Lessons from the Last Crisis-Part 2

Lessons from the Last recession-New Account Underwriting

In my first note on Linkedin, I shared some observations from running the Home Equity business during the last financial crisis and suggested some private and public policy approaches that could help address customers in financial distress.  In this next installment, I want to build upon those lessons and consider the things that creditors should be thinking about in underwriting new loan requests. As in the first piece I wrote, I present concepts without any political motivations, principally to help credit grantors to update their policies during this crisis.

The Landscape

One of the key considerations in determining the severity of your credit change is the recession’s potential depth (how high will unemployment will become) and how long it will take to sustain a recovery. Many economists have suggested a V shape (fast recovery) or an L shape (longer recovery timeframe) curve. Your own economic scenarios (baseline, best/worst cases) will drive your forecasted new account loss curves and usage characteristics (revenue) that will highlight the depth of change you need to take to achieve your target performance goals. 

Another important point to make from the last economic crisis is that not all geographies in the country were affected the same way. There were different factors that drove the depth of home value depreciation (e.g., Nevada, Central California, etc. were deeper than most states) and length of time before the home value depreciation started to meaningfully recover (e.g., New York, New Jersey, Florida, etc. took longer to recover). The lesson to learn from this is that your own credit markets should be segmented into more homogeneous subpopulations and it’s likely that geography could be an important factor for you to distinguish in this segmentation approach, subject to fair lending considerations.

Implications for Line of Credit (LOC) vs. Loans

I often say that the most interesting credit product is the credit card. The reason is that there are so many different dimensions to consider in how to best manage risk/reward. First of all, it is a LOC, which means that there are transactional usage and utilization considerations. Second, there are all kinds of structuring terms and conditions that you can change (e.g., line size, pricing, enhancements, etc.) that provide you customer level frameworks to control risk/reward. With loans, you have many similar considerations, but once the funds are dispersed, you are out if you made a bad credit decision and it becomes more of a collections and payment risk management challenge. Loans are still very interesting, but good risk management can reduce the loss exposure on LOCs with the right account management strategies (the subject of my third piece that will be forthcoming).

New Account Related Fraud

In times of stress, fraud attempts always increase. When individuals are under stress to pay bills, they stretch their incomes and/or lie about their employment. They may over-state the value of their home or their assets. It is important that you have great tools to help you identify new account fraud (first party, third party and synthetic (which can be either)). If you originate credit digitally, you should utilize a company that can assess the device and IP history to evaluate if it is connected to the person applying for credit and/or if it has been used nefariously in the past.

Implications for Credit Strategies

The following points summarize some practical thoughts that you should consider in setting your new account strategies:

1.    Focus first on high-risk portfolio concentrations: Every portfolio has segments that have high usage (driving high interest or transactional revenue) and/or are higher risk. When the economic environment shifts as quickly as it has in this crisis, I will almost guarantee that the risk/reward on these segments will not work. They will likely add a disproportionate amount of loss concentration in your new accounts and you will not be able to increase pricing enough to compensate you for the risk. Experian and Oliver Wyman have off-the-shelf stress testing models available for creditors that could be useful in helping you identify higher risk segments for potential swap-out, in a stressed economic environment. Risk teams should always have a segmented list of marginal cells or tiers of approvals that could be swapped out quickly, without much engineering or technology resources needed to make it happen. 

2.    Learn from your portfolio to help inform your new account strategies: One suggestion that I have historically looked at is to segment the geographies into high, medium and low risk areas or some other type of segments (in real estate valuation risk it may be distressed, soft and stable as another example). These segments were based on both portfolio performance ( in this environment it could be day zero roll-in or 7 day delinquency) and economic data at the state level (you should consult your Legal/Compliance counsel on this). I have seen this used at the Metropolitan Statistical area (MSA) level as well, but the idea is that a large geographic area should be widely diverse and not impacted in a disparate way. This leads to a periodic process (could be weekly in this environment based on unemployment claims) where geographic areas migrate between the levels you have created and you employ tighter credit policies (e.g., higher credit score cut-offs and qualifying criteria, more income/employment verification, Loan to value restriction, etc.) on the riskier geographic segments. One important consideration is that normally economic cycles migrate over many quarters and employing this strategy works best for loans that have a shorter average life. A LOC is typically an evergreen product, so it is not wise to think of the low risk segment as a less stringent credit policy. The low risk segment should still be a policy that will perform over all normal economic cycles. 

