Many credit losses are caused not by unsound loan products or credit policies but by carelessly controlled loan originating.
Often, loan production is administered with the primary goal of minimizing operating expense and increasing production — irrespective of the impact on chargeoffs.
For instance, a large auto lender with many hundreds of dealers asked me to help reduce their losses. I found that they had never generated internal reports of profit, credit losses or even fraud losses broken down by dealer or groups of dealers (such as those for whom the lender's market share was low or high). This made it difficult to act against dealers, or against the lender's own representatives assigned to dealers, when their loan performance was poor.
In fact, no one could recall such an action ever being taken!
Yet it is the dealer who prepares the "loan application" for electronic transmittal to the lender. It is the dealer who sees original borrower documents. There is often little or no direct communication between the lender and the customer.
This lender had a dealer fraud department that had been cut by more than half when volume declined. (The number of dealers had not materially diminished.) No analysis supported the cutback. They figured it was too small a change for them to focus on.
The people who were responsible for approving, pricing and giving final approval to the loan files were compensated based upon the number and dollar volume of loans they bought from dealers. They were not held accountable for the performance of the loans they booked. Hence, they had nothing at all to gain from turning down a shaky deal, from holding out for an additional document or from wringing a concession from the dealer.
This points to one reason why indirect lending is inherently more challenging than direct lending: The lender's production or loan purchase organization is strongly motivated not just to capture the deal but also to maintain an easy relationship with the originator. The people who do this are not blamed for the losses they cause.
In the aftermath of the financial crisis, some major institutions have addressed the problem by simply shutting down or sharply contracting indirect mortgage channels — instead of making good even the obvious inadequacies in previous management of these channels. But this is not possible for auto lending — because direct auto lending has never been able to gain much market share against the dealers, who control the customer through the sales transaction.
The challenge in every case — mortgage, auto or other — is to design and enforce appropriate metrics and controls for originating loans based on an analysis of alternatives. Which element of the organization should do this?
Credit operations often fall in a crack between Credit — which is interested in setting policies rather than optimizing and enforcing procedures — and Operations, which wants to minimize costs and maximize throughput.
So the lender should assign specific responsibility and grant authority to assure that lax procedures do not cause fraud and credit losses; another department should audit samples of losses to check for holes in the dike.
In principle, tighter controls and higher standards for originations entail sacrificing some good loans in order to head off the bad. More rigorous operations often also require more spending. This can only be justified by demonstrating reduced losses.
But it may be worth giving up more than a dollar of loan margin, or spending more than an incremental dollar of operating expense, to reduce credit and fraud losses by a dollar. Loan losses have a disproportionate impact on equity value and tend to increase earnings volatility, as demonstrated during the past three years.
These trade-offs are easy to apply once we carry out an analysis to determine what we could have done to avoid these losses. Using a sample of old origination files for which performance over loan life is already partially known, we can determine the impact on loan revenues, credit losses and profit of alternatives that eliminate more of the bad loans. There may also be ways to improve results by accepting more applicants. Taking a sample of declines and obtaining bureau research samples will show what happened after these applicants obtained credit elsewhere, facilitating detection of opportunities to approve some of them. I've never encountered a lender who was already doing this — but I have consistently found that it can trigger increased production of good loans.
A case in point: Right now, it typically takes well over 30 days to approve a mortgage. This can include requirements for documentation that has no relevance to any risk that has ever caused significant loss. Achieve competitive advantage by finding ways to reduce this time without materially increasing the risk and with maximum leveraging of reliable electronic data sources. Correcting faulty credit operations can not only cut losses but also deliver more good loan volume.
