Unpacking the financial crisis
Struggling to understand the widespread and complex causes of the credit market crisis? Looking for a fresh new remedy? Read this excerpt from the timely new book, Credit Risk Assessment: The New Lending System for Borrowers, Lenders and Investors.
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.
How did we get here?
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 a 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 an 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 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 is 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 be met with acceptance and help bring about the changes that are needed to strengthen today’s credit system and restore confidence.
This article is from the book Credit Risk Assessment: The New Lending System for Borrowers, Lenders and Investors by Clark Abrahams and Mingyuan Zhang. Copyright 2009. Published by arrangement with the authors.
WHAT THE EXPERTS ARE SAYING
This story appears in the Third Quarter 2009 issue of