The lending industry is robust with dialogue as economic recession deepens and delinquency reaches historic heights. In the past, credit unions have been relatively unscathed by the problems which have plagued conventional banks because their lending policies are governed by a member-elected board and are not driven by profit requirements from investors (Bednar 2008). However, despite conservative lending practices and the advantages of member loyalty, credit unions experienced the largest increase in auto loan delinquency throughout 2008 and is expected to continue through 2009 (Reed 2009). There are several factors contributing to the rise in delinquency; at least 1 in 5 U.S. mortgage holders — or relatively 8.3 million households — are currently "underwater," coupled with sagging consumer confidence and forecasted unemployment rates climbing by the end of the third quarter(The Financial Forecast Center 2009).
As credit unions began feeling recession's tightening grip, which had already been squeezing its bank rivals, several articles surfaced from credit union executives on the subject of risk management. It is in response to this conversation that I write this article, with the purpose of outlining what I believe to be foundational underwriting principles upon which we have created a successful lending organization — originating high quality performing auto assets with minimal risk and exposure. And considering 70% of credit unions surveyed by the NAFCU adjusted their growth predictions downward following the NCUA’s decision to levy a premium to shore up the NCUSIF as a result of the corporate stabilization plan, I assumed that information designed to improve your bottom line while managing risk would be useful (Marx 2009).
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Given the rise in delinquency, credit union executives are pushing to better manage liquidity and credit risk — developing more sophisticated analytical models to forecast loan performance, delinquency trends and charge-off data(Banking Wire 2008). Harvard economist Martin Feldstein agrees that these analytical models are valuable but "are still only useful as heuristic devices to help clear our thinking rather than to design specific real-time policies." Feldstein further concludes that science cannot replace judgment and despite how good "science gets, there are problems that inevitably depend on judgment (Feldstein n.d.)."
Lending has evolved significantly in the last quarter century with the growth of information systems and more efficient business models. Prior to 1985 lending was done at arm's length with the customer, operations were decentralized and underwriting was conducted through local branches within the same community as the borrower. Credit rating systems and model scorecards were still in development. Credit Officers had some level of familiarity with their customers and frequently were responsible for servicing and collecting on the loans they originated. Because of this "arm's length" approach, the relationship between community banks and their customers was substantially more personal and by its very nature reinforced the commitment by both lender and borrower to the terms of the agreement.
Information and communication technology experienced unparalleled growth and development during the 1990s and in an effort to become more proficient and profitable, many financial institutions centralized operations and became increasingly automated. Underwriting software replaced methods that required more individualized input. Credit bureaus became efficient at data gathering and reporting. Branches no longer controlled applications, underwriting, or collections, as these functions became centralized. "As the face-to-face experience of the borrower with the underwriting professional was eliminated, borrower character was no longer understood or measured [and] in subtle ways, the obligation to repay was [no longer] reinforced (O'Brien n.d.)."
This movement toward centralized operations and automation created inimitable opportunities for credit unions, who characteristically have smaller scale and therefore less money to invest in operations; however because their investment is in members and not in investor profitability, they typically generate more loyalty from their members than non member-owned institutions. Member loyalty and conservative underwriting policy are largely responsible for the performance of credit union loan portfolios whose national delinquency rate according to the Wall Street Journal was less than half the number of banks. Although this is good news from a competitive standpoint, delinquency reached an estimated 1.45% in January, double the 0.68% rate from 2006 and as a result has arrested the attention of credit union executives (Marte 2009).
Certainly the economy has contributed to the rise in loan defaults, but rather than being the cause of all our trouble, I believe that it is more the result of our underwriting philosophy and has exposed our overconfidence in algorithms, formulas, models and scorecards (i.e. the science of underwriting). We need science in underwriting to increase our efficiency, to streamline and make data more accessible, to calculate and evaluate opportunity and risk with the intention of enhancing our judgment—not to replace it. Rather than using science to guide our judgment frequently the opposite is true.
Many companies have adopted what I call a "Vegas" style approach in their lending models, where instead of budgeting for expected losses, they instead determine what acceptable losses are in each credit tier and subsequently create scoring models that perform to those expectations.
