Monday, October 6, 2008

Is analytics the answer to the downtrodden market?

These have been chaotic and difficult times for bankers. The mortgage crisis and subprime meltdown have touched every sector of the banking and financial community. It has also sparked an interest in figuring out how to avoid a similar meltdown, and how to quickly get an institution back to lending. A key to moving forward is for institutions to better understand the risks they are taking on when they buy or sell packages of mortgages or similar financial instruments. And the best way to do that is to use technology to get an in-depth look at risk across the portfolio or organization.

Today’s current credit challenge requires better optimization of risk adjusted pricing and returns throughout the organization. For both the firms and government regulators, predictive analytics and data integration will be a key tool in analyzing and determining the course of action for illiquid assets (i.e. toxic mortgages). The new risk management efforts that will emerge require technology that provides greater transparency. Despite banks’ high level of investment in response to Basel II and for risk management tools, there’s been little improvement in real transparency of risks.

To help avoid another crisis, next-generation modeling needs an infrastructure that supports greater awareness of the risks being taken on by business units. Specifically, it requires forward-looking components: analyzing risk within loan portfolios, the ability to “price” complex securitizations and derivatives, what if scenario analysis, combining credit and market risk factors, forecasting with stress testing combining credit and market portfolios and presenting a concise enterprise risk view with impacts to capital. Additionally, the ability to not only provide up to date “Value at Risk” calculation, but also the ability to cross correlate portfolio performance with other market factors such as equity performance and issuer risk will be critical. Full valuation capabilities on certain portfolios will also become a required practice. Portfolio risk and capital management modeling functionality are critical to estimate required levels of regulatory and economic capital to support the business strategy and risk appetite.

A recent report by the President’s Working Group on Financial Markets says there was a “breakdown in the underwriting standards for subprime mortgages,” an “erosion of market discipline ... related in part to failures to provide or obtain adequate risk disclosures” and “risk management weaknesses at some large U.S. and European financial institutions.” The breakdown dates to 2004. As the real estate market boomed nationwide, mortgages were granted, packaged and sold and then sold again. But as the Working Group pointed out, no one—not the rating agencies, the sellers or the buyers—had properly analyzed the risk involved. When the investments went sour, “firms struggled to determine the size of these exposures and their losses.”

Financial institutions do not need to put themselves in this type of risk situation. Excellent solutions exist to assess risk down to the individual loan. Equally important, banks with the most sophisticated risk management tools will weather this storm—and any future ones—with an increase in their market share. And as important as it is to avoid unnecessary risk, it’s equally important to deal with sour loans promptly, efficiently and with the best return possible. The same kind of analytics that help banks figure out who their best clients are can be tweaked to determine which loans are salvageable and which should be sold off quickly. Performance management and scenario modeling solutions currently used by leading-edge institutions can be leveraged to support risk analysis, loss mitigation, target marketing and fraud prevention.

Right now, there are few institutions that have a true sense of which loans will go bad and when. Sure, they’re sending out 30-day late or 60-day late payments. But how many employ forecasting tools to determine which of those receiving 30-day late notices will end up in default within six months? By examining a borrower’s past payment history, and bringing in data from credit bureaus and other sources, savvy institutions can automatically score loans to get a better sense of where they stand and take proactive steps to protect against losses. Institutions that do this will be in demand for their loan servicing skills by the investors who buy these bundled products.

For the purchasers of mortgage-backed products, a portfolio-level view of risk is also essential. Few financial institutions are employing tools to balance risk across portfolios. One of the nation’s largest credit unions, Wescom of Southern California, has recently begun doing this. It wants to bring the same rigor to credit risk management that interest rate management has received over the years. “We expect to more accurately assess how much current and future risk we have embedded in our individual loan portfolios and determine where adjustments may be needed,” says Ann Mendez, chief credit officer and SVP of Wescom.

The Working Group suggests that a government authority or market participants need to “ensure that global financial institutions take the appropriate steps to address the weaknesses in risk management and reporting practices that the market turmoil has exposed.” Can your financial institution afford to wait for specific regulations? Acting now can put you ahead of the next financial crisis.

Ellen Joyner is the financial services marketing manager with SAS (Cary, N.C.). She is responsible for researching current market trends in financial services to help determine strategy and direction for new banking- and investment-focused technology solutions.

Oct 6, 2008 at 09:26 AM ET
By Ellen Joyner, SAS

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