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CRT Deal Monitor: Understanding When Credit Becomes Risky

This analysis tracks several metrics related to deal performance and credit profile, putting them into a historical context by comparing the same metrics for recent-vintage deals against those of ‘similar’ cohorts in the time leading up to the 2008 housing crisis. You’ll see how credit metrics are trending today and understand the significance of today’s shifts in the context of historical data. Some of the charts in this post have interactive features, so click around! We’ll be tweaking the analysis and adding new metrics in subsequent months. Please shoot us an email if you have an idea for other metrics you’d like us to track.

Highlights

  • Performance metrics signal steadily increasing credit risk, but no cause for alarm.
    • We’re starting to see the hurricane-related (2017 Harvey and Irma) delinquency spikes subside in the deal data. Investors should expect a similar trend in 2019 due to Hurricane Florence.
    • The overall percentage of delinquent loans is increasing steadily due to the natural age ramp of delinquency rates and the ramp-up of the program over the last 5 years.
    • Overall delinquency levels are still far lower than historical rates.
    • While the share of delinquency is increasing, loans that go delinquent are ending up in default at a lower rate than before.
  • Deal Profiles are becoming riskier as new GSE acquisitions include higher-DTI business.
    • It’s no secret that both GSEs started acquiring a lot of high-DTI loans (for Fannie this moved from around 16% of MBS issuance in Q2 2017 to 30% of issuance as of Q2 this year). We’re starting to see a shift in CRT deal profiles as these loans are making their way into CRT issuance.
    • The credit profile chart toward the end of this post compares the credit profiles of recently issued deals with those of the most recent three months of MBS issuance data to give you a sense of the deal profiles we’re likely to see over the next 3 to 9 months. We also compare these recently issued deals to a similar cohort from 2006 to give some perspective on how much the credit profile has improved since the housing crisis.
    • RiskSpan’s Vintage Quality Index reflects an overall loosening of credit standards–reminiscent of 2003 levels–driven by this increase in high-DTI originations.
  • Fannie and Freddie have fundamental differences in their data disclosures for CAS and STACR.
    • Delinquency rates and loan performance all appear slightly worse for Fannie Mae in both the deal and historical data.
    • Obvious differences in reporting (e.g., STACR reporting a delinquent status in a terminal month) have been corrected in this analysis, but some less obvious differences in reporting between the GSEs may persist.
    • We suspect there is something fundamentally different about how Freddie Mac reports delinquency status—perhaps related to cleaning servicing reporting errors, cleaning hurricane delinquencies, or the way servicing transfers are handled in the data. We are continuing our research on this front and hope to follow up with another post to explain these anomalies.

The exceptionally low rate of delinquency, default, and loss among CRT deals at the moment makes analyzing their credit-risk characteristics relatively boring. Loans in any newly issued deal have already seen between 6 and 12 months of home price growth, and so if the economy remains steady for the first 6 to 12 months after issuance, then that deal is pretty much in the clear from a risk perspective. The danger comes if home prices drift downward right after deal issuance. Our aim with this analysis is to signal when a shift may be occurring in the credit risk inherent in CRT deals. Many data points related to the overall economy and home prices are available to investors seeking to answer this question. This analysis focuses on what the Agency CRT data—both the deal data and the historical performance datasets—can tell us about the health of the housing market and the potential risks associated with the next deals that are issued.

Current Performance and Credit Metrics

Delinquency Trends

The simplest metric we track is the share of loans across all deals that is 60+ days past due (DPD). The charts below compare STACR (Freddie) vs. CAS (Fannie), with separate charts for high-LTV deals (G2 for CAS and HQA for STACR) vs. low-LTV deals (G1 for CAS and DNA for STACR). Both time series show a steadily increasing share of delinquent loans. This slight upward trend is related to the natural aging curve of delinquency and the ramp-up of the CRT program. Both time series show a significant spike in delinquency around January of this year due to the 2017 hurricane season. Most of these delinquent loans are expected to eventually cure or prepay. For comparative purposes, we include a historical time series of the share of loans 60+ DPD for each LTV group. These charts are derived from the Fannie Mae and Freddie Mac loan-level performance datasets. Comparatively, today’s deal performance is much better than even the pre-2006 era. You’ll note the systematically higher delinquency rates of CAS deals. We suspect this is due to reporting differences rather than actual differences in deal performance. We’ll continue to investigate and report back on our findings.

Delinquency Outcome Monitoring

While delinquency rates might be trending up, loans that are rolling to 60-DPD are ultimately defaulting at lower and lower rates. The tables below track the status of loans that were 60+ DPD. Each bar in the chart represents the population of loans that were 60+ DPD exactly 6 months prior to the x-axis date. Over time, we see growing 60-DPD and 60+ DPD groups, and a shrinking Default group. This indicates that a majority of delinquent loans wind up curing or prepaying, rather than proceeding to default. The choppiness and high default rates in the first few observations of the data are related to the very low counts of delinquent loans as the CRT program ramped up. The following table repeats the 60-DPD delinquency analysis for the Freddie Mac Loan Level Performance dataset leading up to and following the housing crisis. (The Fannie Mae loan level performance set yields a nearly identical chart.) Note how many more loans in these cohorts remained delinquent (rather than curing or defaulting) relative to the more recent CRT loans. https://plot.ly/~dataprep/30.embed

Vintage Quality Index

RiskSpan’s Vintage Quality Index (VQI) reflects a reversion to the looser underwriting standards of the early 2000s as a result of the GSEs’ expansion of high-DTI lending. RiskSpan introduced the VQI in 2015 as a way of quantifying the underwriting environment of a particular vintage of mortgage originations. We use the metric as an empirically grounded way to control for vintage differences within our credit model. VQI-History While both GSEs increased high-DTI lending in 2017, it’s worth noting that Fannie Mae saw a relatively larger surge in loans with DTIs greater than 43%. The chart below shows the share of loans backing MBS with DTI > 43. We use the loan-level MBS issuance data to track what’s being originated and acquired by the GSEs because it is the timeliest data source available. CRT deals are issued with loans that are between 6 and 20 months seasoned, and so tracking MBS issuance provides a preview of what will end up in the next cohort of deals. High DTI Share

Deal Profile Comparison

The tables below compare the credit profiles of recently issued deals. We focus on the key drivers of credit risk, highlighting the comparatively riskier features of a deal. Each table separates the high-LTV (80%+) deals from the low-LTV deals (60%-80%). We add two additional columns for comparison purposes. The first is the ‘Coming Cohort,’ which is meant to give an indication of what upcoming deal profiles will look like. The data in this column is derived from the most recent three months of MBS issuance loan-level data, controlling for the LTV group. These are newly originated and acquired by the GSEs—considering that CRT deals are generally issued with an average loan age between 6 and 15 months, these are the loans that will most likely wind up in future CRT transactions. The second comparison cohort consists of 2006 originations in the historical performance datasets (Fannie and Freddie combined), controlling for the LTV group. We supply this comparison as context for the level of risk that was associated with one of the worst-performing cohorts. The latest CAS deals—both high- and low-LTV—show the impact of increased >43% DTI loan acquisitions. Until recently, STACR deals typically had a higher share of high-DTI loans, but the latest CAS deals have surpassed STACR in this measure, with nearly 30% of their loans having DTI ratios in excess of 43%. CAS high-LTV deals carry more risk in LTV metrics, such as the percentage of loans with a CLTV > 90 or CLTV > 95. However, STACR includes a greater share of loans with a less-than-standard level of mortgage insurance, which would provide less loss protection to investors in the event of a default. Credit Profile Low-LTV deals generally appear more evenly matched in terms of risk factors when comparing STACR and CAS. STACR does display the same DTI imbalance as seen in the high-LTV deals, but that may change as the high-DTI group makes its way into deals. Low-LTV-Deal-Credit-Profile-Most-Recent-Deals

Deal Tracking Reports

Please note that defaults are reported on a delay for both GSEs, and so while we have CPR numbers available for August, CDR numbers are not provided because they are not fully populated yet. Fannie Mae CAS default data is delayed an additional month relative to STACR. We’ve left loss and severity metrics blank for fixed-loss deals. STACR-Deals-over-the-past-3-months CAS-Deals-from-the-past-3-months.

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Big Companies; Big Data Issues

Data issues plague organizations of all sorts and sizes. But generally, the bigger the dataset, and the more transformations the data goes through, the greater the likelihood of problems. Organizations take in data from many different sources, including social media, third-party vendors and other structured and unstructured origins, resulting in massive and complex data storage and management challenges. This post presents ideas to keep in mind when seeking to address these.

