Turmoil in the capital markets and significant increases in the cost of funds have led mortgage lenders to look again
at their underwriting and pricing policies for consumer credit. Criteria that worked well just six months ago are no longer effective.
This article examines how the changing capital markets have affected credit and specifically consumer price response.
Our analysis suggests that consumers now know that they need to shop for credit across a number of sources, are willing to accept higher rates, and show significantly higher conversion rates on approved loan applications.
Calculation of consumer price response for credit is a relatively new concept that has been driven by the desire of banks to perform better in the areas of pricing and profitability management.
Our research is based on work with consumer credit organisations in the US, the UK and Canada.
The beginning of the credit crunch is often cited as July 2007, when Bear Stearns’ funds collapsed and lending rates shot up significantly. However, as early as February 2007 our home equity lending customers in the US were seeing increasing delinquency rates on their 2006 vintages.
Banks were slow to react in the area of originations pricing and quantifying the impact of prices on delinquency rates.
A study we undertook in October 2007 found that average rates for home equity lines and loans, as well as rate dispersion across the market, had not risen significantly in the July/September 2007 period compared with prior months.
Similarly, we found no significant changes in consumer behaviour or price responsiveness in Q3 2007 compared with Q2 2007.
But it was clear that underwriting policies were beginning to tighten, with small but deliberate moves by each of the top 10 lenders in the US to curtail high LTV and low credit score lending.
Banks assumed the problem was limited to sub-prime consumers and attempted to reduce their exposure by tightening underwriting on new debts.
Consumers were slow to change their appetite as credit was generally available for consumers with a decent history. But under the surface they were more closely scrutinising their borrowing choices, giving greater importance to price in the face of growing uncertainty.
Throughout Q2 2007 and Q3 2007 the responsiveness of prime consumers to price for home equity loans increased. This indicated that lending sources were still plentiful for prime customers during this period. In contrast, sub-prime customers were starting to see the tightening of underwriting guidelines and the application to funded loan ratio increased from 5-1 to 6-1.
By Q1 2008 most US home lenders had scaled back their volume targets and instituted policies that eliminated no or low-documentation loans, loans at higher than 80% LTV and most non-conforming loans – for example, those that could not be sold to Freddie Mac or Fannie Mae. For some US lenders funding volumes for new home equity loans and lines fell more than 85% from Q1 2007 to Q1 2008.
The UK personal lending market had endured a longer run of low rates and abundant choice for consumers than the US but by the end of Q1 2008 rates started to go up, with an average increase of 67 basis points across the market.
Across our UK customers, we have observed an average 18% increase in take-up rates and a significant decline in res-ponsiveness to price.
To put changing customer behaviour into perspective, in Q4 2007 prices increased significantly as banks passed increases in the cost of funds on to consumers. Consequently take-up rates suffered. But in the first half of 2008 responsiveness to price dropped and take-up rates increased again.
In July 2008, we saw an average 78 basis point increase in APR in the UK consumer loans market combined with a 5% increase in take-up rates. This highlights the fact that pure risk-based pricing will cause banks to leave margin on the table and that rapid and consistent estimation of consumer price response through a pricing optimisation framework can generate significant incremental margin opportunities.
Similarly, UK mortgage lenders had started to tighten their underwriting guidelines, worried about increasing impairment risk and delinquency levels as well as the increasing cost of funds.
Average fixed mortgage rates in the UK went from 6.02% in Q1 2008 to 6.42% in Q2 2008. Based on our proprietary research in the UK mortgage market, consumers’ responsiveness to price had started to decline.
This is the best indicator of the decreased availability of credit and consumer choice and translated directly into an average increase in response of 12.5% to identically-priced refinance offers in Q2 2008 over Q1 2008.
Our analysis suggests that overall, consumers are now at a point where they expect to shop for credit across a number of sources, are willing to accept higher rates, and are showing significantly higher conversion rates on approved loan applications.
These are unprecedented times. Although we are unable to predict the impact of the final rescue packages emenating from Washington and London or the legislation that will ensue concerning consumer credit, what follow are some predictions based on our research.
Credit used to be taken for granted but now it is a privilege. We are seeing a significantly increased willingness among consumers to accept higher rates for credit. This represents a big opportunity for smart lenders equipped with pricing optimisation technology to increase net yield while selectively acquiring quality assets.
A short while ago there was an unconstrained supply of funding for retail credit through secondary markets that were eager to buy credit-based securities. This market has now shrunk dramatically. As a result the supply of credit is limited well below demand in the US and UK markets.
This means lenders will be able to charge an opportunity cost for providing credit above standard risk-based margins to those consumers to whom they choose to lend.
Pricing optimisation will allow lenders to allocate this opportunity cost in a way that is consistent with their goals.
Unless this is clearly analysed and managed, adverse selection will translate into higher losses for lenders. Traditional risk measures based on bureau or custom scoring do not pick up this increasing risk of adverse selection. Pricing optimisation technology enables lenders to quantify the impact of price on a consumer’s risk profile, and can help mitigate adverse selection.
For the UK and the US the past three months have seen the most rapidly changing customer behaviour ever known in the consumer credit market. To stay on top of this, many of our customers have increased the frequency with which they reprice. They are scrutinising and optimising their rates on a weekly basis.
With images of Northern Rock, Washington Mutual, Fortis, and Wachovia still circling the globe consumers are starting to consider the brand and financial stability of their bank when making decisions about savings and deposits.
With this decommoditisation of deposits and savings comes the opportunity to drive incremental margin through optimised pricing and segmentation strategies.
The key for banks to accumulate deposits to support lending without giving away the farm is the ability to make intelligent and targeted pricing decisions that are tightly aligned with their funding goals.
This is especially true for relatively strong banks that need to determine what to pay for deposits to maintain key relationships and build market share.
As the US’ Office of the Comptroller of the Currency, Office of Thrift Supervision, Treasury, Federal Deposit Insurance Corporation and Federal Reserve, as well as the UK’s Financial Services Authority and Bank of England move from their current fire fighting position towards deliberating about a new regulatory framework for the financial system, we expect to see regulation that governs retail credit originations.
This regulation could take the form of suitability and affordability guidelines LSfor consumer credit pricing including stress testing the consumer at the point of origination for various personal and economic scenarios.
It could also include tighter regulation when it comes to incentive compensation across the broker, dealer, and direct channels. Smart banks will invest in increasing the control, visibility, defensibility and auditability of their pricing and underwriting strategies.
These are challenging times but the basic business of banks – gathering de-posits and making loans – will not go away. As banks’ business models change we predict that these core operations will make up a bigger share of the balance sheet in the years to come.
With this, the importance of pricing as a key lever to manage business results will increase and smart banks will invest in approaches such as pricing optimisation and processes to lead the renaissance of financial services.