Author: Adam Mustafa, President
One of the most critical principles in banking is that the worst loans are often made in the best of times. This paradox underscores how economic conditions at the time of a loan's origination can shape its risk profile.
The Worst Loans: 2005–2007 and Beyond
Looking back, many of the worst loans originated during the boom years of 2005, 2006, and 2007. These were times of economic exuberance when borrowers across the board seemed creditworthy. However, the very optimism of the era led to a dangerous loosening of underwriting standards.
Even in more recent history, loans made during 2021 and early 2022 have shown similar vulnerabilities. Many banks that overextended themselves during this period are now facing regulatory pressure and deteriorating asset quality. This cycle of risk highlights a key lesson: economic conditions at the time of loan origination often outweigh other factors in determining long-term performance.
The Best Loans: Lessons from 2010–2012
Conversely, the best loans are often made in the worst economic times. During 2010–2012, when the economy was struggling, unemployment was high, and real estate prices were depressed, the loans made tended to be safer and more profitable. Borrowers resilient enough to qualify during tough times proved to be robust in the long run. Additionally, the collateral backing real estate loans during this period often had more upside potential as prices were at their lowest.
Reframing Underwriting Strategies
One of the key takeaways for banks is the need to shift their underwriting philosophy. Traditionally, underwriting standards loosen during good times to win business and tighten during downturns out of caution. However, this approach often exacerbates risks. Instead, banks should consider tightening standards during economic booms and loosening them during recessions to capitalize on opportunities with resilient borrowers.
Proactive Risk and Reward Analysis
To stay ahead, banks need to adopt forward-looking risk assessment tools. Monitoring trends, such as loan performance by vintage (year of origination), allows for timely course corrections. For instance, identifying a spike in risk among loans made in 2021–2022 could prompt adjustments in underwriting for 2023 and beyond.
Equally important is the evaluation of the risk-reward tradeoff. Loans made during periods of heightened risk should offer correspondingly higher returns. By analyzing weighted average yields across different vintages, banks can ensure they are adequately compensated for taking on additional risk.
Be Opportunistic, Not Reckless
The key message for banks is not to avoid lending during good times or to rush into lending during downturns. Instead, banks should adopt a balanced approach:
- Be cautious during economic booms, focusing on maintaining strong underwriting discipline.
- Seize opportunities during downturns, recognizing the value of resilient borrowers and undervalued collateral.
By embracing these strategies, banks can navigate economic cycles more effectively, ensuring a healthier balance of risk and reward.
Invictus Analytics is here to provide strategic guidance and tailored solutions. With expertise in stress testing, capital planning, and risk management, we empower banks to thrive, even in turbulent times. For more insights, visit our website or follow Adam Mustafa on Linked in.