First, a couple of definitions:

Data quality generally refers to the fitness of a dataset for its purpose in a given context. Data quality encompasses many related aspects, including:

  • Accuracy,
  • Completeness,
  • Update status,
  • Relevance,
  • Consistency across data sources,
  • Reliability,
  • Appropriateness of presentation, and
  • Accessibility

Data lineage tracks data movement, including its origin and where it moves over time. Data lineage can be represented visually to depict how data flows from its source to its destination via various changes and hops.

The challenges facing many organizations relate to both data quality and data lineage issues, and a considerable amount of time and effort is spent both in tracing the source of data (i.e., its lineage) and correcting errors (i.e., ensuring its quality). Business intelligence and data visualization tools can do a magnificent job of teasing stories out of data, but these stories are only valuable when they are true. It is becoming increasingly vital to adopt best practices to ensure that the massive amounts of data feeding downstream processes and presentation engines are both reliable and properly understood.

Financial institutions must frequently deal with disparate systems either because of mergers and acquisitions or in order to support different product types—consumer lending, commercial banking and credit cards, for example. Disparate systems tend to result in data silos, and substantial time and effort must go into providing compliance reports and meeting the various regulatory requirements associated with analyzing data provenance (from source to destination). Understanding the workflow of data and access controls around security are also vital applications of data lineage and help ensure data quality.

In addition to the obvious need for financial reporting accuracy, maintaining data lineage and quality is vital to identifying redundant business rules and data and to ensuring that reliable, analyzable data is constantly available and accessible. It also helps to improve the data governance echo system, enabling data owners to focus on gleaning business insights from their data rather than focusing attention on rectifying data issues.

Common Data Lineage Issues

A surprising number of data issues emerge simply from uncertainty surrounding a dataset’s provenance. Many of the most common data issues stem from one or more of the following categories:

  • Human error: “Fat fingering” is just the tip of the iceberg. Misconstruing and other issues arising from human intervention are at the heart of virtually all data issues.
  • Incomplete Data: Whether it’s drawing conclusions based on incomplete data or relying on generalizations and judgment to fill in the gaps, many data issues are caused by missing data.
  • Data format: Systems expect to receive data in a certain format. Issues arise when the actual input data departs from these expectations.
  • Data consolidation: Migrating data from legacy systems or attempting to integrate newly acquired data (from a merger, for instance) frequently leads to post-consolidation issues.
  • Data processing: Calculation engines, data aggregators, or any other program designed to transform raw data into something more “usable” always run the risk of creating output data with quality issues.

Addressing Issues

Issues relating to data lineage and data quality are best addressed by employing some combination of the following approaches. The specific blend of approaches depends on the types of issues and data in question, but these principles are broadly applicable.

Employing a top-down discovery approach enables data analysts to understand the key business systems and business data models that drive an application. This approach is most effective when logical data models are linked to the physical data and systems.

Creating a rich metadata repository for all the data elements flowing from the source to destination can be an effective way of heading off potential data lineage issues. Because data lineage is dependent on the metadata information, creating a robust repository from the outset often helps preserve data lineage throughout the life cycle.

Imposing useful data quality rules is an important element in establishing a framework in which data is always validated against a set of well-conceived business rules. Ensuring not only that data passes comprehensive rule sets but also that remediation factors are in place for appropriately dealing with data that fails quality control checks is crucial for ensuring end-to-end data quality.

Data lineage and data quality both require continuous monitoring by a defined stewardship council to ensure that data owners are taking appropriate steps to understand and manage the idiosyncrasies of the datasets they oversee.

Our Data Lineage and Data Quality Background

RiskSpan’s diverse client base includes several large banks (with we define as banks with assets totaling in excess of $50 billion). Large banks are characterized by a complicated web of departments and sub-organizations, each offering multiple products, sometimes to the same base of customers. Different sub-organizations frequently rely on disparate systems (sometimes due to mergers/acquisitions; sometimes just because they develop their businesses independent of one another). Either way, data silos inevitably result.

RiskSpan has worked closely with chief data officers of large banks to help establish data stewardship teams charged with taking ownership of the various “areas” of data within the bank. This involves the identification of data “curators” within each line of business to coordinate with the CDO’s office and be the advocate (and ultimately the responsible party) for the data they “own.” In best practice scenarios, a “data curator” group is formed to facilitate collaboration and effective communication for data work across the line of business.

We have found that a combination of top-down and bottom-up data discovery approaches is most effective when working accross stakeholders to understand existing systems and enterprise data assets. RiskSpan has helped create logical data flow diagrams (based on the top-down approach) and assisted with linking physical data models to the logical data models. We have found Informatica and Collibra tools to be particularly useful in creating data lineage, tracking data owners, and tracing data flow from source to destination.

Complementing our work with financial clients to devise LOB-based data quality rules, we have built data quality dashboards using these same tools to enable data owners and curators to rectify and monitor data quality issues. These projects typically include elements of the following components.

  • Initial assessment review of the current data landscape.
  • Establishment of a logical data flow model using both top-down and bottom-up data discovery approaches.
  • Coordination with the CDO / CIO office to set up a data governance stewardship team and to identify data owners and curators from all parts of the organization.
  • Delineation of data policies, data rules and controls associated with different consumers of the data.
  • Development of a target state model for data lineage and data quality by outlining the process changes from a business perspective.
  • Development of future-state data architecture and associated technology tools for implementing data lineage and data quality.
  • Invitation to client stakeholders to reach a consensus related to future-state model and technology architecture.
  • Creation of a project team to execute data lineage and data quality projects by incorporating the appropriate resources and client stakeholders.
  • Development of a change management and migration strategy to enable users and stakeholders to use data lineage and data quality tools.

Ensuring data quality and lineage is ultimately the responsibility of business lines that own and use the data. Because “data management” is not the principal aim of most businesses, it often behooves them to leverage the principles outlined in this post (sometimes along with outside assistance) to implement tactics that will to help ensure that the stories their data tell are reliable.

Here Come the CECL Models: What Model Validators Need to Know

As it turns out, model validation managers at regional banks didn’t get much time to contemplate what they would do with all their newly discovered free time. Passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act appears to have relieved many model validators of the annual DFAST burden. But as one class of models exits the inventory, a new class enters—CECL models.

Banks everywhere are nearing the end of a multi-year scramble to implement a raft of new credit models designed to forecast life-of-loan performance for the purpose of determining appropriate credit-loss allowances under the Financial Accounting Standards Board’s new Current Expected Credit Loss (CECL) standard, which takes full effect in 2020 for public filers and 2021 for others.

The number of new models CECL adds to each bank’s inventory will depend on the diversity of asset portfolios. More asset classes and more segmentation will mean more models to validate. Generally model risk managers should count on having to validate at least one CECL model for every loan and debt security type (residential mortgage, CRE, plus all the various subcategories of consumer and C&I loans) plus potentially any challenger models the bank may have developed.

In many respects, tomorrow’s CECL model validations will simply replace today’s allowance for loan and lease losses (ALLL) model validations. But CECL models differ from traditional allowance models. Under the current standard, allowance models typically forecast losses over a one-to-two-year horizon. CECL requires a life-of-loan forecast, and a model’s inputs are explicitly constrained by the standard. Accounting rules also dictate how a bank may translate the modeled performance of a financial asset (the CECL model’s outputs) into an allowance. Model validators need to be just as familiar with the standards governing how these inputs and outputs are handled as they are with the conceptual soundness and mathematical theory of the credit models themselves.

CECL Model Inputs – And the Magic of Mean Reversion

Not unlike DFAST models, CECL models rely on a combination of loan-level characteristics and macroeconomic assumptions. Macroeconomic assumptions are problematic with a life-of-loan credit loss model (particularly with long-lived assets—mortgages, for instance) because no one can reasonably forecast what the economy is going to look like six years from now. (No one really knows what it will look like six months from now, either, but we need to start somewhere.) The CECL standard accounts for this reality by requiring modelers to consider macroeconomic input assumptions in two separate phases: 1) a “reasonable and supportable” forecast covering the time frame over which the entity can make or obtain such a forecast (two or three years is emerging as common practice for this time frame), and 2) a “mean reversion” forecast based on long-term historical averages for the out years. As an alternative to mean reverting by the inputs, entities may instead bypass their models in the out years and revert to long-term average performance outcomes by the relevant loan characteristics.

