Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
The following items are essential components of a risk
management program for subprime lenders.
Planning and Strategy. Prior to engaging in subprime
lending, the board and management should ensure that
proposed activities are consistent with the institution's
overall business strategy and risk tolerances, and that all
involved parties have properly acknowledged and
addressed critical business risk issues. These issues include
the costs associated with attracting and retaining qualified
personnel, investments in the technology necessary to
manage a more complex portfolio, a clear solicitation and
origination strategy that allows for after-the-fact
assessment of underwriting performance, and the
establishment of appropriate feedback and control systems.
The risk assessment process should extend beyond credit
risk and appropriately incorporate operating, compliance,
market, liquidity, reputation and legal risks.
Institutions establishing a subprime lending program
should proceed slowly and cautiously into this activity to
minimize the impact of unforeseen personnel, technology,
or internal control problems and to determine if favorable
initial profitability estimates are realistic and sustainable.
Strategic plan performance analysis should be conducted
frequently in order to detect adverse trends or
circumstances and take appropriate action in a timely
manner.
Management and Staff. Prior to engaging in subprime
lending, the board should ensure that management and staff
possess sufficient expertise to appropriately manage the
risks in subprime lending and that staffing levels are
adequate for the planned volume of activity. Subprime
lending requires specialized knowledge and skills that
many financial institutions do not possess. Marketing,
account origination, and collections strategies and
techniques often differ from those employed for prime
credit; thus it is generally not sufficient to have the same
staff responsible for both subprime and prime loans.
Servicing and collecting subprime loans can be very labor
intensive and requires a greater volume of staff with
smaller caseloads. Lenders should monitor staffing levels,
staff experience, and the need for additional training as
performance is assessed over time. Compensation
programs should not depend primarily on volume or
growth targets. Any targets used should be weighted
towards factors such as portfolio quality and risk-adjusted
profitability.
Lending Policies and Procedures. Lenders should have
comprehensive written policies and procedures, specific to
each subprime lending product, that set limits on the
amount of risk that will be assumed and address how the
institution will control portfolio quality and avoid
excessive exposure. Policies and procedures should be in
place before initiating the activity. Institutions may
originate subprime loans through a variety of channels,
including dealers, brokers, correspondents, and marketing
firms. Regardless of the source, it is critical that
underwriting policies and procedures incorporate the risk
tolerances established by the board and management and
explicitly define underwriting criteria and exception
processes. Subprime lending policies and procedures
should, at a minimum, address the items outlined in the
loan reference module of the Examination Documentation
Modules for subprime lending. If the institution elects to
use scoring systems for approvals or pricing, the model
should be tailored to address the behavioral and credit
characteristics of the subprime population targeted and the
products offered. It is not acceptable to rely on models
developed for standard risk borrowers or products.
Furthermore, the models should be reviewed frequently
and updated as necessary to ensure assumptions remain
valid.
Given the higher credit risk associated with the subprime
borrower, effective subprime lenders use mitigating
underwriting guidelines and risk-based pricing to reduce
the overall risk of the loan. These guidelines include lower
loan-to-value ratio requirements and lower maximum loan
amounts relative to each risk grade within the portfolio.
Given the high-risk nature of subprime lending, the need
for thorough analysis and documentation is heightened
relative to prime lending. Compromises in analysis or
documentation can substantially increase the risk and
severity of loss. In addition, subprime lenders should
develop criteria for limiting the risk profile of borrowers
selected, giving consideration to factors such as the
frequency, recency, and severity of delinquencies and
derogatory items; length of time with re-established credit;
and reason for the poor credit history.
While the past credit deficiencies of subprime borrowers
reflect a higher risk profile, subprime loan programs must
be based upon the borrowers’ current reasonable ability to
repay and a prudent debt amortization schedule. Loan
repayment should not be based upon foreclosure
proceedings or collateral repossession. Institutions must
recognize the additional default risks and determine if
these risks are acceptable and controllable without
resorting to foreclosure or repossession that could have
been predetermined by the loan structure at inception.
Profitability and Pricing. A key consideration for
lenders in the subprime market is the ability to earn riskadjusted
yields that appropriately compensate the
institution for the increased risk and costs assumed. The
institution must have a comprehensive framework for
Loans (12-04) 3.2-68 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation