Policy Rules and Loan Design

Policy rules help shape loan applications and eliminate
others. In the sub-prime market, according to Van Dijk and
Garga (2006), lenders with manual processes serve a
significantly larger proportion of applicants . Thus, more
applications will receive manual reviews by sub-prime
lenders using partly automated processes than in the prime
market. They view this as an expected outcome, given that
sub-prime applicants are more likely to have characteristics
that may not be acceptable under automated policy rules,
and so are more likely to require manual assessment.
Therefore, greater reliance on policy rules under partial
manual processing is necessary—until further automation of
the process occurs, (assuming that the efficiency and
effectiveness benefits from automation will exceed any
increased losses that may result from having less
experienced judgement applied).


Policy rules will tend to focus upon the applicant and the
loan details—that is, the policy rules will form the minimum
criteria that the applicant must satisfy in order to qualify for
the loan. The applicant criteria may cover, for example:


Minimum and maximum age of applicant,


Criteria for unacceptable credit history,


Legal entity of borrower and jurisdiction,


Minimum and maximum loan amounts requested,


Maximum loan-to-value ratios permitted (LTVs),


Maximum income multiples, and


Thresholds (or cut-off points) for any credit score


The lender creates most of these policy rules (from
empirical evidence and regular adjustment) but the
regulator (FSA) could proscribe some of them, or even the
securitisation participants could stipulate policy (or
otherwise the institution to which an originator intends to
sell, any complete or whole-loans could stipulate policy).


There will also be policy rules surrounding the property—
these policy rules will form the minimum criteria that the
property must satisfy in order to grant the loan. Property
criteria may include, for example:


Type of property (detached or semi-detached, flat,
bungalow, terraced etc.),


Construction method (or materials
certain building company exclusions,


Date of construction period,


What constitutes a defective property, and


Locale restrictions or certain postcode exclusions


In general, the lender specifies these criteria, but it may
also reflect the requirements of insurers and securitisation
vehicles especially for concentration risk issues .


used)Loan Design


One of the more curious aspects of the U.K. mortgage market,
in general, is the proliferation of mortgage ‗products‘, which in
effect amount to nothing more than a simple variation of the
general mortgage contract (for example, applying for a
mortgage with a lower LTV band could therefore mean a
different product is now applicable). This aspect results in
thousands of such ‗products‘ becoming available, even though
the essence of each variation still requires a repayment
schedule at some interest rate for a loan amount borrowed
over a period of time. Marketing departments tend to use the
product variation primarily for dual purposes: 1) to segment
the market for increased penetration of volume and 2) as a
means of applying a rather crude industry-wide standard of
generic
creditworthiness.
Under
this
generic
credit
classification scheme (could refer to it as the ‗ABCD‘
approach), it relies on variations of certain parameters about
the applicant credit history in terms of:


a)


Arrears record (maximum of X missed payments in last
Y months);


b)


Bankruptcy/Involuntary Arrangement (IVA) evidence
indicating satisfied/discharged within set period;


c)


County Court Judgements (CCJs – up to £X in last Y
years, or otherwise unlimited);


d)


Defaults (X number of defaults permitted for previous
rent payments or unsecured loans)


On the basis of how any individual fits within the arbitrary
criteria set suggested above, the applicant will thus become
eligible for a ‗product‘ that might be described as ‗Very Minor‘,
‗Minor‘, ‗Medium‘, ‗Heavy‘ or ‗Unlimited‘ for example. Each of
these ‗products‘ will have an arbitrary margin for risk added to
the base funding mechanism (e.g., LIBOR) and for any other
variations selected (e.g., Self-certification or Buy-to-let
purpose). Interestingly, whenever you create an internal
credit-scoring model using all available data, it is usually the
case that none of the above criteria is automatically selected
as being predictive by the modelling tool but they may instead
be incorporated as part of the generic product group.
Nevertheless, the industry appears to place great faith on
these criteria and they therefore form an integral part of the
automated product selection system in use by brokers and
packagers.It should also be borne in mind that the current design of sub-
prime mortgages provides for early exit fees (via early
redemption penalties) such that the securitisation funding
mechanism expects these additional cash flows as part of the
income for retention by the issuer. Not surprisingly, if the
borrow behaviour is not as anticipated, then a funding crisis
can result, whereas if instead, a charge was made upfront to
cover the prepayment option, then this loan design would
assist the customer by creating more flexibility (but it may also
prove to be less lucrative overall from the lender viewpoint).