Assessing these assumptions (and others like them) requires a model validator to simultaneously wear a “conceptual soundness” testing hat and an “accounting policy” compliance hat. Because the purpose of the CECL model is to prove an accounting answer and satisfy an accounting requirement, what can validators reasonably conclude when confronted with an assumption that may seem unsound from purely statistical point of view but nevertheless satisfies the accounting standard?

Taking the mean reversion requirement as an example, the projected performance of loans and securities beyond the “reasonable and supportable” period is permitted to revert to the mean in one of two ways: 1) modelers can feed long-term history into the model by supplying average values for macroeconomic inputs, allowing modeled results to revert to long-term means in that way, or 2) modelers can mean revert “by the outputs” – bypassing the model and populating the remainder of the forecast with long-term average performance outcomes (prepayment, default, recovery and/or loss rates depending on the methodology). Either of these approaches could conceivably result in a modeler relying on assumptions that may be defensible from an accounting perspective despite being statistically dubious, but the first is particularly likely to raise a validator’s eyebrow. The loss rates that a model will predict when fed “average” macroeconomic input assumptions are always going to be uncharacteristically low. (Because credit losses are generally large in bad macroeconomic environments and low in average and good environments, long-term average credit losses are higher than the credit losses that occur during average environments. A model tuned to this reality—and fed one path of “average” macroeconomic inputs—will return credit losses substantially lower than long-term average credit losses.) A credit risk modeler is likely to think that these are not particularly realistic projections, but an auditor following the letter of the standard may choose not find any fault with them. In such situations, validators need to fall somewhere in between these two extremes—keeping in mind that the underlying purpose of CECL models is to reasonably fulfill an accounting requirement—before hastily issuing a series of high-risk validation findings.

CECL Model Outputs: What are they?

CECL models differ from some other models in that the allowance (the figure that modelers are ultimately tasked with getting to) is not itself a direct output of the underlying credit models being validated. The expected losses that emerge from the model must be subject to a further calculation in order to arrive at the appropriate allowance figure. Whether these subsequent calculations are considered within the scope of a CECL model validation is ultimately going to be an institutional policy question, but it stands to reason that they would be.

Under the CECL standard, banks will have two alternatives for calculating the allowance for credit losses: 1) the allowance can be set equal to the sum of the expected credit losses (as projected by the model), or 2) the allowance can be set equal to the cost basis of the loan minus the present value of expected cash flows. While a validator would theoretically not be in a position to comment on whether the selected approach is better or worse than the alternative, principles of process verification would dictate that the validator ought to determine whether the selected approach is consistent with internal policy and that it was computed accurately.

When Policy Trumps Statistics

The selection of a mean reversion approach is not the only area in which a modeler may make a statistically dubious choice in favor of complying with accounting policy.

Discount Rates

Translating expected losses into an allowance using the present-value-of-future-cash-flows approach (option 2—above) obviously requires selecting an appropriate discount rate. What should it be? The standard stipulates the use of the financial asset’s Effective Interest Rate (or “yield,” i.e., the rate of return that equates an instrument’s cash flows with its amortized cost basis). Subsequent accounting guidance affords quite a bit a flexibility in how this rate is calculated. Institutions may use the yield that equates contractual cash flows with the amortized cost basis (we can call this “contractual yield”), or the rate of return that equates cash flows adjusted for prepayment expectations with the cost basis (“prepayment-adjusted yield”).

The use of the contractual yield (which has been adjusted for neither prepayments nor credit events) to discount cash flows that have been adjusted for both prepayments and credit events will allow the impact of prepayment risk to be commingled with the allowance number. For any instruments where the cost basis is greater than unpaid principal balance (a mortgage instrument purchased at 102, for instance) prepayment risk will exacerbate the allowance. For any instruments where the cost basis is less than the unpaid principal balance, accelerations in repayment will offset the allowance. This flaw has been documented by FASB staff, with the FASB Board subsequently allowing but not requiring the use of a prepay-adjusted yield.

Multiple Scenarios

The accounting standard neither prohibits nor requires the use of multiple scenarios to forecast credit losses. Using multiple scenarios is likely more supportable from a statistical and model validation perspective, but it may be challenging for a validator to determine whether the various scenarios have been weighted properly to arrive at the correct, blended, “expected” outcome.

Macroeconomic Assumptions During the “Reasonable and Supportable” Period

Attempting to quantitatively support the macro assumptions during the “reasonable and supportable” forecast window (usually two to three years) is likely to be problematic both for the modeler and the validator. Such forecasts tend to be more art than science and validators are likely best off trying to benchmark them against what others are using than attempting to justify them using elaborately contrived quantitative methods. The data that is mostly likely to be used may turn out to be simply the data that is available. Validators must balance skepticism of such approaches with pragmatism. Modelers have to use something, and they can only use the data they have.

Internal Data vs. Industry Data

The standard allows for modeling using internal data or industry proxy data. Banks often operate under the dogma that internal data (when available) is always preferable to industry data. This seems reasonable on its face, but it only really makes sense for institutions with internal data that is sufficiently robust in terms of quantity and history. And the threshold for what constitutes “sufficiently robust” is not always obvious. Is one business cycle long enough? Is 10,000 loans enough? These questions do not have hard and fast answers.

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Many questions pertaining to CECL model validations do not yet have hard and fast answers. In some cases, the answers will vary by institution as different banks adopt different policies. Industry best practices will doubtless emerge in response to others. For the rest, model validators will need to rely on judgment, sometimes having to balance statistical principles with accounting policy realities. The first CECL model validations are around the corner. It’s not too early to begin thinking about how to address these questions.

Houston Strong: Communities Recover from Hurricanes. Do Mortgages?

The 2017 hurricane season devastated individual lives, communities, and entire regions. As one would expect, dramatic increases in mortgage delinquencies accompanied these events. But the subsequent recoveries are a testament both to the resilience of the people living in these areas and to relief mechanisms put into place by the mortgage holders.

Now, nearly a year later, we wanted to see what the credit-risk transfer data (as reported by Fannie Mae CAS and Freddie Mac STACR) could tell us about how these borrowers’ mortgage payments are coming along.

The timing of the hurricanes’ impact on mortgage payments can be approximated by identifying when Current-to-30 days past due (DPD) roll rates began to spike. Barring other major macroeconomic events, we can reasonably assume that most of this increase is directly due to hurricane-related complications for the borrowers.

Houston Strong - Analysis by Edge

The effect of the hurricanes is clear—Puerto Rico, the U.S. Virgin Islands, and Houston all experienced delinquency spikes in September. Puerto Rico and the Virgin Islands then experienced a second wave of delinquencies in October due to Hurricanes Irma and Maria.

But what has been happening to these loans since entering delinquency? Have they been getting further delinquent and eventually defaulting, or are they curing? We focus our attention on loans in Houston (specifically the Houston-The Woodlands-Sugar Land Metropolitan Statistical Area) and Puerto Rico because of the large number of observable mortgages in those areas.

First, we look at Houston. Because the 30-DPD peak was in September, we track that bucket of loans. To help us understand the path 30-DPD might reasonably be expected to take, we compared the Houston delinquencies to 30-DPD loans in the 48 states other than Texas and Florida.

Houston Strong - Analysis by Edge

Houston Strong - Analysis by Edge

Of this group of loans in Houston that were 30 DPD in September, we see that while many go on to be 60+ DPD in October, over time this cohort is decreasing in size.

Recovery is slower than the non-hurricane-affected U.S. loans, but persistent. The biggest difference is that a significant number of 30-day delinquencies in the rest of the country loans continue to hover at 30 DPD (rather than curing or progressing to 60 DPD) while the Houston cohort is more evenly split between the growing number loans that cure and the shrinking number of loans progressing to 60+ DPD.

Puerto Rico (which experienced its 30 DPD peak in October) shows a similar trend:

Houston Strong - Analysis by Edge

Houston Strong - Analysis by Edge

To examine loans even more affected by the hurricanes, we can perform the same analysis on loans that reached 60 DPD status.

Houston Strong - Analysis by Edge

Here, Houston’s peak is in October while Puerto Rico’s is in November.

Houston vs. the non-hurricane-affected U.S.:

Houston Strong - Analysis by Edge

Houston Strong - Analysis by Edge

Puerto Rico vs. the non-hurricane-affected U.S.:

Houston Strong - Analysis by Edge

Houston Strong - Analysis by Edge

In both Houston and Puerto Rico, we see a relatively small 30-DPD cohort across all months and a growing Current cohort. This indicates many people paying their way to Current from 60+ DPD status. Compare this to the rest of the US where more people pay off just enough to become 30 DPD, but not enough to become Current.

