Three Behind-the-Scenes Lending Observations

By Michael Cochrum, CUBI.Pro

When I was a junior in high school, my school’s marching banding, The O’Fallon Township Marching Panthers, was invited to march in the Orange Bowl Parade.  Band geeks around the world, like me, understand what a prestigious honor an invitation like this is.  It is equivalent, or more, to a state championship for an athletic team.  It’s a really big deal.  I have no real memory of most of the parade, however there are two things that do stand out in my recollection of this trip.  First, I remember being behind the Budweiser Clydesdale horses in the parade, which adds a level of complexity to making it through the parade with clean shoes.  Second, I remember our backstage tour of Walt Disney World on our trip back home to Illinois.

Few visitors to Walt Disney World ever have the opportunity to go ‘behind the wall’ and learn how Disney manages to make a family’s trip to their park so seemingly miraculous.  While this was an interesting tour, I’m sure that even our ‘all-access’ tour didn’t really give us the complete picture of what goes on behind the scenes.  I suspect that you have to be a true insider to get the full picture of the grand production that is Walt Disney World.  There is a real advantage to having access to information that others do not.

In my role as a credit union data analytics consultant, I get ‘insider’ access to credit union loan performance data.  While I would never tell any specific credit union’s secrets, there are some things that I’ve seen consistently from credit union to credit union that one might find interesting.  So, I thought I would share some portfolio performance ‘secrets’ that you may find beneficial.

The Significance of a Co-Borrower

When I interview credit union lenders about the value of a co-borrower, the reaction I get, most often, is that co-borrowers do not add much value to the quality of a loan.  Many lenders form their impressions of co-borrowers based on their experience with co-borrowers once a loan has defaulted.  Often, when a loan defaults, co-borrowers are not very helpful in recovering the loan loss.  So, it is probably true that bad co-borrowers do very little to help recover losses on a defaulted loan; however, I have found that good co-borrowers have a significant impact on loan performance overall.  In fact, I have found that, when a loan has a co-borrower, the likelihood of default is as much 66% less.  This could be the same as the difference between a borrower with a 680 credit score and a borrower with a 720 credit score, depending upon the credit score model a lender is using.

What is interesting, very few credit unions offer a pricing differential purely due to the fact that a loan has two borrowers versus one.  In a risk-based pricing environment, pricing of loans is supposed to be based the risk that the loan will default and result in a loss.  If one loan is 300% more likely to default than another, there is a strong argument that the two loans should have a different price.  I’m not suggesting that the lender should simply price the loan based on the better credit score, but that a loan with a co-borrower should have a lower price than a loan without, even if the best score on both loans is exactly the same.  With this insider knowledge, is it possible that a lender could originate more loans with lower risk if they were able to price the loans appropriately?

Low Debt-to-Income Ratios

Most lenders I work with have a maximum debt-to-income (DTI) ratio threshold between 35 and 45%, depending upon how it is calculated.  Borrowers within this range tend to perform as predicted and certainly borrowers with DTI’s that exceed this threshold tend to perform less favorably.  But, what is interesting is that I have found that borrowers with DTI’s between 0 and 20% often perform considerably less favorably than borrowers with higher DTI’s.  This can be problematic because there is a basic assumption that the lower the DTI, the more discretionary income a borrower has to repay a loan.  But, a low debt-to-income can also signal low debt experience, not just for first-time buyers but also for reluctant borrowers, or those that do not make use of their credit lines.  Mature borrowers, or those who carry moderate debt over a long term, have experience managing debt.  It is important to understand the full significance of a low DTI ratio and not simply assume that a resistance to debt is a good indicator of performance.

Long-Term Loans

If you were to survey lenders across the country, I believe that many lenders will say that longer-term loans carry higher risk, not just because of interest rate volatility, but because the longer a loan is ‘on the books’ the higher the probability is that the borrower will default and it is likely that the collateral will have depreciated to a point that it is not adequately securing the loan.  You might be surprised by what this ‘insider’ has found.

When comparing 72-month and 84-month auto loans, our analysis has found that there is very little difference in the average number of months the loan is in the portfolio, between 30 and 33 months.  One can assume that the pay-off rate of the loan has to do with something other than the loan term, perhaps consumer demand for a newer vehicle.  Another interesting observation about longer term loans, in general, is that they tend to default less often than the shorter-term loans.  One could assume that this is due to affordability supported by lower payments.  However, one interesting finding sheds additional light on the differences in performance based on loan term; if a longer-term loan does default, it tends to do so earlier in the life-cycle of the loan than a shorter-term loan.  This is important because less of the origination costs have been recouped at this earlier stage of the loan’s life-cycle.

Often, longer terms loans will be priced higher based solely on the perceived risk related to interest rate volatility and increased probability of default due to repayment speeds, but if the foregoing is true, this is probably not the right argument.  In some cases, one might even seek to encourage the right borrowers to take longer term loans, with equivalent or lower pricing, as it provides the borrower with a safety valve in times of economic stress and the overall probability of default is lower.  However, this strategy would need to be targeted at the right borrower with the right collateral.

As every amusement park is not like Disney World, for good and bad, every credit union is not the same.  Therefore, one should not assume that these observations would be true in every lending environment.  The purpose of this article is to simply highlight that what seems to be true on the surface may not always be true once you dig a little deeper.  This requires testing long-held assumptions which involves analyzing data.  If you are not able to do this level of analytics on your own, CUBI.Pro can help.  Check us out online at www.cubi.pro for more information.

Contact Michael Cochrum at michael.cochrum@cubi.pro or at 972.814.1477