Credit Risk Assessment E-Book

Clark R. Abrahams

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: SAS Institute Inc
• Sprache: Englisch

Seitenzahl: 455

Veröffentlichungsjahr: 2009

Beschreibung

Credit Risk Assessment The New Lending System for Borrowers, Lenders, and Investors Credit Risk Assessment: The New Lending System for Borrowers, Lenders, and Investors equips you with an effective comprehensive credit assessment framework (CCAF) that can provide early warning of risk, thanks to its forward-looking analyses that do not rely on the premise that the past determines the future. Revealing how an existing credit underwriting system can be extended to embrace all relevant factors and business contexts in order to accurately classify credit risk and drive all transactions in a transparent manner, Credit Risk Assessment clearly lays out the facts. This well-timed book explores how your company can improve its current credit assessment system to balance risk and return and prevent future financial disruptions. Describing how a new and comprehensive lending framework can achieve more complete and accurate credit risk assessment while improving loan transparency, affordability, and performance, Credit Risk Assessment addresses: * How a CCAF connects borrowers, lenders, and investors--with greater transparency * The current financial crisis and its implications * The root cause to weaknesses in loan underwriting practices and lending systems * The main drivers that undermine borrowers, lenders, and investors * Why a new generation of lending systems is needed * Market requirements and how a comprehensive risk assessment framework can meet them * The notion of an underwriting gap and how it affects the lenders' underwriting practices * Typical issues associated with credit scoring models * How improper use of credit scoring in underwriting underestimates the borrower's credit risk * The ways in which the current lending system fails to address loan affordability * How mortgage and capital market financial innovation relates to the crisis

Leseprobe

Table of Contents

Wiley & SAS Business Series

Title Page

Copyright Page

Dedication

Preface

ORGANIZATION OF THE BOOK

AUDIENCE FOR THE BOOK

CHAPTER 1 - Unpacking the Financial Crisis

THE FINANCIAL CRISIS

CAUSES OF THE CRISIS

ROLES OF BORROWERS, LENDERS, AND INVESTORS

ROOT CAUSES

KEY DRIVERS OF THE CRISIS

THE IMPACT

THE CONSEQUENCES

THE IMPLICATIONS

SUMMARY

CHAPTER 2 - The Case for a Comprehensive Credit Assessment Framework

THE NEED FOR A NEW LENDING SYSTEM

HISTORICAL REVIEW

NEW LENDING SYSTEM

OVERVIEW OF THE FRAMEWORK

HOW CCAF CLASSIFIES BORROWERS

CCAF AND EXISTING UNDERWRITING MODELS

EXAMPLE

SUMMARY

CHAPTER 3 - The Lender and the Underwriting Gap

MORTGAGE UNDERWRITING PROCESS BASICS

THE UNDERWRITING GAP AND ITS KEY COMPONENTS

HOW TO CLOSE THE UNDERWRITING GAP

SUMMARY

CHAPTER 4 - The Borrower and Loan Affordability

LOAN AFFORDABILITY

SUBPRIME LENDING AND LOAN AFFORDABILITY

SUBPRIME LOAN PERFORMANCE

CREDIT SCORING SYSTEMS AND LOAN AFFORDABILITY

HOW CCAF QUALIFIES THE BORROWERS

EXAMPLES: CCAF QUALIFIES LOAN AFFORDABILITY FOR BORROWERS

SUMMARY

CHAPTER 5 - The Investor and Financial Innovation

MORTGAGE BANKING BUSINESS VALUE CHAIN

LOAN SECURITIZATION AND THE FINANCIAL CRISIS

THE ROLE OF INVESTMENT VEHICLES

ROLE OF CREDIT RATING AGENCIES

HOW CCAF CAN HELP IMPROVE THE RATING PROCESS

HOW CCAF TRACKS THE UNDERLYING LOAN PERFORMANCE

FUTURE OF FINANCIAL INNOVATION

SUMMARY

CHAPTER 6 - Crisis Intervention and Prevention

LENDING-RELATED REGULATIONS

CRISIS INTERVENTION

NEW FRAMEWORK

CRISIS PREVENTION

LOOKING AHEAD

SUMMARY

CLOSING OBSERVATION

Index

Wiley & SAS Business Series

The Wiley & SAS Business Series presents books that help senior-level managers with their critical management decisions.