The lack of defaults in post-hurricane Houston and Puerto Rico can be explained by several relief mechanisms Fannie Mae and Freddie Mac have in place. Chiefly, disaster forbearance gives borrowers some breathing room with regards to payment. The difference is even more striking among loans that were 90 days delinquent, where eventual default is not uncommon in the non-hurricane affected U.S. grouping:

Houston Strong - Analysis by Edge

Houston Strong - Analysis by Edge

And so, both 30-DPD and 60-DPD loans in Houston and Puerto Rico proceed to more serious levels of delinquency at a much lower rate than similarly delinquent loans in the rest of the U.S. To see if this is typical for areas affected by hurricanes of a similar scale, we looked at Fannie Mae loan-level performance data for the New Orleans MSA after Hurricane Katrina in August 2005.

As the following chart illustrates, current-to-30 DPD roll rates peaked in New Orleans in the month following the hurricane:

Houston Strong - Analysis by Edge

What happened to these loans?

Houston Strong - Analysis by Edge

Here we see a relatively speedy recovery, with large decreases in the number of 60+ DPD loans and a sharp increase in prepayments. Compare this to non-hurricane affected states over the same period, where the number of 60+ DPD loans held relatively constant, and the number of prepayments grew at a noticeably slower rate than in New Orleans.

Houston Strong - Analysis by Edge

The remarkable number of prepayments in New Orleans was largely due to flood insurance payouts, which effectively prepay delinquent loans. Government assistance lifted many others back to current. As of March, we do not see this behavior in Houston and Puerto Rico, where recovery is moving much more slowly. Flood insurance incidence rates are known to have been low in both areas, a likely suspect for this discrepancy.

While loans are clearly moving out of delinquency in these areas, it is at a much slower rate than the historical precedent of Hurricane Katrina. In the coming months we can expect securitized mortgages in Houston and Puerto Rico to continue to improve, but getting back to normal will likely take longer than what was observed in New Orleans following Katrina. Of course, the impending 2018 hurricane season may complicate this matter.

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Note: The analysis in this blog post was developed using RiskSpan’s Edge Platform. The RiskSpan Edge Platform is a module-based data management, modeling, and predictive analytics software platform for loans and fixed-income securities. Click here to learn more.

 

From Main Street to King Abdullah Financial District: Lessons Learned in International Mortgage Finance

In December 2016, I was asked to consult on a start-up real estate refinance company located in the Saudi Arabia. I wasn’t sure I understood what he was saying. As someone who has worked in the U.S. mortgage business since college, the word “refinance” has very strong connotations, but its use seemed wrong in this context. As it turned out in overseas mortgage markets, the phrase real estate refinance refers to “providing funding” or “purchasing mortgage assets.” And that started my quick introduction into the world of international mortgage finance where, “everything is different but in the end it’s all the same.”

By early January 2017 I found myself in Riyadh, Saudi Arabia, working as an adviser to a consulting firm contracted to manage the start-up of the new enterprise. Riyadh in January is nice—cool temperatures and low humidity. In the summer it’s another story. Our client was the Ministry of Housing and the Saudi Sovereign Wealth fund. One of the goals of Saudi Arabia’s ambitious Vision 2030 is the creation of its own secondary mortgage company. Saudi Arabia has 18 banks and finance companies originating Islamic mortgages, but the future growth of the economy and population is expected to create demand for mortgages that far exceeds the current financial system’s capacity. The travel and hotel accommodations were delightful. The jet lag and working hours were not.

My foremost motivation for taking the project was to check off “worked overseas” from my career bucket list. Having spent my entire career in the U.S. mortgage business, this had always seemed too distant an opportunity. The project was supposed to last three months, but seventeen months later I’m writing this article in a hotel room overlooking downtown Riyadh. The cultural experience living and working in Saudi Arabia is something I have spent hours discussing with family and friends.

But the goal of this article is not to describe my cultural experiences but to write about the lessons I’ve learned about the U.S. mortgage business sitting 7,000 miles away. Below, I’ve laid out some of my observations.

Underwriting is underwriting

As simple as that. Facts, practices and circumstances may be local, but the principles of sound mortgage underwriting are universal: 1) develop your risk criteria, 2) validate and verify the supporting documentation, 3) underwrite the file and 4) capture performance data to confirm your risk criteria.  Although mortgage lending is only 10 years old in Saudi Arabia, underwriting criteria and methodologies here strongly resemble those in the USA. Loan-to-value ratios, use of appraisals, asset verification, and debt-to-income (DTI) determination—it’s basically the same. All mortgages are fully documented.

But it is different. In Saudi Arabia, where macro-economic issues—i.e., oil prices and lack of economic diversification—dominate the economy, lenders need to find alternatives in underwriting. For example, the use of credit scores takes a second seat to employment stability. To lenders, a borrower’s employer—i.e., government or the military—is more important than a high credit score. Why? Lower oil prices can crush economic growth, leading to higher unemployment with little opportunity for displaced workers to find new jobs. The lack of a diversified economy makes lenders wary of lending to employees of private-sector companies, hence their focus on lending to government employees. This impact leads to whole segments of potential borrowers being left out of the mortgage market.

The cold reality in emerging economic countries like Saudi Arabia is that only the best borrowers can get loans. Even then, lenders may require a “salary assignment,” in which a borrower’s employer pays the lender directly. The lesson is that the primary credit risk strategy in Saudi Arabia is to avoid credit losses by all means—the best way to manage credit risk is to avoid it.

Finance is finance

Finance is the same everywhere and concepts of cash flow and return analysis are universal, whether the transaction is Islamic or conventional. There’s lots of confusion about what Islamic finance is and how it works.  Many people misunderstand shariah law and its rules on paying interest. Not all banks in Saudi Arabia are Islamic, and although many are, while paying interest on debt is non-sharia, leases and equity returns are sharia compliant. The key to Islamic finance is selecting appropriate finance products that comply with shariah but also meet the needs of lenders.

In Saudi Arabia, most lenders originate Islamic mortgages called Ijarah.  With an Ijarah mortgage the borrower selects a property to purchase and then goes to the lender. At closing the lender accepts a down payment from the borrower and the lender purchases the property directly from the seller. The lender then executes an agreement to lease the property to the borrower for the life of the mortgage.  This looks a lot like a long-term lease. Instead of paying an interest rate, the borrower pays an APR on a stated equity return or “profit rate” to the lender on the lease arrangement.

Similarly, Islamic warehouse lending on mortgage collateral resembles a traditional repo transaction—an agreed upon sale price and repurchase price and a bunch of commodity trades linked to the transaction.  In Islamic finance, the art relies on a sound understanding of the cash flows, the collateral limitations, the needs of all parties, and Islamic law. Over the past decade, the needs of the lenders, investors and intermediaries has evolved into set of standardized transactions that meet the financing needs of the market.

People are people

People are the same everywhere—good, bad and otherwise—and it’s no different overseas. And there is a lot of great talent out there. The people I have worked with are talented, motivated and educated. I have had the opportunity to work with Saudis and people from at least 15 other countries. Fortunately for me, English is the operating business language in Saudi Arabia and no one is any wiser to whether my explanations of the U.S. mortgage market are accurate or not. The international consulting and accounting firms have done a tremendous job creating strong business models to identify, hire, train and manage employees, cultivating a rich talent pool of consultants and future employees.  A rich country like Saudi Arabia is a magnet for expats—it has both the money and vision to afford talent. In addition, Saudi Arabia’s rapid population growth and strong education system has added to a homegrown pool of talented employees.

Standardization is a benefit worth fighting for

One of the primary goals of any international refinance or secondary market company is standardization. The benefits of standardization extend to all market participants—borrowers, lenders and investors. Secondary market companies thrive where transactions are cheaper, faster and better, making it an easy choice for government policymakers to support. For consumers, rates are lower, the choices of lenders and products are better, and the origination process is more transparent. For investors, the standardization of structures, cash flows and obligations improves liquidity, increases the number of active market participants and ultimately lowers the transactional bid/ask spreads and yields.

However, the benefits of standardization are less clear for the primary customer they are meant to help—the lenders. While standardization can lower operating expenses or improve business processes, it does little to increase the comparative advantages of each lender.

Saudi lenders are focused on customer service and product design, leaving price aside. This focus has led lenders to design mortgage products with unique interest rate adjustment periods, payment options and one-of-a-kind mortgage notes and customized purchase and sale agreements.[1] This degree of customization can be a recipe for disaster, leading to endless negotiations, misunderstandings of rate reset mechanisms, extended deal timelines, and differences of opinion among shariah advisers. When negotiations are culturally a zero-sum game, trying to persuade lenders of the rationale for advancing monthly payments by the 10th of each month is exhausting.

