Are We Underwriting Correctly?

by:  Shari Storm

(authors note – the views expressed here are NOT the views of my employer, Verity Credit Union)

In September, I attended the Washington Credit Union League conference. One of my favorite sessions was a panel facilitated by Frank Diekmann. The panelists were James Kwak, co-author of the book 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,  Ben Rogers, research director at Filene Research Institute and Michael Steinberger, associate dean, Western CUNA Management School.

Toward the end of the discussion, Frank asked the presenters what the last few years have taught them.

James Kwak gave, what I thought, was a fascinating answer. He replied, “That we can’t rely on credit scores to evaluate credit worthiness anymore.”

I thought it was fascinating because just a few weeks before, I had burst into my boss’ office and said the exact same thing. What made me so passionately argue this fact with the CEO of my credit union?

A trip to Costco.

I had just learned that there was a possibility that my book might be featured in Costco Connection. Since that newsletter goes out to 8 million households, I wanted to make sure I hadn’t let my membership lapse. As I was standing in the bustling Costco, upgrading to an Executive Membership, the Costco employee asked me if I wanted to apply for a credit card.

My mind raced. Do I want to apply? I would probably be turned down. But maybe having their credit card might make me a better candidate for the newsletter? I must have been nodding my head while I was debating with myself because she said, “OK, it will just be a minute.”

I started to sweat as I waited. This was 2009. My husband had been “underemployed” that whole year; making less at his freelance job than we expected. Our daycare bill was almost $30,000 annually and I had borrowed from our 401(k) to pay off some of our student loan debt.

“Alright! You are approved for a $3,000 credit card. “

I couldn’t believe it. But the more I thought about it, the more it made sense. My credit score has always been in the high 700’s.  A credit report doesn’t capture reduced income, non-reported loans nor high expenses. All of the things that make me a poor credit risk are not captured on a credit report. And that’s not good.

Enter Robert Manning. Dr. Manning, director of the center for consumer financial services at the Rochester Institute of Technology, devised an algorithm that statistically estimates the net return to creditors. In other words, instead of relying on a score that only reports past performance, he designed a way to predict future returns. I listened to him present when I was on Filene’s i3 team. Putting it over-simply, his program determines a person’s cash flow.

There are two types of scenarios that credit scores do not protect us against.

The first is the member who has had a long period of unemployment. They have not been able to pay their bills for a few months and they went delinquent. But now they are employed and are current on all obligations. They now have the capacity and the character to repay the credit union, but the credit union will not grant them credit because of a low credit score.

The second scenario is the member who has pristine credit rating, but is not making ends meet. They are robbing Peter to pay Paul. They have huge expenses, like daycare, that makes them struggle to pay bills every month. They have not been late yet, but any minute, their house of cards will crumble. The credit union will grant them more credit because of their good credit score.

In both scenarios a cash flow analysis would be a great assistance.  It would tell you that the first person will pay the credit union back and the second person cannot. I remember when our credit union was implementing business lending. The mantra of our consultant was “Cash is king. Collateral is crap.” Are we to a point where “Cash is king and credit scores are crap?”  Probably not. But I do think that running a second analysis on each credit applicant, using Robert Manning’s tool, would help credit unions underwrite better. I think it would further help them avoid risk and keep them from turning their back on a viable member opportunity. 

Underwriting is still a huge issue for all financial institutions. Until the crystal ball is invented, I think credit unions would benefit from taking a look at what Robert Manning has to offer.

Shari Storm is Senior Vice President and Chief Marketing Officer of Verity Federal Credit Union and is the author of the book ‘Motherhood is the New MBA”, available here.

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5 thoughts on “Are We Underwriting Correctly?

  1. While there is always room for innovation in anything, I believe that lenders must walk a tightrope when it comes to underwriting. Fair Lending is a huge concern. Reg. B and the ECOA have been around for a long time and there is a lot of case law that’s been generated over the years. This creates some hesitancy to embrace something that’s untested in the courts with respect to discrimination. Even though credit scores aren’t perfect, at least lenders can rely on them to some degree without fear of getting sued.

  2. I spent a lot of years in the lending arena – prior to spending 20+ years in CU world, I started out of college at HFC. First thing I learned was that credit granted would be based upon 2 primary “C”s – capacity and character. In other words, did an applicant have the ability AND intent to repay. Collateral was a distant third consideration and was taken into consideration only to determine pricing (secured vs. unsecured credit) and loan amount (LTV). As one of my first bosses said “I have never seen a car write a check”. Credit scores were a quick and easy way to get away from doing true underwriting – a shortcut. Shari, both of your scenarios noted above are indicative of the potential problems of a short cut.

  3. @Rob – I agree it’s in everyone’s best interest – credit union and consumer – for underwriting standards to be fair. If an institution applies Manning’s tool consistently across all loan applications and uses the information in a uniform way, it’s hard to argue that it would be unfair. It might even protect the recently re-employed.

    Underwriting tools also need to be highly predictive. That is also in everyone’s best interest. That is why I like the idea of using this along with credit scores.

    The one criticism with my suggestion is that it eliminates efficiencies. It would require both the consumer and the credit union to do more work. The days of instant loan approval would be gone.

    Would I be too radical to suggest that a slower money lending process might also be better for the credit union and the consumer?

  4. interesting points Shari. this could be one of the many ways credit unions could differentiate themselves. Wouldn’t have to be all-in on the slow money approach, but a segment of your loan portfolio takes a different underwriting approach. Good thinking

  5. Pingback: More On Underwriting. « That Credit Union Blog

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