Credit Union Magazine recently featured an article titled “Analytics help Credit Unions Manage Portfolio Risk” by Twenty Twenty Analytics Senior Analyst and Blogger Alan Veitengruber where he explains how understanding the drivers of default risk and loss given default are central to managing your lending portfolio. Below is an excerpt from the article and the entire write-up can be seen here. Enjoy!
… Default risk (credit risk) normally is measured at the loan level, and is a rating that captures the likelihood that borrowers will not repay their full loans. That means the credit union may lose principle and interest payments if the borrower becomes delinquent.
Although credit scores act as the industry standard in quantifying credit risk, you may also want to consider these questions when building your default risk model:
• How much has the borrower’s credit score migrated since origination?
• Is there a co-borrower on the loan?
• Is the borrower currently delinquent on this or another loan?
• Bankruptcy navigation indexes or debt-to-income estimators.
Loss given default, measured in dollars, represents the value at risk if a default occurs. Loss given default risk is tied directly to collateral securing the loan and represents the recoverable amount if a loan is charged-off. This dovetails with an important distinction: a default on its own does not result in a loss.
To experience a loss there needs to be both a default and a collateral deficiency. A collateral deficiency occurs when the loan balance at default is greater than the value of the collateral.
To quantify your credit union’s loss given default, you will want to know:
• What is the current loan-to-value (LTV) ratio?
• If the borrower has a line of credit, what would the LTV be if the line was fully funded?
• If the loan is a second mortgage, is there a superior loan?
• What is the loan’s current default risk?
Intuitively, the loss given default on a high default risk loan can give you a measurement to understand how the risk in your portfolio is changing over time. This intersection is where your future losses are most likely to occur.”