Saudi lenders see the long-term benefits of increased volume, selling credit exposure and servicing income. But they haven’t figured out that strong secondary markets lead to the development of tertiary markets like forward trading in MBS, trading of Mortgage Servicing Rights (MSRs) or better terms for warehouse lending.

Mortgages are sold, not purchased

It’s a universal tenet throughout the world: buying real estate and financing it with a mortgage is a complex transaction. It requires experienced and well-trained loan officers to aid and walk the consumers through the process.  A loan officer’s skill at persuading a potential customer to submit a loan application is every bit as important as his knowledge of mortgages. It’s no different in Saudi Arabia. While building relationships with realtors is important, the Saudi market is more of a construction-to-permanent market than a resale market. Individuals builders are simply too small to be able to channel consumers to lenders.

What to do? The Saudi mortgage origination market has quickly evolved to using alternatives like social media to capture consumer traffic.  Saudi citizens are some of the most active users of social media in world.[2] (How active? From my experience, 9 out of 10 drivers on the road are reading their smart phones instead on looking at the road—it’s downright scary.) Lenders have developed sophisticated media campaigns using Twitter, You Tube and other platforms to drive traffic to their call centers where loan officers can sell mortgages to potential borrowers.

Whatever the language, closing lines are the same everywhere.

Regulation – A necessary evil

Saudi Arabia’s is a highly regulated financial market. Its primary financial regulator is the Saudi Arabia Monetary Authority, better known as SAMA. Regulation and oversight is centrally controlled and has been in place for almost 70 years. SAMA has placed a premium on well-capitalized financial institutions and closely monitors transactions and the liquidity of its institutions. The approval process is detailed and time consuming, but it has resulted in well-capitalized institutions. The minimum capital of the country’s five non-bank mortgage lenders exceeds $100MM USD.

A secondary role of SAMA has been to maintain stability within the financial markets—protecting consumers against bad actors and minimizing the market’s systematic risks. Financial literacy among Saudi citizens is low and comprehensive consumer protections akin to the Real Estate Settlement Procedures Act (RESPA) in the U.S. don’t exist here. SAMA fills this role, resulting in an ad hoc mix of consumer protections with mixed enforcement actions. Sometimes the cost of the protection is greater than evil it’s ostensibly protecting against.

As examples, SAMA regulates the maximum LTVs for the mortgage market and limits the consumer’s out-of-pocket cash fees to $1,250 USD. Managing LTV limits for the market goes a long way toward preventing over-lending when the markets are speculative. This was extremely beneficial in cooling down a hot Saudi real estate market in 2013.

Capping a borrower’s out-of-pocket expenses makes sense to limit unscrupulous market players from hustling borrowers. But the downside is the inability of lenders to monetize their transactions—i.e., to get cash from borrowers, sell mortgages at premium prices or sell servicing rights. This results in higher mortgage rates as lenders push up their mortgage coupons to generate cash to reimburse them for the higher costs associated with originating the mortgage. It is also a factor in the lenders’ use of prepayment penalties.

External constraints affect the design of local mortgage products

Ultimately, mortgage financing products available to consumers in any country are a function of the maturity level and the previous legacy development of its financial and capital markets. In Saudi Arabia, where large banks dominate, the deposit funding strategies determine mortgage product design.  Capital markets are relatively new in the Kingdom. Only in the past several years has the Saudi government issued enough Sukuks to fill the Saudi Arabian yield curve out to ten years. While the government has plenty of buyers for its debt, the primary mortgage lenders do not. The concept of amortizing debt products is anathema to the market’s debt investors. Without access to longer-term debt buyers, the mortgage market products are primarily linked to 1-year SAIBOR (the Saudi version of LIBOR). This inability to secure long-term funding impacts amortization periods the lenders can offer, with most mortgages limited to a maximum amortization period of 20 years. The high mortgage rates, short-fixed payment tenors and short amortization periods all contribute to affordability issues for the average Saudi citizen.

Affordable Housing is an issue everywhere

Over the past 50 years Saudi Arabia’s vast oil wealth has enabled it to become an educated, middle-class society. The trillions of dollars in oil revenues have enabled the country to transform from a nomadic culture to a modern economy with growth centered in its primary cities. But its population growth rate and urban migration has created a mismatch of affordable housing in the growth centers of the country.  The lack of affordable urban housing, outdated government housing policies and restrictive mortgage lending policies has stifled both the demand and supply of affordable housing units.

While well-functioning capital markets can help to lower mortgage rates and improve credit terms, it is only a small part of the solution for helping people afford and remain in housing. In this regard, Saudi Arabia looks a lot like the United States. With entities like the Real Estate Development Fund (REDF), Saudia Arabia is trying to manage the challenges of creating housing programs that solve housing issues for all, as opposed to subsidy programs that only help a small minority of people, operating with the high cost of program administration and with nominal benefits to its participants.

Concluding Thoughts

The past year and half have been both personally and professionally rewarding. The opportunity to live and work abroad and to become immersed in another culture has been gratifying. Professionally, it’s been eye-opening to see the limits of my previous experiences and need to recalibrate my core assumptions and thinking.

I maintain that the United States absolutely has the best mortgage finance system in the world. The ability of our secondary markets to provide consumers with low mortgage rates and a 30-yr fixed rate mortgage has no match in the world. The modern U.S. mortgage market, with its century of history and supportive policy decisions, has the luxury of scale, government guarantees and depth of investor classes.

Saudi Arabia’s own mortgage solutions are mostly a result of necessity. For the country, it has been more important to build a stable and well-capitalized banking system—and then to provide affordable mortgage products and terms. Think of it in terms of airline safely instructions—secure your own oxygen mask first, and then take care of your children.

Housing finance systems aren’t like building smart phone networks. You can’t just import the technology and billing systems and flip a switch. It’s a long-cycle development that requires the legal systems, regulatory framework and entities and a mature finance industry before you can start contemplating and building a secondary market.

As I reflect on my experiences in Saudi Arabia, I would describe the role I have played as that of an intermediary—applying proven “best in class” secondary market and risk management approaches I learned at home to Saudi Arabia. And then trying to understand their limits and coming up with Plan B. And sometimes Plan C…


[1] Competition has not prompted an expansion of the credit box, as lenders are generally risk averse and their regulators are hyper diligent on credit standards.

[2] https://www.go-gulf.com/blog/social-media-saudi-arabia/

MDM to the Rescue for Financial Institutions

Data becomes an asset only when it is efficiently harnessed and managed. Because firms tend to evolve into silos, their data often gets organized that way as well, resulting in multiple references and unnecessary duplication of data that dilute its value. Master Data Management (MDM) architecture helps to avoid these and other pitfalls by applying best practices to maximize data efficiency, controls, and insights.

MDM has particular appeal to banks and other financial institutions where non-integrated systems often make it difficult to maintain a comprehensive, 360-degree view of a customer who simultaneously has, for example, multiple deposit accounts, a mortgage, and a credit card. MDM provides a single, common data reference across systems that traditionally have not communicated well with each other. Customer-level reports can point to one central database instead of searching for data across multiple sources.

Financial institutions also derive considerable benefit from MDM when seeking to comply with regulatory reporting requirements and when generating reports for auditors and other examiners. Mobile banking and the growing number of new payment mechanisms make it increasingly important for financial institutions to have a central source of data intelligence. An MDM strategy enables financial institutions to harness their data and generate more meaningful insights from it by:

  • Eliminating data redundancy and providing one central repository for common data;
  • Cutting across data “silos” (and different versions of the same data) by providing a single source of truth;
  • Streamlining compliance reporting (through the use of a common data source);
  • Increasing operational and business efficiency;
  • Providing robust tools to secure and encrypt sensitive data;
  • Providing a comprehensive 360-degree view of customer data;
  • Fostering data quality and reducing the risks associated with stale or inaccurate data, and;
  • Reducing operating costs associated with data management.

Not surprisingly, there’s a lot to think about when contemplating and implementing a new MDM solution. In this post, we lay out some of the most important things for financial institutions to keep in mind.

 

MDM Choice and Implementation Priorities

MDM is only as good as the data it can see. To this end, the first step is to ensure that all of the institution’s data owners are on board. Obtaining management buy-in to the process and involving all relevant stakeholders is critical to developing a viable solution. This includes ensuring that everyone is “speaking the same language”—that everyone understands the benefits related to MDM in the same way—and  establishing shared goals across the different business units.

