When I graduated from Northern Illinois University with a Bachelor of Science degree in Finance, my hope was to become a stockbroker. That was my dream job. In an attempt to improve my skills, I read many books about buying and selling stocks. One of the common themes was “the trend is your friend.” Buy a stock when the stock price is trending up and your chances for success are in your favor. Sell a stock when the stock price is trending down and save yourself some money.
Like today, the job market was soft for recent college graduates. Unable to find my stockbroker dream job resulted in my working the same job that got me through college. I was a valet or carhop at the local country club for the summer. With summer drawing to an end, I found a collections job working in the “field” for an auto finance company. The “field” was a nice term for the rougher neighborhoods of Chicago. The father of my first high school girlfriend set me up with the job. I am glad I treated his daughter well when we dated. It did not help me out much in high school as she went to the Prom with my brother, but six years later it paid dividends. Who would have known?
After a year collecting in the streets of Chicago, I moved to an inside collection job for a large airline credit union. They needed help after thousands of members were furloughed. Once the airline recalled their furloughed employees, I was transferred to the loan department. Lending was easy for the airline credit union. You knew the members income by the number of stripes on their uniform and seniority date. Most loans were funded in ten minutes or less.
Lending became more complex as my career progressed. I worked for a large multi sponsored credit union in the telecommunications field and also for a community credit union. Along comes indirect lending, risk based pricing, a housing bubble, a major recession and numerous regulations to help make things more challenging.
I recently accepted a new position as a Consultant for Lending Solutions Consulting Inc. or LSCI. I spent the last four months shadowing Rex Johnson, the founder of Lending Solutions and industry icon. His training discusses credit score trends. I found it to be an interesting connection to my past. Loan officers are making investment decisions for the credit union. They are investing their member’s deposits in loans to other members to provide a service to the borrower and hopefully receive a nice return for the savers. I wondered if “the trend is your friend” concept applies to making loan decisions?
The concept of risk based pricing of loans is to compensate the lender for the level of risk. Loan rates are priced lower for those with high credit scores and the lower credit score members receive higher loan rates. While this concept is widely used today, it was revolutionary in the early 1990’s.
Today, regulatory agencies have asked credit unions for credit score migration studies. Most credit unions have their CFO, VP of Lending or analyst study credit score migration of their existing loan portfolio. How many A’s have moved down to B, C, D or E scores? How many E’s moved up to D, C, B or A scores? Where are the B, C and D loans now? The number and dollar amount of loans are analyzed to determine risk changes in the loan portfolio. If the direction of the credit score on the existing portfolio is important to study, isn’t the direction of the credit score before the loan is funded also important?
LSCI renowned University of Lending teaches credit union staff how to determine the trend of the credit score from reading the credit report. The school wants to take the intellectual talent level that is in the CFO or VP level and put it in the loan office. Instead of studying the trend of the existing loan portfolio, we are teaching skills necessary to identify the trend of the credit score before the loan is approved.
Suppose we have evidence of a 740 credit score trending downward. We will give the member the best available rate because of the 740 credit score. The low rate coupled with the knowledge that the credit score is moving down leads us to believe we are not being compensated for our risk. Does it make sense to give this member A+ rates today knowing that they will not stay in the A+ credit tier for long? Is this a good investment decision for your credit union? What should you do?
Suppose we have evidence of a 540 credit score trending upward? We give the member our highest loan rates because of the 540 credit score. Knowing the credit score is trending upward makes this loan or investment decision a financial bonanza for the credit union. You will get the highest possible loan rate knowing the risk is overstated with the 540 credit score.
Reflecting back to the books I read on buying and selling stocks with the “trend is your friend” concept, one would say, approve the 540 loan and be cautious or decline the 740 loan in the above examples. I agree!
The 740 credit score member discussed above is a textbook example that most of us have seen. Twenty plus year credit history with perfect payment history and then something changes. Large medical expenses or job loss caused financial concerns. You get it, “stuff happens!” The member continues to make payments as agreed because that’s what they always do. They start carrying balances on credit cards, maxing them out and opening new accounts. Anyone with a 20 plus year credit history without a missed payment should have a credit score of 830 plus. The score is moving down because of capacity or maxing out the cards and length of credit as they open new accounts. We at LSCI call this living on inflated income. Many credit unions approve these loans and take losses. What if your staff knew the credit score was moving south and avoided making the loan or only made a loan that survives bankruptcy?
The 540 credit score loan is also a textbook example that most of us have seen. It is the same member as the 740 score only after they filed bankruptcy. Imagine a member with a perfect payment history before bankruptcy. Do you expect bankruptcy to all of sudden change their habits and they start becoming slow payers? These are some of the best loans a credit union can make. The bankruptcy relieved them of their debt, the low scores produce high loan yields, and with perfect payment habits the credit score will move up. The credit union will receive a risk premium without the risk! This is a member you want to build a life long relationship with. It is also a great example of why LSCI teaches credit unions to build relationships with bankruptcy attorneys and market to recent bankrupt people to develop business opportunities, but that is a subject for another article.
The key to developing skills necessary to identify trends in credit scores is to know the credit score model and focus on the “score codes.” A score code of 10, or “proportion of balances to credit limits is too high on bank revolving or other revolving debt” is a great example. This would be the first score code on the 740 credit score example we discussed. The first thing to do when you see a code 10 is review the level of unsecured debt. If the level of debt is reasonable you have nothing to worry about, if the debt is excessive make sure the loan you build survives bankruptcy. Seeing a code 10 coupled with years of perfect payment history and a score less than 800 tells you the credit score is trending downward. One would expect to see a score in the 800’s with that type of history.
Seeing the first score code of 38 or “serious delinquency, and derogatory public record or collection filed” with a credit score of 600 or more, indicates the credit score is rising. If the serious delinquency or public record was current you would expect to see a credit score in the mid to low 500’s. The fact that the credit score is above 600 indicates the delinquency or public record is old news and the credit score is moving upward.
When looking for opportunities to increase loan yields by funding loans for C, D, and E loans, look at the direction of the credit score. If the credit score is moving upward, the trend is your friend.
For credit unions to succeed and prosper in this low interest rate environment, they must use all available tools to reduce losses while looking for opportunities to offer high yield loans that make sense. Training your staff on credit score trending will help you overcome these challenges and prosper. This article is being written at the same time we are working on the 7th edition of the LSCI University of Lending book. New materials are being added to emphasize credit score trends. I hope to see you and your staff at the new University of Lending to learn and master the skill of recognizing credit score trends. In this class, you will learn many techniques in addition to the ones discussed in this article.
Happy lending to all!
Bob Schroeder, CLE
Vice President / Consultant
Lending Solutions Consulting Inc.