Titles in the Wiley and SAS Business Series include:

Business Intelligence Competency Centers: A Team Approach to Maximizing Competitive Advantage, by Gloria J. Miller, Dagmar Brautigam, and Stefanie Gerlach

Case Studies in Performance Management: A Guide from the Experts, by Tony C. Adkins

CIO Best Practices: Enabling Strategic Value with Information Technology, by Joe Stenzel

Credit Risk Scorecards: Developing and Implementing Intelligent Credit Scoring, by Naeem Siddiqi

Customer Data Integration: Reaching a Single Version of the Truth, by Jill Dyche and Evan Levy

Enterprise Risk Management: A Methodology for Achieving Strategic Objectives, by Gregory Monahan

Fair Lending Compliance: Intelligence and Implications for Credit Risk Management, by Clark R. Abrahams and Mingyuan Zhang

Information Revolution: Using the Information Evolution Model to Grow Your Business, by Jim Davis, Gloria J. Miller, and Allan Russell

Marketing Automation: Practical Steps to More Effective Direct Marketing, by Jeff LeSueur

Performance Management: Finding the Missing Pieces (to Close the Intelligence Gap), by Gary Cokins

Performance Management: Integrating Strategy Execution, Methodologies, Risk, and Analytics, by Gary Cokins

For more information on any of the above titles, visit www.wiley.com.

Copyright © 2009 by SAS Institute. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Abrahams, Clark R., 1951-

Credit risk assessment: the new lending system for borrowers, lenders, and investors/Clark Abrahams and Mingyuan Zhang.

p. cm.—(Wiley & SAS business series)

Includes index.

eISBN : 978-0-470-50035-4

1. Credit—Management. 2. Consumer credit—Management. 3. Bank loans—Management.

4. Risk management. I. Zhang, Mingyuan. II. Title.

HG3751.A27 2009

332.7—dc22

2008054910

To Judy, Brad, Candice, and my lifelong mentor, Estella Hunter.

—CLARK ABRAHAMS

To Lily, our parents, and Amy, Larry, and Gary.

—MINGYUAN ZHANG

Preface

In September 2008, the subprime mortgage crisis that began earlier in 2007 evolved into a global financial crisis, and further deepened the economic recession. This is the most serious economic downturn since the Great Depression and there are many opinions and theories concerning its causes and perpetrators. However, the root cause can be traced to incomplete credit risk assessment in lending systems that failed to qualify borrowers for appropriate and affordable loan products. Disconnects between lenders and investors, and lack of transparency in loan underwriting, rating, and securitization processes, only made matters worse. Simply recalibrating existing models and choosing the path of least resistance is a bad strategy that will fail to solve the problem at the root cause and expose us to more of the same. Hence, it is out of necessity that a paradigm shift in the lending system will emerge that benefits both lenders and borrowers, while promoting greater financial market stability and confidence among investors.

There are several factors that have hindered evolutionary improvements in these processes. First, very complicated proprietary processes are involved. There has been an overreliance upon, and lack of understanding of, technically complex credit granting and loan securitization practices and their associated assumptions. Part of the reason is the “secret sauce” nature of credit scoring models and how they are developed. Some solution vendors have steadfastly refused to share the details of their processes with federal regulators. Further complicating matters was the emergence of asset-backed securities, which evolved into very complex packaging of cash flows from the underlying securities. In the case of mortgages, those underlying securities added complexity due to imbedded options and elaborate pricing features. Furthermore, all parties have so much invested in the status quo, including credit scoring, that their thinking and perceived options seem to have been constrained by the presumption that any improvements in the system would build upon, rather than replace, what currently exists. There is a common mind-set in business, namely “If it isn’t broken, don’t fix it.” This sort of “Do Nothing” rationale, like the argument against preventative medicine, is just plain bad thinking. With any business solution, critical assumptions need to be identified and rechecked periodically. Fixing a system after it breaks is far more costly than if corrections are made in time to avoid failure.

