I have over 25 years of experience in the consumer finance industry covering a wide range of subprime lending products. I have served as an expert witness on approximately 15 cases involving subprime lending products, and I was responsible for the underwriting and origination strategies of both subprime auto and subprime unsecured loans during my tenure at a major corporate bank. As an expert witness, I built and defended in deposition statistical models that demonstrated that many undisclosed mortgage products defaulted at higher rates than those products that Fannie classified and disclosed as subprime mortgage. In another case, I constructed and testified in deposition about statistical default models that measured the impact of poor underwriting on default rates after accounting for changes in the housing prices. I have also testified in trial and arbitration proceedings on prime and subprime automobile loans. While at a major corporate bank, I spent extensive time studying and performing due diligence on subprime lending firms who were using certain accounting practices to report substantial income gains derived in large part from improper or loose underwriting practices.
Typically, lenders employ a scorecard-based approach to underwriting loans. The scorecards are often generic credit risk models (i.e. FICO or VantageScore), but can also be custom models developed in-house. These scorecards are often used to risk-base price applicants where those scoring worse receive higher interest rates on their loans than those scoring better. Though less common, lenders may use a debt-to-income (DTI) ratio as part of their underwriting criteria. If a company has built a reliable, validated scorecard or employs an effective generic model, a lowering of the score cutoff for approvals will almost certainly result in an increase in delinquency and ultimately in charge-offs. There are several ways to demonstrate this relationship, but the most common and straightforward method is to perform static pool analysis on different credit score cohorts of loans and then compare the performance of each group of loans. Often, collection activities are organized by delinquency stage (i.e. early stage delinquencies, late-stage delinquencies, and post charge-off), but some firms, especially in the deep subprime sector, employ a “cradle-to-grave” approach. Regardless, a deterioration in underwriting quality typically will lead to higher delinquencies and increased collection activities. The higher delinquencies usually will manifest in higher default rates, no matter how intensively the accounts are worked or collection efforts intensified.