Once all the relevant parties are on board, it’s important to identify the scope of the business process within the organization that needs data refinement through MDM. Assess the current state of data quality (including any known data issues) within the process area. Then, identify all master data assets related to the process improvement. This generally involves identifying all necessary data integration for systems of record and the respective subscribing systems that would benefit from MDM’s consistent data. The selected MDM solution should be sufficiently flexible and versatile that it can govern and link any sharable enterprise data and connect to any business domain, including reference data, metadata and any hierarchies.

An MDM “stewardship team” can add value to the process by taking ownership of the various areas within the MDM implementation plan. MDM is just not about technology itself but also involves business and analytical thinking around grouping data for efficient usage. Members of this team need to have the requisite business and technical acumen in order for MDM implementation to be successful. Ideally this team would be responsible for identifying data commonalities across groups and laying out a plan for consolidating them. Understanding the extent of these commonalities helps to optimize architecture-related decisions.

Architecture-related decisions are also a function of how the data is currently stored. Data stored in heterogeneous legacy systems calls for a different sort of MDM solution than does a modern data lake architecture housing big data. The solutions should be sufficiently flexible and scalable to support future growth. Many tools in the marketplace offer MDM solutions. Landing on the right tool requires a fair amount of due diligence and analysis. The following evaluation criteria are often helpful:

  • Enterprise Integration: Seamless integration into the existing enterprise set of tools and workflows is an important consideration for an MDM solution.  Solutions that require large-scale customization efforts tend to carry additional hidden costs.
  • Support for Multiple Devices: Because modern enterprise data must by consumable by a variety of devices (e.g., desktop, tablet and mobile) the selected MDM architecture must support each of these platforms and have multi-device access capability.
  • Cloud and Scalability: With most of today’s technology moving to the cloud, an MDM solution must be able to support a hybrid environment (cloud as well as on-premise). The architecture should be sufficiently scalable to accommodate seasonal and future growth.
  • Security and Compliance: With cyber-attacks becoming more prevalent and compliance and regulatory requirements continuing to proliferate, the MDM architecture must demonstrate capabilities in these areas.

 

Start Small; Build Gradually; Measure Success

MDM implementation can be segmented into small, logical projects based on business units or departments within an organization. Ideally, these projects should be prioritized in such a way that quick wins (with obvious ROI) can be achieved in problem areas first and then scaling outward to other parts of the organization. This sort of stepwise approach may take longer overall but is ultimately more likely to be successful because it demonstrates success early and gives stakeholders confidence about MDM’s benefits.

The success of smaller implementations is easier to measure and see. A small-scale implementation also provides immediate feedback on the technology tool used for MDM—whether it’s fulfilling the needs as envisioned. The larger the implementation, the longer it takes to know whether the process is succeeding or failing and whether alternative tools should be pursued and adopted. The success of the implementation can be measured using the following criteria:

  • Savings on data storage—a result of eliminating data redundancy.
  • Increased ease of data access/search by downstream data consumers.
  • Enhanced data quality—a result of common data centralization.
  • More compact data lineage across the enterprise—a result of standardizing data in one place.

Practical Case Studies

RiskSpan has helped several large banks consolidate multiple data stores across different lines of business. Our MDM professionals work across heterogeneous data sets and teams to create a common reference data architecture that eliminates data duplication, thereby improving data efficiency and reducing redundant data. These professionals have accomplished this using a variety of technologies, including Informatica, Collibra and IBM Infosphere.

Any successful project begins with a survey of the current data landscape and an assessment of existing solutions. Working collaboratively to use this information to form the basis of an approach for implementing a best-practice MDM strategy is the most likely path to success.

Making Data Dictionaries Beautiful Using Graph Databases

Most analysts estimate that for a given project well over half of the time is spent on collecting, transforming, and cleaning data in preparation for analysis. This task is generally regarded as one of the least appetizing portions of the data analysis process and yet it is the most crucial, as trustworthy analyses are borne out of clean, reliable data. Gathering and preparing data for analysis can be either enhanced or hindered based on the data management practices in place at a firm. When data are readily available, clearly defined, and well documented it will lead to faster and higher-quality insights. As the size and variability of data grows, however, so too does the challenge of storing and managing it. Like many firms, RiskSpan manages a multitude of large, complex datasets with varying degrees of similarity and connectedness. To streamline the analysis process and improve the quantity and quality of our insights, we have made our datasets, their attributes, and relationships transparent and quickly accessible using graph database technology. Graph databases differ significantly from traditional relational databases because data are not stored in tables. Instead, data are stored in either a node or a relationship (also called an edge), which is a connection between two nodes. The image below contains a grey node labeled as a dataset and a blue node labeled as a column. The line connecting these two nodes is a relationship which, in this instance, signifies that the dataset contains the column. Graph 1 There are many advantages to this data structure including decreased redundancy. Rather than storing the same “Column1” in multiple tables for each dataset that contain it (as you would in a relational database), you can simply create more relationships between the datasets demonstrated below: Graph 2 With this flexible structure it is possible to create complex schema that remain visually intuitive. In the image below the same grey (dataset) -contains-> blue (column) format is displayed for a large collection of datasets and columns. Even at such a high level, the relationships between datasets and columns reveal patterns about the data. Here are three quick observations:

  1. In the top right corner there is a dataset with many unique columns.
  2. There are two datasets that share many columns between them and have limited connectivity to the other datasets.
  3. Many ubiquitous columns have been pulled to the center of the star pattern via the relationships to the multiple datasets on the outer rim.

Graph 3 In addition to containing labels, nodes can store data as key-value pairs. The image below displays the column “orig_upb” from dataset “FNMA_LLP”, which is one of Fannie Mae’s public datasets that is available on RiskSpan’s Edge Platform. Hovering over the column node displays some information about it, including the name of the field in the RiskSpan Edge platform, its column type, format, and data type. Graph 4 Relationships can also store data in the same key-value format. This is an incredibly useful property which, for the database in this example, can be used to store information specific to a dataset and its relationship to a column. One of the ways in which RiskSpan has utilized this capability is to hold information pertinent to data normalization in the relationships. To make our datasets easier to analyze and combine, we have normalized the formats and values of columns found in multiple datasets. For example, the field “loan_channel” has been mapped from many unique inputs across datasets to a set of standardized values. In the images below, the relationships between two datasets and loan_channel are highlighted. The relationship key-value pairs contain a list of “mapped_values” identifying the initial values from the raw data that have been transformed. The dataset on the left contains the list: [“BROKER”, “CORRESPONDENT”, “RETAIL”] Graph 5 While the dataset on the right contains: [“R”, “B”, “C”, “T”, “9”] Graph 6 We can easily merge these lists with a node containing a map of all the recognized enumerations for the field. This central repository of truth allows us to deploy easy and robust changes to the ETL processes for all datasets. It also allows analysts to easily query information related to data availability, formats, and values. Graph 7 In addition to queries specific to a column, this structure allows an analyst to answer questions about data availability across datasets with ease. Normally, comparing pdf data dictionaries, excel worksheets, or database tables can be a painstaking process. Using the graph database, however, a simple query can return the intersection of three datasets as shown below. The resulting graph is easy to analyze and use to define the steps required to obtain and manipulate the data. Graph 8 In addition to these benefits for analysts and end users, utilizing graph database technology for data management comes with benefits from a data governance perspective. Within the realm of data stewardship, ownership and accountability of datasets can be assigned and managed within a graph database like the one in this blog. The ability to store any attribute in a node and create any desired relationship makes it simple to add nodes representing data owners and curators connected to their respective datasets. Graph 9 The ease and transparency with which any data related information can be stored makes graph databases very attractive. Graph databases can also support a nearly infinite number of nodes and relationships while also remaining fast. While every technology has a learning curve, the intuitive nature of graphs combined with their flexibility makes them an intriguing and viable option for data management.

Augmenting Internal Loan Data to Comply with CECL and Boost Profit

The importance of sound internal data gathering practices cannot be understated. However, in light of the new CECL standard, many lending institutions have found themselves unable to meet the data requirements. This may have served as a wake-up call for organizations at all levels to look at their internal data warehousing systems and identify and remedy the gaps in their strategies. For some institutions, it may be difficult to consolidate data siloed within various stand-alone systems. Other institutions, even after consolidating all available data, may lack sufficient loan count, timespan, or data elements to meet the CECL standard with internal data alone. This post will discuss some of the strategies to make up for shortfalls while data gathering systems and procedures are built and implemented for the future.  

