‘Pangs of Optimism’ [RMA Journal, The]

The economy, the crisis, and the regulators were the focus of RMA's 2011 Retail Risk Conference.

Mark Zandi admitted that the economy has not lived up to his expectations this year, but he still has "pangs of optimism." The senior economist at Moody's Analytics told attendees at RMA's Retail Risk Conference in June that this year's 2% growth in GDP is only half of what he had expected, and that the economy needs growth of 2.5% to 3% just to keep the unemployment rate from rising.

Zandi gave three reasons for the slowdown:

1. The surges in oil and food prices have weighed heavily on spending. Increased oil prices cost the economy $150 billion and sucked the wind out of the payroll tax cut stimulus.

2. The Japanese earthquake and tsunami had more of an impact than he anticipated, particularly on auto production and sales, cutting GDP by 1%. This development took a key growth driver out of the economy.

3. The general lack of confidence in the economy has amplified the above impacts and contributed to the sharp slowdown.

Yet, Zandi finds some glimmers of optimism. He believes that GDP growth will be closer to 4% by year-end 2011 and also in 2012, which will result in the creation of 1 million jobs this year and 3 million next year. He expects unemployment to be down to 8% by the end of 2012, with full employment (5-6% unemployment) by 2014 or 2015.

Why? Again, there are three reasons:

1. American companies are in good financial shape, with the bigger ones doing better than smaller ones. Corporate earnings grew more than 30% across industries in the past year and balance sheets are strong. The ratio of liquid assets of nonfinancial companies is 55%, a record high. Companies are postponing expansion for now because of policy uncertainty around a wide range of issues including health care reform, regulatory reform, and immigration.

2. The economy is making progress in overcoming the reasons for the recession. Households are deleveraging, having paid down $1.2 trillion in debt. Debt service burdens are declining rapidly and will be at record lows in spring 2012.

3. Credit flows are improving. Commercial and industrial loans, a lagging economic indicator, are accelerating in double digits. Originations of home equity and auto loans are increasing, but they are not yet high enough to offset charge-offs.

Zandi may be optimistic, but he also confessed to being nervous, providing three reasons for remaining on edge:

1. A Greek default would cause economic havoc, but Zandi doesn't think the European Union will allow that to happen in 2011 or 2012. He thinks the Greeks will default, but not until 2013 or 2014, after European countries have Beanshad the opportunity to "inoculate themselves" against it. But one never knows because politics are involved and Germany is key-hence his nervousness.

2. The foreclosure crisis is ongoing and the percentage of distressed sales is rising. Housing prices have stabilized, but Zandi believes this is just a lull before foreclosure activity increases again, weighing heavily on prices, particularly in distressed markets. Investor demand for distressed sales is increasing and pricing in nondistressed markets is holding up, but still Zandi thinks there's good reason to be nervous about housing prices.

3. Fiscal problems are serious. In Zandi's view, the policy response to the crisis was good, if not perfect, and it would have been far more costly to taxpayers if the government had done nothing. However, the 5% ratio of debt to GDP is unsustainable, he warned. What's needed, he said, is a minimum of 2%, or $350 billion to $450 billion, a year in spending cuts or revenue increases.

Blame the Politicians

Unlike Zandi, keynote speaker William M. Isaac, former director of the FDIC, was critical of the policy response to the financial crisis. Indeed, he lays the blame for the crisis on Washington politicians. According to Isaac, the politicians failed to learn the lessons of past crises, particularly the savings and loan crisis of the 1980s, which he battled when head of the FDIC.

Moreover, Isaac said that politicians have failed us in the recent crisis by creating what he calls a "senseless panic" in his book by the same name. Isaac is highly critical of the Dodd-Frank Act-calling it "the worst financial legislation in history"-because it fails to address some of the causes of the crisis, including the nation's fragmented regulatory structure and issues with Fannie Mae and Freddie Mac and the rating agencies.