This book describes how a new and comprehensive lending framework can achieve more complete and accurate credit risk assessment, while improving loan transparency, affordability, and performance. We introduce the concept of the underwriting gap, the starting point of the crisis, in order to expose weaknesses, and then offer a new way to evaluate and balance the risk to the lenders and investors, and the affordability for the borrowers. Instead of more narrowly addressing improvement of the lending system from the lender’s perspective, this book describes how a comprehensive credit assessment framework (CCAF, pronounced “See-Caf ”) connects lenders, borrowers, and investors, with greater transparency. Existing credit risk assessment approaches put too much emphasis on past loan performance and historical market conditions but not enough on borrower capacity, new mortgage product risk characteristics, and economic cycles. CCAF would have provided early warning of the dangers because it provides forward-looking analyses and does not rely on the premise that the past determines the future. CCAF effectively signals deterioration in underlying instruments and considers a far broader range of possible future outcomes. Further, it identifies growing risk concentration exposures and emerging delinquency and default trends early on in the process to allow the course of events to be altered for the better.

The new lending system we propose represents a departure from the status quo, and may seem a bit unfamiliar and complex. There is a natural tendency for people to confuse lack of familiarity with complexity. In reality, the proposed new lending system will actually simplify today’s current underwriting processes, and make them more consistent, effective, and transparent. As with any solution, the “devil is in the details.” In this book we do more than describe a framework that provides sufficient context to address the problem. We take it a step further to specify how the framework works, with extensive examples throughout. The new lending system offers an alternative to the current way of doing business that will benefit borrowers, lenders, and investors. It will ensure that the true credit risk is captured and the loan product chosen in order to maximize affordability over the life of the obligation. CCAF can help prevent future financial disruption and can be easily modified for loss mitigation for loans facing foreclosure and for reevaluation of securities backed by those loans. We hope the new credit system described in the book will meet with acceptance and help bring about the changes that are needed to strengthen today’s credit system and restore confidence.

ORGANIZATION OF THE BOOK

Chapter 1, Unpacking the Financial Crisis. This chapter provides an overview of the current financial crisis and its implications. We first survey opinions and theories about causes and perpetrators. We trace the root cause to weaknesses in loan underwriting practices and lending systems, and identify the main drivers that undermine borrowers, lenders, and investors. We discuss the fallout from various perspectives including all key participants. Clearly, the current lending system needs a major overhaul.

Chapter 2, The Case for a Comprehensive Credit Assessment Framework. In this chapter we explain why a new generation of lending systems is needed. We first provide a historical review of credit market developments and point out areas where a comprehensive risk assessment framework can help. We next provide a system overview and describe the main components and interplay of this new system. Various examples are provided to demonstrate how this framework can improve the current lending system with respect to transparency and accuracy.

Chapter 3, The Lender and the Underwriting Gap. This chapter describes the notion of the underwriting gap and how it affects lenders’ underwriting practices. We first define and identify the gap components and explain how each of them contributed to the flaws in the current system. In particular, we describe typical issues associated with credit scoring models and how improper use of credit scoring in underwriting leads to underestimation of the borrower’s credit risk. We describe how the new system addresses and closes the underwriting gap.

Chapter 4, The Borrower and Loan Affordability. This chapter describes how the current lending system fails to address loan affordability. We provide detailed examples of different kinds of loan products and borrowers and how interests are better served by this new system. The added transparency afforded by CCAF will boost borrowers’ financial literacy and improve their credit standing and loan performance.