Identify Your Data

The first step is to identify the data that is available. As many tasks go, this is easier said than done. Often, organizations without formal data gathering practices and without a centralized data warehouse find themselves looking at multiple data storage systems across various departments and a multitude of ad-hoc processes implemented in time of need and not upgraded to a standardized solution. However, it is important to begin this process now, if it is not already underway. As part of the data identification phase, it is important to keep track of not only the available variables, but also the length of time for which the data exists, and whether any time periods have missing or unreliable information. In most circumstances, to meet the CECL standard, institutions should have loan performance data that will cover a full economic cycle by the time of CECL adoption. Such data enables an institution to form grounded expectations of how assets will perform over their full contractual lives, across a variety of potential economic climates. Some data points are required regardless of the CECL methodology, while others are necessary only for certain approaches. At this part of the data preparation process, it is more important to understand the big picture than it is to confirm only some of the required fields—it is wise to see what information is available, even if it may not appear relevant at this time. This will prove very useful for drafting the data warehousing procedures, and will allow for a more transparent understanding of requirements should the bank decide to use a different methodology in the future.  

Choose Your CECL Methodology

There are many intricacies involved in choosing a CECL Methodology. Each organization should determine both its capabilities and its needs. For example, the Vintage method has relatively simple calculations and limited data requirements, but provides little insight and control for management, and does not yield early model performance indicators. On the other hand, the Discounted Cash Flow method provides many insights and controls, and identifies model performance indicators preemptively, but requires more complex calculations and a very robust data history. It is acceptable to implement a relatively simple methodology at first and begin utilizing more advanced methodologies in the future. Banks with limited historical data, but with procedures in place to ramp up data gathering and data warehousing capabilities, would be well served to implement a method for which all data needs are met. They can then work toward the goal of implementing a more robust methodology once enough historical data is available. However, if insufficient data exists to effectively implement a satisfactory methodology, it may be necessary to augment existing historical data with proxy data as a bridge solution while your data collections mature.  

Augment Your Internal Data

Choose Proxy Data

Search for cost-effective datasets that give historical loan performance information about portfolios that are reasonably similar to your go-forward portfolio. Note that proxy portfolios do not need to perfectly resemble your portfolio, so long as either a) the data provider offers filtering capability that enables you to find the subset of proxy loans that matches your portfolio’s characteristics, or b) you employ segment- or loan-level modeling techniques that apply the observations from the proxy dataset in the proportions that are relevant to your portfolio. RiskSpan’s Edge platform contains a Data Library that offers historical loan performance datasets from a variety of industry sources covering multiple asset classes:

  • For commercial real estate (CRE) portfolios, we host loan-level data on all CRE loans guaranteed by the Small Business Administration (SBA) dating back to 1990. Data on loans underlying CMBS securitizations dating back to 1998, compiled by Trepp, is also available on the RiskSpan platform.
  • For commercial and industrial (C&I) portfolios, we also host loan-level on all C&I loans guaranteed by the SBA dating back to 1990.
  • For residential mortgage loan portfolios, we offer large agency datasets (excellent, low-cost options for portfolios that share many characteristics with GSE portfolios) and non-agency datasets (for portfolios with unique characteristics or risks).
  • By Q3 2018, we will also offer data for auto loan portfolios and reverse mortgage portfolios (Home Equity Conversion Mortgages).

Note that for audit purposes, limitations of proxy data and consequent assumptions for a given portfolio need to be clearly outlined, and all severe limitations addressed. In some cases, multiple proxy datasets may be required. At this stage, it is important to ensure that the proxy data contains all the data required by the chosen CECL methodology. If such proxy data is not available, a different CECL model may be best.  

Prepare Your Data

The next step is to prepare internal data for augmentation. This includes standard data-keeping practices, such as accurate and consistent data headers, unique keys such as loan numbers and reporting dates, and confirmation that no duplicates exist. Depending on the quality of internal data, additional analysis may also be required. For example, all data fields need to be displayed in a consistent format according to the data type, and invalid data points, such as FICO scores outside the acceptable range, need to be cleansed. If the data is assembled manually, it is prudent to automate the process to minimize the possibility of user error. If automation is not possible, it is important to implement data quality controls that verify that the dataset is generated according to the metadata rules. This stage provides the final opportunity to identify any data quality issues that may have been missed. For example, if, after cleansing the data for invalid FICO scores, it appears that the dataset has many invalid entries, further analysis may be required, especially if borrower credit score is one of the risk metrics used for CECL modeling. Once internal data preparation is complete, proxy metadata may need to be modified to be consistent with internal standards. This includes data labels and field formats, as well as data quality checks to ensure that consistent criteria are used across all datasets.  

Identify Your Augmentation Strategy

Once the internal data is ready and its limitations identified, analysts need to confirm that the proxy data addresses these gaps. Note that it is assumed at this stage that the proxy data chosen contains information for loans that are consistent with the internal portfolio, and that all proxy metadata items are consistent with internal metadata. For example, if internal data is robust, but has a short history, proxy data needs to cover the additional time periods for the life of the asset. In such cases, augmenting internal data is relatively simple: the datasets are joined, and tested to ensure that the join was successful. Testing should also cover the known limitations of the proxy data, such as missing non-required fields or other data quality issues deemed acceptable during the research and analysis phase. More often, however, there is a combination of data shortfalls that lead to proxy data needs, which can include either time-related gaps, data element gaps, or both. In such cases, the augmentation strategy is more complex. In the cases of optional data elements, a decision to exclude certain data columns is acceptable. However, when incorporating required elements that are inputs for the allowance calculation, the data must be used in a way that complies with regulatory requirements. If internal data has incomplete information for a given variable, statistical methods and machine learning tools are useful to incorporate the proxy data with the internal data, and approximate the missing variable fields. Statistical testing is then used to verify that the relationships between actual and approximated figures are consistent with expectation, which are then verified by management or expert analysis. External research on economic or agency data, where applicable, can further be used to justify the estimated data assumptions. While rigorous statistical analysis is integral for the most accurate metrics, the qualitative analysis that follows is imperative for CECL model documentation and review.  

Justify Your Proxy Data

Overlaps in time periods between internal loan performance datasets and proxy loan performance datasets are critical in establishing the applicability of the proxy dataset. A variety of similarity metrics can be calculated that compare the performance of the proxy loans with the internal loan during the period of overlap. Such similarity metrics can be put forward to justify the use of the proxy dataset. The proxy dataset can be useful for predictions even if the performance of the proxy loans is not identical to the performance of the institutions’ loans. As long as there is a reliable pattern linking the performance of the two datasets, and no reason to think that pattern will discontinue, a risk-adjusting calibration can be justified and applied to the proxy data, or to results of models built thereon.  

Why Augment Internal Data?

While the task of choosing the augmentation strategy may seem daunting, there are concrete benefits to supplementing internal data with a proxy, rather than using simply the proxy data on its own. Most importantly, for the purpose of calculating the allowance for a given portfolio, incorporating some of the actual values will in most cases produce the most accurate estimate. For example, your institution may underwrite loans conservatively relative to the rest of the industry—incorporating at least some of the actual data associated with the lending practices will make it easier to understand how the proxy data differs from characteristics unique to your business. More broadly, proxy data is useful beyond CECL reporting, and has other applications that can boost bank profits. For example, lending institutions can build better predictive models based on richer datasets to calibrate loan screening and loan pricing decisions. These datasets can also be built into existing models to provide better insight on risk metrics and other asset characteristics, and to allow for more fine-tuned management decisions.

Applying Machine Learning to Conventional Model Validations

In addition to transforming the way in which financial institutions approach predictive modeling, machine learning techniques are beginning to find their way into how model validators assess conventional, non-machine-learning predictive models. While the array of standard statistical techniques available for validating predictive models remains impressive, the advent of machine learning technology has opened new avenues of possibility for expanding the rigor and depth of insight that can be gained in the course of model validation. In this blog post, we explore how machine learning, in some circumstances, can supplement a model validator’s efforts related to:

  • Outlier detection on model estimation data
  • Clustering of data to better understand model accuracy
  • Feature selection methods to determine the appropriateness of independent variables
  • The use of machine learning algorithms for benchmarking
  • Machine learning techniques for sensitivity analysis and stress testing

 

 

Outlier Detection

Conventional model validations include, when practical, an assessment of the dataset from which the model is derived. (This is not always practical—or even possible—when it comes to proprietary, third-party vendor models.) Regardless of a model’s design and purpose, virtually every validation concerns itself with at least a cursory review of where these data are coming from, whether their source is reliable, how they are aggregated, and how they figure into the analysis.

