S6 Ep4: The Nuances in Credit Underwriting that Most People Miss with Frank Rotman
Jan 31, 2024
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Frank Rotman, Chief Investment Officer at QED Investors, shares insights on credit underwriting, cashflow underwriting, alternative data, payment protection insurance, and the future of fintech. They discuss distinguishing willingness to pay from ability to pay, accurate pricing of risk, explaining declines, American mortgages, predatory lending, and innovating credit and insurance delivery.
Credit underwriting involves assessing different dimensions such as ability to pay, willingness to pay, stability, and collateral for accurate decision-making.
Regulations like Reg B can make underwriting challenging by restricting the use of certain data sources correlated with protected classes.
Cash flow underwriting provides insights into borrowers' financial management but may not capture long-term stability and predictability.
Aligning lending programs with borrowers' repayment capacity is crucial to avoid loans that are known to be unaffordable.
Deep dives
Importance of Understanding Credit Underwriting Dimensions
Credit underwriting involves assessing multiple dimensions including ability to pay, willingness to pay, stability, and collateral. These dimensions help determine a borrower's creditworthiness. While willingness and ability to pay are often the primary focus, neglecting stability and collateral can lead to oversimplification and flawed assumptions. For example, relying solely on ability to pay without considering stability may overlook factors like job stability, cash cushion during emergencies, or past repayment behavior. Considering all dimensions is crucial for accurate underwriting decisions.
Challenges and Complexity of Regulated Underwriting
Regulations like Reg B aim to prevent discrimination and ensure fair lending practices. However, they can also make underwriting more challenging. Reg B restricts the use of data directly correlated with protected classes. It also prohibits disparate impact, where models unintentionally result in different outcomes for protected classes. These regulations can limit the use of valuable data sources and make it difficult to develop sophisticated models. Striking a balance between regulatory compliance and accurate underwriting is a complex task for lenders.
Cash Flow Underwriting and Its Limitations
Cash flow underwriting, which entails analyzing a borrower's cash inflows and outflows, is an innovative approach. It provides insights into how individuals manage their finances and handle various economic situations. Cash flow data can be highly predictive for short-term loans and offer a current snapshot of a borrower's financial situation. However, cash flow underwriting has limitations for longer-term loans. It may not capture the full picture of stability, cyclicality, or predictability needed for assessing borrowers' ability to maintain financial obligations over an extended period. Consideration of historical credit performance and broader economic cycles remains crucial in underwriting decisions.
The Predatory Lending Issue and Government Student Loans
A thought-provoking observation is that lending to borrowers who are likely to fail is a key characteristic of predatory lending. In this regard, government student loan programs might be considered the largest predatory lending program due to the advance knowledge of many loans being unaffordable based on future income projections. While structured as a social program, if evaluated under traditional lending principles, these loans could be seen as predatory because borrowers are expected to make repayments that may not align with their ability to pay. This highlights the importance of aligning lending programs with borrowers' repayment capacity and avoiding loans that are known to be unaffordable.
Prediction 1: Refactoring the Stock Market
The stock market will undergo a complete overhaul in the way it operates due to the acceleration of AI-driven trading. The traditional game of buying and selling stocks, in which human traders rely on limited information, will be disrupted by AI bots that can make faster, more accurate decisions. This shift will lead to destabilization, potentially requiring a complete rethinking of how the stock market works.
Prediction 2: Refactoring Cost Structures in Financial Institutions
Financial institutions will completely refactor their cost structures, driven by the adoption of AI. With the rise of digital banking and fintech companies, the traditional cost structures of banks, heavily reliant on physical branches and outdated processes, will become inefficient. This transition will result in significant job transformation or displacement, particularly for roles that can be replaced or augmented by AI technology.
Prediction 3: Perfect Discovery and the Rise of Stablecoins in Money Movement
Perfect discovery will become the norm, facilitated by the use of stablecoins in money movement. With the advent of blockchain-based stablecoins, friction in moving money between banks, currencies, and countries will be greatly reduced. Stablecoins, backed by fiat currencies, will power the rails of money movement, eliminating the need for interbank settlement processes and currency conversions. This shift will have significant implications for cross-border trade and may lead to stablecoins becoming the currency of choice for global transactions.
Frank Rotman, Chief Investment Officer at QED Investors, makes his triumphant return to the podcast to share his wisdom on all things lending. As the first Chief Credit Officer at Capital One (before this role officially existed), Frank has an incredibly rich and nuanced perspective on topics like cashflow underwriting, the value of traditional credit data vs alternative data, and payment protection insurance.
In this conversation, Frank and Alex break down the importance of distinguishing willingness to pay for a loan from the ability to pay for a loan when assessing creditworthiness and wax poetic about what possibilities fintech might be missing out on when it simplifies the credit building down to these two characteristics.
And stay tuned because later, Alex asks Frank for his predictions for the future of fintech and financial services and Frank’s answers are unlike any other predictions you’ve heard!
00:00:53 - From Lending to Writing: Frank's Journey
00:03:05 - The Nuance of Credit Underwriting
00:09:21 - Building Sophisticated Underwriting Models with Capital One
00:36:38 - The Unique Marvel of American Mortgages
00:49:10 - The Truth About Predatory Lending
00:55:18 - Innovating Credit and Insurance Delivery
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