These models frequently change and are based on short-term trends or market conditions, which compromise their longer-term strategies. Models are helpful for creating controls and preventing human error; however are insufficient at accurately measuring and identifying risk—instead it requires three fundamental considerations by underwriting professionals: Ability, Stability and Credit (listed in order of importance).
The importance of the borrower's ability to repay the loan cannot be overstated. Both stability and credit weigh in the balance of the obligator’s ability to pay. Ability is calculated by factoring the loan applicant's total outstanding debt and requested monthly payment in relation to their gross monthly income. Because we do not have the benefit of knowing all the obligations the borrower is responsible for, debt-to-income ratios should never exceed 50% of their gross income.
With the advent of sophisticated credit ratings and scorecards, the customer's ability to pay was less relevant to the loan decision than their FICO score. The fundamental problem with this logic is that credit ratings, although helpful in the loan decision, fail to account for the risk of overspending. Pam Finch, CFO for Mid Minnesota Federal Credit Union, recently told the Credit Union Journal that they are detecting "a lot of 'A' and better paper moving into delinquency…it's people who have overspent, extended themselves, and are [now] starting to hand over the keys (Credit Union Journal 2008).” And with more access to credit, these prime borrowers present greater risk and exposure to lenders in the event of default if that risk is not managed appropriately.
Stability is weighed by several factors, including the collectability of the account. Historically, homeowners were perceived as more stable for obvious reasons; however in this current economic environment with 8.3 million homeowners underwater, the value we assign to home ownership must be reconsidered. The length of time at a given address or within the same community; tenure with an employer or within a specialized profession are typically what constitute stability, and reflects the likelihood that a borrower will continue to have the ability to pay during the life of the loan.
Credit bureaus represent historical data reflecting a consumer's borrowing and repayment habits and how they have managed their debt given their financial ability. Credit scores are designed to measure the risk of default by weighing the punctuality of payments; the amount of debt, expressed as the ratio of current revolving debt to total available revolving credit; length of credit history; types of credit used; and requests for credit and/or amount of credit recently obtained (Wikipedia n.d.).
Credit scores are helpful in determining rate and ensuring that loans are adequately priced against potential risk; however these scores are not always entirely accurate and should not be isolated from the customer's ability, stability and credit history as the sole basis for loan decisions. Credit unions typically favor FICO-based models and considering the advantage of member loyalty, these models have been sustainable. However, we are living in unprecedented economic times, which have challenged and tested our business models and strategies and found many of them unsustainable in this current environment. Credit unions must be willing to reevaluate their underwriting policies to determine their relevance in the current market.
Another important underwriting consideration in addition to ability, stability and credit, is the loan-to-value ratio, another area of risk credit unions have not typically managed well. While competitors use invoice and wholesale book to determine fair market value, credit unions use inflated MSRP and retail values. The only beneficiary in lending based on the latter is the dealership. Members are not encouraged to put money down and are therefore not personally invested in the agreement and are significantly upside-down on their loans before the ink dries on the contract. Credit unions assume the heightened risk and enormous losses in the event of repossession. Considering auction volatility, which is subject to demand, gas prices and other unforeseeable variables, credit unions must scale these ratios back to what is standard for the industry.
It cannot be assumed that the information disclosed on credit applications is correct — which is why scoring models fall short of accurately depicting risk. It is important that seasoned underwriting professionals interview each loan applicant to ensure the accuracy of the information presented, to reinforce the terms of the agreement and their contractual obligation, and additionally to mitigate the frequency of fraudulent loans—including, but not limited to straw purchases. Credit officers who are regionally located are also uniquely qualified to understand local economic variables that can be helpful in making informed underwriting decisions.
As delinquency, mortgage foreclosures and unemployment percentages increase, while many credit unions are adjusting their growth predictions downward for the year, credit unions must mitigate their risk exposure by returning to basic underwriting principles and build high quality loan portfolios that are based on sound judgment and not FICO scores alone. In turn you will experience a better return on assets and significantly reduce losses, which ultimately increase value for members.
If you found this piece informative, you might be interested in our follow up article on creating an effective loan-servicing platform with industry leading results — Coming Soon.
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