Part Three-Risk Adjustments
If you have been tuned into this series, then you may have already read the first two parts which are an overview of pricing, pricing terminology, and margins. If you missed those postings, they can be found on our website which is www.fairlendingdiversity.com. I strongly recommend that you read those postings first.
Today, I will be discussing risk adjustments. This is an important piece to the Fair Lending puzzle because it is another high-risk area for fair lending compliance monitoring.
In my last post, I discussed Margins. As a quick refresher, margins are the profit that is added by your company to the raw pricing from the investor. It can be added at many levels, starting at the corporate level all the way down to the branch level. Checking these margins are important because you need to see if those margins result in higher rates to consumers either overall, or at the varying State or regional levels.
Just as important in detecting pricing variance in margins, are the Risk Adjustments and how those are handled in your pricing. Without this knowledge, you may be signing off on a policy that causes disparate treatment or disparate impact.
Risk Adjustments: Risk adjustments are either positive or negative depending on the level of risk of the consumer profile. Negative risk adjustments mean that an investor is adjusting their price and corresponding rate by charging the lender more. Positive risk adjustments mean that an investor is willing to pay your company more for that loan. An adjustment can make the price, along with the corresponding rate, go Up or Down!
Internal Risk Adjustments: If your company does their own pricing, it may be that they have added their own risk adjustments, in addition to the investor adjustments. If that is the case, you will need a business justification for your company adjusters. You will likely not need business justifications if they “pass through” from the investor. The rule is generally that whoever creates the adjustment has to justify the adjustment.
Note: In today’s pricing world, most lenders use a pricing engine to minimize pricing mistakes and to handle the complexity of scenarios with multiple risk adjustments. To understand this concept, I’m only going to focus on one risk adjustment. However, you can probably imagine why a computer is needed when you have multiple investors, with varying adjustments, rates, and prices.
To Illustrate the concept of a risk adjustment, let’s look at the risk adjustment of credit score. Credit Scores are a common risk adjuster and one that most of you are familiar with.
3.50% today is PAR-Which means the Price is 100. At this rate, the consumer does not pay points, and the consumer does not get a lender credit. This is the Rate and corresponding price AFTER your company builds in their company margins. In other words, this is what is being offered to the consumer before any risk adjustments have occurred.
Your Company Pricing For Today (w/Margins already included)
Scenario Number 1-Your Consumer has a credit score that is low and the investor believes that loans with credit scores below a defined range are a higher risk. Therefore, they are going to “hit” your price with a risk adjustment.
Scenario Number 1-The Math
Your client has a credit score of 640. The risk adjustment from your investor is 100bps.
This means that the investor is going to charge your company 100bps MORE in price. Now one may think if they are charging your company 100bps, then you should add that to PAR, right? Not quite! Now don’t get frustrated because this is initially the toughest thing to grasp!
If you have a risk adjuster where the investor charges your company more for a higher risk loan, then you actually have to SUBTRACT it from your price!
Here is why:
Your investor says that they will pay your company 100%, (PAR), 100 in Price (it all is the same) for a loan with no risk adjustments at a 3.5% rate. But your client has a risk adjustment of 100bps for credit score. This charge means that they are only going to pay your company 99% for that loan at 3.50%. 100 (PAR) -100 bps risk adjustment = 99. This now means that your borrower will have to pay 1% in order to get 3.5% in rate. Your consumer says, no way, I cannot pay your company a point! Now what do you do? You can offer them a rate at 3.75% which is priced at 101. Then, take the 100 bps “hit” for credit score, which means the new price is 100 or PAR with that credit score risk adjuster. The borrower gets a PAR Price (no points, no credits) but their rate is 3.75%, not 3.50%.
Scenario Number 2-Your Consumer has a credit score that is super high. The investor considers this a low risk and is willing to pay your company more for that loan. Therefore, they are going to give your company a pricing “credit” for that loan.
Scenario Number 2-The Math
Your client has an 820 credit score, WOW! The investor says “we love borrowers with great credit scores” and states that if you sell that loan to them, they will give your company 100bps more!
This means that they will actually raise your price from 100bps to 101bps. In other words, they are willing to pay you 101% of the loan amount, or a price of 101 for that loan. Their little mouths are drooling with delight!
Here is Why:
3.50% is PAR, or 100bps, or 100% today. However, your consumer gets a credit of 100bps for a great credit score. If you look at your pricing today, that means that a price of 99 + 100bps (1%) = 100. Therefore, my new PAR price is 3.25% at 99, because after you add the credit for your borrower’s credit score you get 100 again! This means that at 3.25% your consumer will get a PAR price, and your company will receive 100% of the loan amount. Or, you could keep the rate at 3.5% and give the client a 1% lender credit. It really is the consumer’s choice as to what they would prefer!
Compliance folks, I need you to pay close attention to this scenario, because this is one of the scenarios you must watch out for in fair lending!
The originator could say,
“Awesome, I can lower this client’s rate to 3.25% and they still pay no points” (Ding, Ding-Correct)
“Awesome, my consumer can now get a lender credit of 1% at 3.5%” (Ding, Ding-Correct)
“Awesome, my branch, company, self, just made 1% more on this loan” (Buzzer Sound-Wrong Answer!)
In fair lending, when a consumer earns a rate/price, either better or worse due to their credit risk adjustments, that rate/price belongs to them, not the lender! Otherwise, you will have Disparate Treatment issues where two similarly situated clients end up with a different cost or rate and you have no reason to justify that.
Scenario Number 3-Your Consumer has a credit score that does not require any risk adjustment. The Rate and Price listed on the pricing sheet require no adjusting either.
Scenario Number 3-The Math
There is none because there are no adjustments. This borrower would receive 3.5% at no points and no credits.
Understanding how risk adjustments work will help you understand and explain your pricing policy to an examiner. It also helps you keep disparate treatment and disparate impact under control. In my next posting for this series, I’ll discuss the basic elements of loan originator adjustments and how they may impact your fair lending results. Stay Tuned!