Conventional model validation techniques sometimes overlook (or fail to look deeply enough at) the question of whether the data population used to estimate the model is problematic. Outliers—and the effect they may be having on model estimation—can be difficult to detect using conventional means. Developing descriptive statistics and identifying data points that are one, two, or three standard deviations from the mean (i.e., extreme value analysis) is a straightforward enough exercise, but this does not necessarily tell a modeler (or a model validator) which data points should be excluded.

Machine learning modelers use a variety of proximity and projection methods for filtering outliers from their training data. One proximity method employs the K-means algorithm, which groups data into clusters centered around defined “centroids,” and then identifies data points that do not appear to belong to any particular cluster. Common projection methods include multi-dimensional scaling, which allows analysts to view multi-dimensional relationships among multiple data points in just two or three dimensions. Sophisticated model validators can apply these techniques to identify dataset problems that modelers may have overlooked.

 

Data Clustering

The tendency of data to cluster presents another opportunity for model validators. Machine learning techniques can be applied to determine the relative compactness of individual clusters and how distinct individual clusters are from one another. Clusters that do not appear well defined and blur into one another are evidence of a potentially problematic dataset—one that may result in non-existent patterns being identified in random data. Such clustering could be the basis of any number of model validation findings.

 

 

Feature (Variable) Selection

What conventional predictive modelers typically refer to as variables are commonly referred to by machine learning modelers as features. Features and variables serve essentially the same function, but the way in which they are selected can differ. Conventional modelers tend to select variables using a combination of expert judgment and statistical techniques. Machine learning modelers tend to take a more systematic approach that includes stepwise procedures, criterion-based procedures, lasso and ridge regresssion and dimensionality reduction. These methods are designed to ensure that machine learning models achieve their objectives in the simplest way possible, using the fewest possible number of features, and avoiding redundancy. Because model validators frequently encounter black-box applications, directing applying these techniques is not always possible. In some limited circumstances, however, model validators can add to the robustness of their validations by applying machine learning feature selection methods to determine whether conventionally selected model variables resemble those selected by these more advanced means (and if not, why not).

 

Benchmarking Applications

Identifying and applying an appropriate benchmarking model can be challenging for model validators. Commercially available alternatives are often difficult to (cost effectively) obtain, and building challenger models from scratch can be time-consuming and problematic—particularly when all they do is replicate what the model in question is doing.

While not always feasible, building a machine learning model using the same data that was used to build a conventionally designed predictive model presents a “gold standard” benchmarking opportunity for assessing the conventionally developed model’s outputs. Where significant differences are noted, model validators can investigate the extent to which differences are driven by data/outlier omission, feature/variable selection, or other factors.

 

 Sensitivity Analysis and Stress Testing

The sheer quantity of high-dimensional data very large banks need to process in order to develop their stress testing models makes conventional statistical analysis both computationally expensive and problematic. (This is sometimes referred to as the “curse of dimensionality.”) Machine learning feature selection techniques, described above, are frequently useful in determining whether variables selected for stress testing models are justifiable.

Similarly, machine learning techniques can be employed to isolate, in a systematic way, those variables to which any predictive model is most and least sensitive. Model validators can use this information to quickly ascertain whether these sensitivities are appropriate. A validator, for example, may want to take a closer look at a credit model that is revealed to be more sensitive to, say, zip code, than it is to credit score, debt-to-income ratio, loan-to-value ratio, or any other individual variable or combination of variables. Machine learning techniques make it possible for a model validator to assess a model’s relative sensitivity to virtually any combination of features and make appropriate judgments.

 

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Model validators have many tools at their disposal for assessing the conceptual soundness, theory, and reliability of conventionally developed predictive models. Machine learning is not a substitute for these, but its techniques offer a variety of ways of supplementing traditional model validation approaches and can provide validators with additional tools for ensuring that models are adequately supported by the data that underlies them.

Applying Model Validation Principles to Machine Learning Models

Machine learning models pose a unique set of challenges to model validators. While exponential increases in the availability of data, computational power, and algorithmic sophistication in recent years has enabled banks and other firms to increasingly derive actionable insights from machine learning methods, the significant complexity of these systems introduces new dimensions of risk.

When appropriately implemented, machine learning models greatly improve the accuracy of predictions that are vital to the risk management decisions financial institutions make. The price of this accuracy, however, is complexity and, at times, a lack of transparency. Consequently, machine learning models must be particularly well maintained and their assumptions thoroughly understood and vetted in order to prevent wildly inaccurate predictions. While maintenance remains primarily the responsibility of the model owner and the first line of defense, second-line model validators increasingly must be able to understand machine learning principles well enough to devise effective challenge that includes:

  • Analysis of model estimation data to determine the suitability of the machine learning algorithm
  • Assessment of space and time complexity constraints that inform model training time and scalability
  • Review of model training/testing procedure
  • Determination of whether model hyperparameters are appropriate
  • Calculation of metrics for determining model accuracy and robustness

More than one way exists of organizing these considerations along the three pillars of model validation. Here is how we have come to think about it.

 

Conceptual Soundness

Many of the concepts of reviewing model theory that govern conventional model validations apply equally well to machine learning models. The question of “business fit” and whether the variables the model lands on are reasonable is just as valid when the variables are selected by a machine as it is when they are selected by a human analyst. Assessing the variable selection process “qualitatively” (does it make sense?) as well as quantitatively (measuring goodness of fit by calculating residual errors, among other tests) takes on particular importance when it comes to machine learning models.

Machine learning does not relieve validators of their responsibility assess the statistical soundness of a model’s data. Machine learning models are not immune to data issues. Validators protect against these by running routine distribution, collinearity, and related tests on model datasets. They must also ensure that the population has been appropriately and reasonably divided into training and holdout/test datasets.

Supplementing these statistical tests should be a thorough assessment of the modeler’s data preparation procedures. In addition to evaluating the ETL process—a common component of all model validations—effective validations of machine learning models take particular notice of variable “scaling” methods. Scaling is important to machine learning algorithms because they generally do not take units into account. Consequently, a machine learning model that relies on borrower income (generally ranging between tens of thousands and hundreds of thousands of dollars), borrower credit score (which generally falls within a range of a few hundred points) and loan-to-value ratio (expressed as a percentage), needs to apply scaling factors to normalize these ranges in order for the model to correctly process each variable’s relative importance. Validators should ensure that scaling and normalizations are reasonable.

Model assumptions, when it comes to machine learning validation, are most frequently addressed by looking at the selection, optimization, and tuning of the model’s hyperparameters. Validators must determine whether the selection/identification process undertaken by the modeler (be it grid search, random search, Bayesian Optimization, or another method—see this blog post for a concise summary of these) is conceptually sound.

 

Process Verification

Machine learning models are no more immune to overfitting and underfitting (the bias-variance dilemma) than are conventionally developed predictive models. An overfitted model may perform well on the in-sample data, but predict poorly on the out-of-sample data. Complex nonparametric and nonlinear methods used in machine learning algorithms combined with high computing power are likely to contribute to an overfitted machine learning model. An underfitted model, on the other hand, performs poorly in general, mainly due to an overly simplified model algorithm that does a poor job at interpreting the information contained within data.

Cross-validation is a popular technique for detecting and preventing the fitting or “generalization capability” issues in machine learning. In K-Fold cross-validation, the training data is partitioned into K subsets. The model is trained on all training data except the Kth subset, and the Kth subset is used to validate the performance. The model’s generalization capability is low if the accuracy ratios are consistently low (underfitted) or higher on the training set but lower on the validation set (overfitted). Conventional models, such as regression analysis, can be used to benchmark performance.

 

Outcomes Analysis

Outcomes analysis enables validators to verify the appropriateness of the model’s performance measure methods. Performance measures (or “scoring methods”) are typically specialized to the algorithm type, such as classification and clustering. Validators can try different scoring methods to test and understand the model’s performance. Sensitivity analyses can be performed on the algorithms, hyperparameters, and seed parameters. Since there is no right or wrong answer, validators should focus on the dispersion of the sensitivity results.

 

Many statistical tactics commonly used to validate conventional models apply equally well to machine learning models. One notable omission is the ability to precisely replicate the model’s outputs. Unlike with an OLS or ARIMA model, for which a validator can reasonably expect to be able to match the model’s coefficients exactly if given the same data, machine learning models can be tested only indirectly—by testing the conceptual soundness of the selected features and assumptions (hyperparameters) and by evaluating the process and outputs. Applying model validation tactics specially tailored to machine learning models allows financial institutions to deploy these powerful tools with greater confidence by demonstrating that they are of sound conceptual design and perform as expected.

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