3 C's of Credit

It has been estimated that I've made credit decisions on somewhere between 20,000 and 30,000 individual transactions throughout my career in the lending industry; therefore I feel qualified to speak to this subject. Internally I have followed this simple guide upon reviewing a complete credit report: "An applicant is acceptable if they have a satisfactory credit history with no recent significant credit problems" because, if the customer can't pass that standard, it's unlikely I would ultimately find them qualified to receive an approval.

When you are reviewing a loan package for approval consideration, if for example, you are a mortgage broker or a mortgage banker (who 'originates to distribute' servicing released) your thinking is quite different - but it shouldn't be - from someone who is a portfolio lender and/or a mortgage banker seller/servicer - as in both of the later cases you're with those lending decisions to the conclusion of their repayment term; it's not 'you're approved then buh-bye' instead, your own future career is on the line, as are the subsequent efforts it may take to collect all of the monthly payments, along with avoiding losses, in the final analysis. So if you're among those first two groups, time to change is long overdue, because that 'cyborg approach' is precisely what has caused the collapse of the secondary market.

These days credit decisions are arrived at utilizing credit scores, and matrixes of scores vs. LTV vs. DTI ratios and also by utilizing 'adds' to the buy-rates for perceived increased risk. Unlike the more common sense methods above, where getting back the payments was a paramount consideration, today Wall Street's commission-driven computerization approach, and often arbitrary 'adds' plus pushing the paper/and risks down the street (or overseas) to the next guy, has clouded this subject to a considerable degree in my judgment. They may argue it's usage is justified do to a range of increased production needs, but it has spawned reckless lending programs, and almost no common sense to approval decisions.

This issues of unrestrained 'adds' to the buy rate has puzzled me for almost two decade, since the Wall Street investment bankers and others have been slicing and dicing what they call 'risks.' I've often wondered as you may have as well, do they mean risk of potential loss or risk of reduced/delayed income because of increased servicing activities and expenses? For example, we intuitively know there is both an 'increased risk of loss' and additionally an 'increased risk of extra expense to service' a non-owner occupied property vs. an owner occupied one; but should that difference increase the 'coupon' by as much as 200 basis points? Or, a 50 basis point spread on duplex vs. tri-plex or four-plex, or how about 25 basis points for an impound waiver? Having also been a FreddieMac seller/servicer myself, and knowing the internal numbers as the owner of the company ... I can tell you, NO is the real answer to those questions. Now, I'm sure somebody could try and baffle me with stats, but nope, those pumped-up annual interest rate amounts I frequently see on 'rate sheets' are much too high for these variances. 'Too high' translates into extra profits, or seen from the other side, rates higher than they need to be for consumers, thereby increasing the risk of DTI's chocking the customers in short order, and creating an unnecessary extra risk of default. You see, it can easily be argued from either viewpoint.

The Three C's of Credit are simply: Character, Capacity, and Collateral all considered together with a heavy dose of common sense.

Acceptable Character is basically a detailed line-item analysis of the credit report of an applicant, along with their stability of residence, occupation and employment. On balance, there is a scale here, from top-notch 'gold plated' all the way down to 'lousy.' The further away from lousy, the stronger this segment is. FICO completely misses much of this Character area. And this one is considered most important by many long-experienced consumer credit grantors (like me BTW).

An applicant's (proven verified long-term historically stable) Capacity to good lending decisions is critical, as it is essential that any new customer have the ability to repay their debts. The Character segment's relative strength tells us their willingness to take care of their obligations in an acceptable manner. Capacity measures their ability (whereas Character deals with their desire to make payments on time). Can they afford it is the question to be asked here. For this area to be acceptable, a likely reliable and steady available future income stream is essential so the customer has the funds to make timely payment.
The Collateral, which secures the transaction, is the third of the Three C's. Obviously, the more security, which collateralizes the loan the better, and the stronger, this piece, will be. This segment is thought of by many however, as the least important area of approvals, as it can lose value and, upon default is not always of satisfactory quality/marketability, or accessibility.

With two of these segments strong, and only one weaker, even though not ideal, it can still be an adequate formula for a more 'conservative' loan approval. If two segments are weak, that is generally a recipe for disaster. Having all three fragile at origination, barring a miracle, it's most certainly a future loss.

These are the principles, which yield tolerable loss ratios and maintain a sound-lending environment, both for today and tomorrow. When these time-honored standards are not followed, chaos is the outcome. And sometimes it comes at warp speed!

Article by Peter Samuel Cugno, Chairman & CEO of Secret! University, the educational division of Americas Money Center, Inc. with 40+ years experience in the subprime industry niche; today an industry Teacher/Mentor. Questions or comments may be directed to Peter 310-833-4068 or online at: http://www.americasmoneycenter.com