Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
pricing decisions and profitability analysis that considers
all costs associated with each subprime product, including
origination, administrative/servicing, expected charge-offs,
funding, and capital. In addition, the pricing framework
should allow for fluctuations in the economic cycle. Fees
often comprise a significant portion of revenue in subprime
lending. Consideration should be given to the portion of
revenues derived from fees and the extent to which the fees
are a recurring and viable source of revenue. Profitability
projections should be incorporated into the business plan.
Management should track actual performance against
projections regularly and have a process for addressing
variances.
Loan Review and Monitoring. Institutions must have
comprehensive analysis and information systems that
identify, measure, monitor and control the risks associated
with subprime lending. Analysis must promote
understanding of the portfolio and early identification of
adverse quality/performance trends. Systems employed
must posses the level of detail necessary to properly
evaluate subprime activity. Recommended portfolio
segmentation and trend analyses are fully discussed in the
subprime lending loan reference module of the
Examination Modules.
Analysis should take into consideration the effects of
portfolio growth and seasoning, which can mask true
performance by distorting delinquency and loss ratios.
Vintage, lagged delinquency, and lagged loss analysis
methods are sometimes used to account for growth,
seasoning, and changes in underwriting. Analysis should
also take into account the effect of cure programs on
portfolio performance. Refer to the glossary of the Credit
Card Specialty Bank Examination Guidelines for
definitions of vintage, roll rate, and migration analysis.
Servicing and Collections. Defaults occur sooner and in
greater volume than in prime lending; thus a welldeveloped
servicing and collections function is essential
for the effective management of subprime lending. Strong
procedures and controls are necessary throughout the
servicing process; however, particular attention is
warranted in the areas of new loan setup and collections to
ensure the early intervention necessary to properly manage
higher risk borrowers. Lenders should also have welldefined
written collection policies and procedures that
address default management (e.g., cure programs and
repossessions), collateral disposition, and strategies to
minimize delinquencies and losses. This aspect of
subprime lending is very labor intensive but critical to the
program's success.
Cure programs include practices such as loan restructuring,
re-aging, renewal, extension, or consumer credit
counseling. Cure programs should be used only when the
institution has substantiated the customer’s renewed
willingness and ability to pay. Management should ensure
that its cure programs are neither masking poor initial
credit risk selection nor deferring losses. Effective
subprime lenders may use short-term loan restructure
programs to assist borrowers in bringing loans current
when warranted, but will often continue to report past due
status on a contractual basis. Cure programs that alter the
contractual past due status may mask actual portfolio
performance and inhibit the ability of management to
understand and monitor the true credit quality of the
portfolio.
Repossession and resale programs are integral to the
subprime business model. Policies and procedures for
foreclosure and repossession activities should specifically
address the types of cost/benefit analysis to be performed
before pursuing collateral, including valuation methods
employed; timing of foreclosure or repossession; and
accounting and legal requirements. Policies should clearly
outline whether the bank will finance the sale of the
repossessed collateral, and if so, the limitations that apply.
Banks should track the performance of such loans to assess
the adequacy of these policies.
Compliance and Legal Risks. Subprime lenders
generally run a greater risk of incurring legal action given
the higher fees, interest rates, and profits; targeting
customers who have little experience with credit or
damaged credit records; and aggressive collection efforts.
Because the risk is dependent, in part, upon the public
perception of a lender’s practices, the nature of these risks
is inherently unpredictable. Institutions that engage in
subprime lending must take special care to avoid violating
consumer protection laws. An adequate compliance
management program must identify, monitor and control
the consumer protection hazards associated with subprime
lending. The institution should have a process in place to
handle the potential for heightened legal action. In
addition, management should have a system in place to
monitor consumer complaints for recurring issues and
ensure appropriate action is taken to resolve legitimate
disputes.
Audit. The institution’s audit scope should provide for
comprehensive independent reviews of subprime activities.
Audit procedures should ensure, among other things, that a
sufficient volume of accounts is sampled to verify the
integrity of the records, particularly with respect to
payments processing.
Third Parties. Subprime lenders may use third parties for
a number of functions from origination to collections. In
dealing with high credit-risk products, management must
DSC Risk Management Manual of Examination Policies 3.2-69 Loans (12-04)
Federal Deposit Insurance Corporation