Re evaluation of risk models

The current credit crunch in the United States is becoming increasingly contentious. Fingers are being pointed in multiple directions. The problem involves ordinary citizens, commercial, investment and mortgage banks and the government. However, technology has reshaped the face of the corporate world in a positive way, but the misinterpretation and inefficiency of technology could be met with drastic consequences. The issuance of mortgage-backed securities (the foundation of this credit crisis), which was recklessly sold to the homebuyers, uses a credit assessment system to determine eligibility for these securities. While these securities were recklessly issued, the scoring assessment models were inadequate and as a result, have misled the banks by excluding a host of risk factors in the determination of the FICO score.
In the article titled “The reverse reengineering of risk”, Clark Abrahams explains a new credit scoring system used for evaluating credit risk - The Comprehensive Credit Assessment Framework (CCAF). The CCAF “uses advanced technology and a safe sound model to develop and validate scoring processes. It considers all primary credit factors and takes appropriate action relative to those assigned segments. It also monitors the implications of these actions in a comprehensive and efficient manner”. It does this and distinguishes itself from the old system in such a way that it considers secondary factors, such as good consumer behavior, which could include payment of utility bills. It also factors a borrowers capital. Borrowers with a lot of debt and a lot of capital will be placed in a different category as someone with a lot of debt and no capital. Next, cash basis customers who save will no longer have subtle terms compared to installment debt carriers. Bank balances and a history of deposited savings will now be built onto the risk model using the CCAF. In addition, the CCAF will now take action in each scoring segment that allows the lender to determine what loan product the borrower will be successful at paying off and what he or she could afford. Furthermore, it possesses a feedback mechanism that considers macro economic conditions in the society such as interest rates, unemployment rates, inflation and housing price escalation to determine who qualifies and under what condition. Finally, while the old system looks at the past, the CCAF looks at the future and determines the worst-case scenario when economic factors come into play. For example, if interest rates go up, the CCAF determines the lowest possible default a borrower can issue, considering the concomitant rise in inflation rate. This is a powerful tool for the risk management division of banks.
On the other hand, some may argue that this new system while building a lot of new segments and factors in its model could lead to unfair lending. This may be the case; however, it may be necessary in issuing complex and expensive securities, such as mortgage securities. This new system may be seen as non-profitable in the short run, but will allow stability in the long run. It will not just influence people on how to save and manage money, but will also influence banks to realize the necessary elements and conditions that allow for ability to buy a risky security. This new carefully developed credit model may not be the solution to prevent another crisis. Human factors also need strong attention. At the end of the day, the bankers themselves say whether a loan could be given or not, in which greed is a large component of their decision. Combining a sound judgment with a carefully structured credit risk model will prevent another sub prime mortgage crisis from happening and will also stress the importance of technology in the economy, especially in the banking industry.


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