Financial/Risk Analysis of Lenders - The Cure May Be As Troublesome As The Problem

Implications: The problems of subprime lending are hot topics.  Lack of underwriting standards and poor pricing are the primary concern.

However lenders need to understand the cure or reaction to such concerns can cause even more harm.  Financial analysts need to understand how their clientele (e.g., banks) are coping with the challenges.  Financial analysts must consider the proposed solutions.  The solutions may cause as many, if not more, problems.  The issue is value at risk.

Analysis: Nobody debates that subprime lending is creating a lot of problems for financial institutions (e.g., Washington Mutual) and the overall economy.  These problems are the direct result of an expanding economy, poor underwriting standards, and poor pricing standards.  The desire of financial institutions to create value was driven by growth and volume, balanced with inadequate consideration of all risks.  This resulted in taking too much risk for a given price.  Adjustable rate mortgages (ARM's) are prime examples of this.  Customers were loaned money that they could afford only if interest rates remained low.  Lenders justified the low rates with two facts.  First, the customer's converge ratio was deemed adequate (current debt service to available income).  Second, financial institutions were funding the ARM's with floating rate money.  In terms of asset-liability management, financial institutions were not directly taking interest rate risk.  They were hedging the interest rate risk with an immunization strategy.  (Note:  Lenders transferred their interest rate risk to their customers.)

However financial institutions failed to look at the interaction of default and interest rate risks.  As interest rates increased, customer coverage ratios dropped, causing default.  The push to lower interest rate risk (asset-liability) caused an increase in default risk.

What is interesting are the many cries for institutions to stop lending money on a floating rate basis.  The referenced article is a example of this.  This strategy does help in evaluating and managing default risk.  Current coverage ratios are more reliable predictors of future coverage rations.  However this ignores the asset-liability issue.  How does a financial institution fund long-term loans?

Financial analysis must look at a financial institution's "total" risk profile.  What is critical are the answers to the following two questions:
1.    What is the total risk profile of the financial institution, and is that risk level appropriate for this financial institution?  Don't forget regulation.
2.    Given the total risk profile of the financial institution, is the pricing/return adequate?