August 2008 Issue
With the economy in a freefall, the obvious challenge for creditors is to collect from clients that are feeling its effects. Most insiders agree this should mean more business, but the debt is much more difficult to liquidate.
With the luxury of hindsight, creditors know they paid too much attention to the past performance of debtors without considering their future prospects. This has proven to be a key contributor to the credit fallout, says Jeff Judy, principal of Jeff Judy & Associates, based in Bloomington, Minn.
Risk assessment is comprised of two principal components, Judy says, including the marketplace where the debtor operates and their performance within that environment. "What we have done is we have been looking at the debtors and saying, 'They've had good performance in the past, I'll bet that it will continue,' " he says. "No one has thought about what might change."
Tally Ferguson, senior vice president of risk management at the Bank of Oklahoma in Tulsa, Okla., says recent economic events will push lenders to consider the contagion effect – where one portion of a market, such as single-family subprime mortgages, spills to create problems in another segment of the same market, such as mortgage-backed securities.
"I think risk managers around the country, certainly in the financial world, are probably looking to form some kind of contagion measurement, and to take stress testing perhaps a little more seriously than they had before," says Ferguson, who is careful to point out that the Bank of Oklahoma did not deal in subprime mortgages. "Anyone doing risk assessment from a credit perspective needs to aggregate these sources of exposure for the same counterpart. Only when you do that can you really see where your exposure is going to be."
David Ruffin, founder and partner at Credit Risk Management LLC, a Raleigh, N.C.-based provider of credit services to banks and lenders, notes that the blame for recent events tends to be placed on how the risk was priced – a misnomer, in his opinion. Ruffin believes that the root of the problem lies in how risk was quantified.
After all, he says, you cannot get to pricing without quantification.
With mortgages, he adds, decisions were based on credit scores and rating agency grades for the bundling of securitization. "The traditional elements of underwriting were ignored – whether they involved documentation of income or issues related to stability in a job, the types of collateral and anything deeper than a credit score," he says. "The lack of quantification of risk is endemic to the entire banking community right now because of good times and there was a presumption that traditional underwriting was too much of a drag on productivity."
The problem with credit scores, Ruffin says, is they do not take into account a client's balance sheet, liquidity or secondary source of repayment. "Most of the consumer purpose-loan decision-making – and that was mainly mortgage – basically ignores a balance sheet or a secondary source of repayment," Ruffin says.
Relying too much on credit scores alone leaves little room for true judgment, Judy adds. "We are building a generation of bankers that know what the number is because they used a computer to get to that number, but they don't know what went into generating that outcome," he says. "If they don't know what went into generating an outcome, how can they possibly analyze what the risks might be?"
Ruffin believes underwriting should not simply be regarded as a risk management tool but also as a marketing tool. Practicing strong underwriting means that a lender understands the product being sold and is selling the appropriate product to a creditworthy customer. "The inability to underwrite means that you are throwing product out there blindly, without really knowing what you are selling," he says.
The employment of database and spreadsheet technology is necessary, however this should be complemented by more traditional concepts, Ruffin says. "There are more systematic ways of doing it within a bank – of having more centralized analytical functions that help to not be such a drag on productivity," he says.
The danger of too much centralization, however, can lead to underwriters who are hard-pressed to use the basic skills associated with risk assessment. "The big bank strategies have been, for several years now, to centralize and black box credit underwriting so that there is less classically trained credit talent in banking today than ever before," Ruffin says.
This business model, he concedes, is understandable thanks to the cost pressures that larger institutions must handle. Still, these organizations will have to inject a more human element into the equation. "Even the big banks are going to have to go back to using some judgment, in terms of having a human call in this thing, rather than accepting that somehow a model can completely handle it all."
This is where community banks tend to differ, Ruffin says, because the lender has more ownership of the underwriting. "The reason so many community banks have flourished – particularly in the small business arena – is that ability for the banker and customer to interact and understand that there are differences and nuances around a particular credit decision," he said.
At Bank of Oklahoma, Ferguson says his organization's fundamental risk assessment procedures are largely the same as they were 20 years ago. What is different is the attention the bank pays to the potential credit exposure of their customers.
"That exposure isn't just a loan anymore: that exposure could be a line of credit that they may or may not use, or it might be in the form of securities," he says. For example, the bank might be selling securities that the customer is not immediately paying for. Or, they may be paying cash based on the value of the securities, and the bank will repurchase them at a later date. Some clients sign up for derivative contracts to protect an interest rate, an oil price or a foreign currency value.
"All of these have credit exposures to them," Ferguson says. "Now, when we look at underwriting, we have to add a component that speaks to exposure. All of a sudden, exposure isn't just how big is the loan? Exposure is, how under water can the customer get from this transaction?"
In analyzing exposure, risk managers are well positioned to discern the potential for grave losses and whether or not their organizations are equipped to handle them. "The financial markets have a habit of moving toward taking a greater risk little by little, and then all of a sudden pulling back a lot," Ferguson says. "I think that the risk managers of the financial world will give better credence to stress testing and looking at what can go wrong, then apply something like a concentration limit by counter party or type of business, and making sure that they can digest losses."
Still, Ruffin says, there is a need for better training – practices that emphasize the basics of what underwriting is about. "The lack of training out there is at a crisis level and we have a lot of bankers who were classically trained and are aging out of the industry."
"We need to go back to the basics," says Judy, noting that he often encounters professionals in classes he runs who are ill-equipped to recall the fundamental formulas involved in risk assessment. "How do I do a current ratio? How do I do leverage? How do I do receivables day's turns? How do I do inventory day's turns? Let's get back to the numbers."
In reapplying underwriting concepts, lenders can avoid what Ruffin calls a pack mentality, where the entire industry reacts to events – either positive or negative – that drive it to take a broad-brush approach to decision making. "You can only do that when you discern, customer-to-customer, through the ability to underwrite well and understand: this customer has this risk profile, and that customer has that risk profile, and therefore I can go with A but not B," he said. Institutions must accept that basic underwriting is necessary, but it doesn't have to be overly laborious or inefficient. "You've got to go back to that approach of understanding who you are dealing with."
As companies reexamine their risk assessment procedures, the challenge will be to implement effective processes that are generally accepted in the marketplace. "The problem with having the perfect underwriting standard is that if no one else has it and everyone else is wrong, they will price you out of the market and you're out of business anyway," Ferguson conceded. "You've got to be able to play in the market and be competitive, even though the market is wrong."
Ruffin predicts that in the coming months, a divide will emerge in the community banking sector between banks that can find opportunities and those that will not – and much of this will depend on risk assessment.
"Those that can take advantage of this problem will be those that are intellectually honest about their problems, accept that time is of the essence in identifying their problems and using more probative risk management tools to detect their risk pockets," he said.
Banks that rely on historical gauges of portfolio management do not stand as much of a chance to gain ground. "That is all in the past. That is all about the last quarter or the last year. It's not using probative tools to figure out what's next in your risk assessment. The divide between the banks that are intellectually honest versus in denial will make the difference between those that can capitalize on opportunities – because I think there will be a lot of opportunity for consolidation and growing franchises in the next two years as a result of all of this – and those that can't." CCR