Chapter 5, The Investor and Financial Innovation. This chapter addresses how mortgage and capital market financial innovation relates to the crisis. In particular, we examine the connections among borrowers, lenders, and investors, and explain how transparency was lost during the entire process from loan origination through securitization and rating, and finally through sale to investors. CCAF is used to reestablish the connections by bringing greater transparency via effective monitoring of the performance of the underlying assets. As a result, investors are better informed about the risk of securities derived from loans.

Chapter 6, Crisis Intervention and Prevention. This chapter discusses how CCAF methodology enables development of an effective loan monitoring system for crisis intervention and prevention. We demonstrate how this monitoring system can benefit investors, borrowers, rating agencies, and lenders. We also discuss how CCAF can help government agencies anticipate lending problems through enhanced risk indicators and reporting systems. We end the book with our vision of a future credit system within a global context.

AUDIENCE FOR THE BOOK

This book is a valuable reference for borrowers, investors, and lenders who seek a better understanding of the weaknesses in today’s loan underwriting and how they are impacted by them. Armed with this information, readers will be able to recognize and better cope with those weaknesses so as to achieve their financial goals. Some ways in which this book can benefit a particular audience include:

• Borrowers, who will better understand the loan underwriting process so they can spot predatory lending tactics and avoid unsuitable or overpriced loan products

• Lenders, who will more deeply understand the consequences of loan underwriting flaws that result in high risk concentrations and losses

• Investors, who will better understand risks associated with the mortgages that back their investment security and how those risks affect the performance and value of their investment

• Regulatory agencies, who will more proactively spot issues using new monitoring methods and technology

This book is also a valuable reference for use in developing countries where credit products are rapidly evolving and the need to avoid financial disruption is pronounced.

CLARK ABRAHAMSMINGYUAN ZHANG

CHAPTER 1

Unpacking the Financial Crisis

A problem well-defined is half solved.

—JOHN DEWEY, EDUCATIONAL PIONEER

In September 2008, the subprime mortgage crisis emerged as a global economic crisis that rocked the world’s financial system and triggered responses from governments of many countries. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 was signed into law to provide for a troubled asset relief program (TARP). Under this program a $700 billion liquidity pool was made available to purchase or insure any troubled assets and to cover any administrative and custodial expenses associated with purchasing, insuring, warehousing, and selling those assets. Government officials felt tremendous pressure to take swift action because they feared that the global financial system might collapse. However, the global financial markets have remained unstable with elevated systematic risk indicators, despite some significant financial market adjustments through a series of interventions carried out by the U.S. Department of the Treasury and the Federal Reserve System. According to the Global Financial Stability Report (GFSR), the International Monetary Fund (IMF) estimates that losses on U.S. subprime assets and securities will total $1.45 trillion—more than 59% above April 2008 estimates of $945 billion.1 The crisis has caused the U.S. economy to continue to shrink. On October 30, 2008, the U.S. government confirmed that the gross domestic product (GDP) declined at an annual rate of 0.3% in the third quarter, the largest contraction in seven years, while consumer disposable income declined 8.7%, the biggest drop on record.2

Based on these and other facts, it is entirely possible that the $700 billion initial allocation will prove insufficient to accomplish what is needed. The fact is that financial firms face simultaneous pressures posed by a reduction in assets, difficulties in raising capital, and challenges associated with implementing new business models. Hence, it is vital that we first seek to understand what is going on (that is, what caused the crisis, who played an active role in bringing it about, and what processes and controls failed to prevent it from reaching its enormous scope and scale). Failure to define a problem fully before solving it can result in flawed strategies that waste precious time and resources. In the business world, we call these “Ready, Fire, Aim” strategies. Only too often, they occur when there is never sufficient time devoted to fixing things right in the first place, but always enough time to repair them over and over again. It is in this spirit that we devote this first chapter to surveying various opinions concerning the causes of the current financial crisis; its impact, consequences, and implications; and finally the role of loan underwriting, which we see as being at the core of the problem.