Isaac also said that Washington politicized the regulatory process and that the regulatory bodies need to be consolidated and independent so they can take actions that will correct the problems. He said that allowing members of the existing regulatory bodies to sit on the board of the newly created Financial Stability Oversight Council is akin to allowing those who grant loans at institutions to also sit on the loan review committee.

The actions of leaders in Washington at the outset of the crisis contributed to the panic that caused markets to collapse, he said. Mark-to-market accounting led banks to write down good-quality assets because there was no market for them at the time.

Isaac was particularly critical of the public nature of the stress tests of the nation's largest 19 banks, believing it created more uncertainty. Stress tests are an important tool, he said, but they need to be done privately as part of the exam process. As a result of this blunder, he continued, the government indicated that all 19 of these banks are systemically important or "too big to fail," thereby giving them access to lower cost funding and increasing their competitive advantage. Regional and community banks are important to the financial system, and Isaac believes they should not be disadvantaged vis-à-vis the big 19.

Addressing the issue of capital, Isaac said banks need to be countercyclical, not procyclical. A bank shouldn't walk away from its customers when they are struggling in a weak economy, he emphasized. Banks lose customer loyalty when they do that. Banks need tangible equity that is available to lend when the economy turns down.

Isaac said he was never a proponent of Basel II because it relied on models to allow banks to reduce capital. U.S. banks wanted to impose Basel II's lower capital requirements so they could stay competitive with European banks, but Isaac says that's not the answer. He believes European banks that want to operate in the U.S. should be required to hold the same amount of capital as U.S. banks.

The Dodd-Frank Act will not prevent the next crisis, Isaac concluded. He said that RMA is needed more today than ever, and he urged everyone to speak out about issues that they believe harm the industry.

Protecting Consumers

A regulatory panel offered its perspective on numerous topics including views on recently issued regulatory guidance and various aspects of the Dodd-Frank Act. Brian Valenti, manager of the risk section in banking supervision at the Federal Reserve Board, said that the Dodd-Frank Act specifies that certain consumer protection responsibilities under Regulation Z were scheduled to move from the Board to the CFPB upon its official launch date of July 21. The Dodd-Frank Act also specifies that disclosures and financial education for consumers are important parts of the agency's mission.

In relation to the appraisal guidance issued in December, Kevin Russell, Retail Credit Risk, OCC, said that banks will need to know the actual physical condition of a property as part of an evaluation and not rely solely on automated valuation models (AVMs).

In discussing qualified residential mortgages (QRMs), Russell said they were not intended to cover every mortgage in America, so low-income borrowers will still be able to qualify for credit. The ability to repay is a consideration for borrowers of all income levels. The down-payment requirement does not preclude borrowers from using funds from nonbank sources such as family, friends, government agencies, and charitable organizations.

On mortgage servicing, Russell said an interagency group is developing national servicing standards that would be separate from foreclosure practices. He said the OCC will ask banks to do a self-assessment of foreclosure management practices, consistent with the size of their operation, to make sure they have the processes and procedures in place to ensure they are compliant with foreclosure laws.

On documentation, another big issue, Russell said the OCC wants institutions to make sure that the documents they file with the court are accurate and have appropriate endorsements or assignments of documents. In other words, he said, "A clear audit trail of anything that was presented in the state filing must be correct and supported in the bank's records."

Regarding loan modifications, Christopher J. Spoth, deputy director, FDIC, said that they're all about loss mitigation. The modifications are a standard banking practice not previously applied in the residential mortgage portfolio.

Valenti added that one important lesson to be learned from the foreclosure documentation problems is that lenders need to make sure sufficient resources and risk management attention is paid to areas where there is high growth, be it back-office operations or growth in various lending areas. It's important to recognize high-growth areas and the risks they represent.

Spoth also encouraged bankers to take a forward-looking approach to risk management. Do you expect past-dues and losses-given-default to increase? If so, at what level? How do you aggregate that information into the enterprise risk and what is the resulting capital ratio? What's the impact on earnings? At what point will you not pay a dividend?