3.    Score/odds relationships will change in an economic downturn: Stress testing has taught us that when economic stress occurs, the relationship between credit scores and the odds of loss or “bad” outcomes will change as well. You will see a negative shift in the score to bad rate relationship. This is important to understand and consider as you look at your cut-off strategies. Higher risk scores will likely change less than the super prime scores (on a relative basis). Use the bureau tools, e.g., the Experian Sandbox, to go back to the last economic crisis and obtain a relative sense of how much those relationships did change from the last crisis. 

4.    Eliminate and Simplify Certain Product Structures: In the last crisis, we learned that certain mortgage and home equity products did not work. Product structures like Negatively Amortizing loans, Stated Income/Stated Asset loans, etc. were eliminated due to their severely adverse performance. In this crisis, we should be shortening terms for Personal Loans, lowering credit limits for certain credit card customers, etc. Make sure your loan purposes are being used for responsible reasons and take control of the disbursement of funds to pay-off debts wherever possible. 

5.    Increase Employment and Income Verification (with little to no friction): Many products, such as personal and auto loans, have historically been mostly approved on stated income in the prime space. With a high level of unemployment, underemployment and with fraud attempts likely rising, it is prudent to increase the level of verification for higher risk loans (e.g., larger loan requests, higher risk geographies, etc.). The key to being successful in this area is to utilize services like the Equifax Work Number product and Deposit Aggregators like Finicity and Plaid. The Work Number provides data from company payrolls and will help you evaluate the risk for W-2 type employees. Deposit aggregators can provide recurring deposit data to help verify employment and income; this is not for everyone as about 65-70% of banks have direct deposit and you must see a very recent deposit to rely upon it ( seeing a deposit in the last 2 weeks and some history of it for at least 6 months). What you are balancing here is not losing too many “Good” customers by asking them to provide documentation when they should not have to provide it with finding some risky “Bads”, given the high level of both unemployment and underemployment. I also would suggest that you discuss with your Legal and Compliance counsel whether it is acceptable to verify income/employment for applicants who apply for LOCs/loans who are on Deferment/Forbearance with other lending products on their credit report. This approach should be focused on higher risk loans, as previously stated above. There may be some reputation risk associated with using the Deferment/Forbearance tradeline status so your CEO and company leadership team should consider that in whatever strategies you choose to follow.

6.    Use Trended Credit Data and Primary Deposit Account Cash Flow: Understanding the changes in how applicants are using their credit over time as well as how their primary (where their income is deposited) deposit account cash flow is trending should be very indicative of their overall risk level. In particular, look at the most recent behavioral data,  (e.g., payment rates of credit cards, balance and utilization trends and overall cash flow (both inflow and outflow trends)).  You may have to out-sort some applicants for manual review, based on judgmental rules that you can solidify with additional experience over time.

7.    Create a team focused on managing risk at the customer level: If you are a retail bank, you will likely have multiple credit and deposit relationships with the same customers and in the same household. Rather than letting each Line of Business treat a customer as an account, there is significant value in thinking through how to ensure that you consider the customer relationship data in your credit processes when they apply for new credit. I will have much more to say on this in the next publication on Customer Management, Collections and Payment Priorities. 

8.    Create a forum to share results daily: When you are in a crisis, over-communicating is important to ensure that everyone is on the same page. One thing that I have used in the past is a daily meeting with the stakeholders to review progress against the goals that you laid out for the team. To make this work, you must create a set of management information that summarizes the key metrics you are trying to move through this effort and set goals along the way that measure material progress.   

9.    Employees are your greatest asset: Talk often with your employees about what changes to credit policy you are making, the rationale for those changes and provide them feedback on how they are doing against your expectations. It is important to make sure that all employees understand that it is for the greater good of the company, as team members who focus on growth and product innovation may view these changes differently. Track individualized performance, (e.g., watch the levels of overrides that occur with credit underwriters) and coach team members often and quickly to avoid any significant problems. Lastly, ensure that there is an employee assistance process in place, as some of your team members will be experiencing the same things as your customers.  

I hope you will find this note helpful in thinking through the changes you may need to make with your own new account credit policies and within your organizational management approach. Thanks for taking the time to read this and feel free to contact me directly. 

Kevin Moss