.  In the banking industry, credit risk managers are looking for who or what to blame for the tide of charge offs and delinquencies in their under-performing loan portfolios and in their commercial loan origination operations.  Credit scoring has definitely taken it on the chin as an easy target during 2008. 

Is credit scoring the problem? Absolutely not! 

As with anything, the more complacent we become…and the more we “turn off our brains” and stop thinking…the more risk we assume.  The more we solely rely upon the credit score alone, the more we subject ourselves to the risks inherent in “score and go” lending.

We are all well aware that credit scoring measures propensity to repay and not capacity to repay.  Over the past several years, the propensity to repay has been boosted by ever-increasing real estate values and by the refinance boom.  For example, some consumers have been able to survive on a 50 percent debt–to- income due to constant use of credit cards …by paying off those cards with a home mortgage refinance.  That set of behaviors would have shown a propensity to repay…but  was it ever acceptable to have 50 percent of your income go to debt payments?! 

Statistically it may have worked for a few years, but once real estate values stopped escalating, the problem with lack of capacity to repay reared its ugly head. 

When it comes to risk management, let’s get back to reality and sound principles.