Navigating the Consumer Loan Portfolio through Rougher Seas

RMA Journal, The, Oct, 2001 by Terino McMullen

Ahoy, mateys! Keep those portfolios high and dry in rough seas. Predictive tools, used in conjunction with careful monitoring and good leadership, will keep your boat afloat.

Consumer loan portfolio managers have been navigating their ships through some rougher seas in recent months. A series of storms are converging in the form of a slowing economy, increasing delinquencies, rising household debt burdens, and increasing consumer bankruptcy filings and charge-offs.

Nimble steering involves a three-step process:

1. Establishing indicators for whether the seas are calming or worsening.

2. Selecting navigational tools that will allow you to set the course.

3. Making navigational decisions and adjustments throughout the voyage.

Lighthouses, Buoys, Landmarks

Primary indicators of credit quality deterioration in consumer loans include the consumer debt service burden, the employment level, consumer bankruptcy, and the housing market.

Consumer debt service burden. According to data from the Federal Reserve, consumer credit increased by $5.3 billion, or at an annual rate of 4.5% in June 2001 compared with 10.5% in April 2001. Consumer debt service burden has experienced a sharp increase, rising to 14.35% in the first quarter of 2001. The Fed's most recent Survey of Consumer Finances indicates that the debt burdens are highest among households that have annual incomes of less than $50,000.

Corporate layoffs. Slowdowns in consumer spending, particularly in the retail sector, and significant reductions in corporate information technology expenditures are leading to aggressive cost-cutting programs by major corporations. During the month of June, employment declined by 114,000 jobs, bringing total job losses during the past 12 months to 785,000.

Consumer bankruptcy. During the first quarter 2001, personal bankruptcy filings increased 20% compared with the same period a year earlier. This increase is in part attributable to a rise in filings by consumers in anticipation of legislation that would impose more stringent rules on filers. However, another significant contributor to the rise in filings is the unanticipated disruption of household incomes due to reductions in work hours or the loss of jobs. According to data from VISA, almost 80% of consumer bankruptcy filings originated from households that had annual incomes of less than $50,000. Continued weakening of the labor market will lead to further increase in filings.

Housing market. Currently, a steady housing market is a key factor standing between a weakening economy and a recession. Aggressive actions by the Fed, reflected in low mortgage interest rates, continue to help drive demand. The annualized pace of existing home sales in June was 5.33 million units. The strong demand is leading to increases in homeowner equity. The national median house price in June was $152,600, reflecting an 8.8% year-over-year increase. Cash-out refinancings are providing financially stressed households with needed breathing room. However, increasing mortgage rates and the jobless rate, as well as diminished gains in income, will probably challenge the current pace of demand for homes.

Triggers as a Navigational Tool

Event-based triggers and predictive technologies can be extremely effective navigational tools in the environment just described. Predictive technologies can identify such upcoming storms as bankruptcy, higher delinquencies, and losses. Predictive technologies then allow the skipper to make appropriate changes in course and then track progress toward the shore. If the portfolio begins to "take on water," eventbased triggers can provide precious time to take the appropriate action. What follows is a detailed discussion of these navigational tools and the decisions that dictate their usage.

Portfolio managers traditionally have had to rely on dated information to make decisions about risk and risk exposure because they had access only to risk statistics from the end of the prior month or quarter. The unfortunate results are reactive management processes and supervisory approaches. Rather than a reactive approach to risk management, institutions need to rely on a proactive flow of data that quickly identifies potential problems before they appear.

A portfolio-triggering tool notifies portfolio managers within 24 hours of any risk indicators that could lead to a loss or balance transfer. By alerting the institution of any new bankruptcy, past-due account, new trade line, or new credit inquiry, a portfolio-triggering tool further can provide the earlywarning detectors needed to proactively attain, maintain, or retain customers and serve to identify cross-selling opportunities.

Although timing of the triggers is a key aspect in ensuring early detection of existing and potential problems, certain other aspects are required to ensure the success of a complete triggering program:

Flexibility. An inflexible triggering solution results in an influx of useless triggering data, making it difficult to filter out what's most relevant. The ideal triggering program allows for changes in the hierarchy surrounding the triggering events. In this way, an institution can adjust trigger delivery for changes in the marketplace or its own risk tolerance.