The regulators expect risk management practices to reflect a bank's risk profile, Spoth said. "Strong practices, such as stress testing, scenario analysis, and continuity planning, are required when the risk is high."

Valenti added that regulators don't expect stress-testing practices to be one-size-fits-all. Banks that have lower levels of assets will not need to do the same level of stress testing as Bank of America, Citi, JPMorgan Chase, or Wells Fargo.

Credit Bureaus Weigh In

Having science on your side is essential, said Daniel J. Riner, SVP, Consumer Risk Management, JPMorgan Chase, who moderated a credit bureau panel. When he asked the panel if it's true that consumers have deleveraged, Chuck Robida, director, Research and Development, Experian, said the deleveraging includes loans that consumers simply did not pay and those were charged off. Less availability of credit and a cutback in credit limits also contribute to the deleveraging, he said, but consumers actively paying down debt are not a big contributor to the decline in outstanding balances.

Overall, though, the health of the consumer is improving, according to the Standard & Poor's Experian Default Index, which tracks auto, bank card, and first and second mortgage loans. Robida explained that the index tracks new defaults and indicates consumer health much as new jobless claims indicate economic health. The index shows that default rates are coming down, but are still high historically. First mortgage defaults are twice as high as they were before 2007.

In addressing the performance of scorecards, Robida said there has not been a shift in the way consumers perform. He explained that the shift has occurred in how those scores are interpreted. Bank cards and auto loans remained stable, but the odds associated with mortgage payments declined as consumers put mortgages lower on the hierarchy of bills they would pay. Underwater mortgages and unemployment contributed to these decisions not to pay, he said.

Martin O'Connor, head of modeling and analytics, Equifax, emphasized the importance of tracking exactly what a score means over time and adjusting your strategy accordingly.

Chet Wiermanski, global chief scientist, TransUnion, said the challenge for the credit bureaus is tracking consumer behavior to see which characteristics are evolving and then implementing those changes into the scorecard. The bureaus must determine if the behaviors are temporary or long term.

Strategic defaulters represent an interesting behavior. Wiermanski said that of those consumers who defaulted only on their mortgage or were extremely delinquent, a third were able to obtain a new line of credit or a new loan within six to 18 months. Consumers who were delinquent in other types of accounts took longer to get credit and obtained smaller loans.

O'Connor also advised lenders to understand the different dimensions used in credit income models. "Many different flavors are available," he said. Does it measure individual income or household income? Does it measure Fair Credit Reporting Act data or non-FCRA data? "Make sure you have the right model for the application you are using," he advised.

Focus on Customer Needs

Noting that organic growth is the single strongest driver of shareholder value creation, Sean Rowles, EVP and CCO, Consumer and Business Banking, RBS Citizens Financial, said that organizations must consistently focus on customer needs. It's not just about credit risk, he said. It's also about market risk, operational risk, and liquidity risk.

Rowles offered a hierarchy of what customers want from banks, in reverse order of importance:

7. Be safe.

6. Be trustworthy.

5. Be convenient.

4. Be competent.

3. Meet my needs.

2. Be approachable.

1. Know me.

According to Rowles, customers are mostly indifferent about the bank they use and aren't likely to change unless they encounter a problem. They are looking for safety and convenience. Density of the branch network is important, he noted, as are an approachable and competent staff and excellent business processes. Don't ask for an address every time the customer comes to the bank, he advised. v

American companies are in good financial shape, with the bigger ones doing better than smaller ones. Corporate earnings grew more than 30% across industries in the past year and balance sheets are strong.

A bank shouldn't walk away from its customers when they are struggling in a weak economy. Banks lose customer loyalty when they do that.

The regulators expect risk management practices to reflect a bank's risk profile. "Strong practices, such as stress testing, scenario analysis, and continuity planning, are required when the risk is high."

Christopher J. Spoth, deputy director, FDIC

Kathleen M. Beans is editor of The RMA Journal. She can be reached at [email protected]