Lenders and creditors of all sizes are asking three key questions related to the impacts of the COVID-19 pandemic:
- How has the pandemic changed credit data?
- How has the pandemic impacted credit scores?
- How can lenders understand and control risk to their portfolios?
These are important questions. The pandemic’s overall effect on the U.S. economy and consumers continues to be largely fluid making it difficult to set forecasts and projections related to portfolio performance. There are fact-based insights that I can share to help creditors and lenders understand how the economic impacts of the pandemic may affect credit decision-making and what actions they should consider to best respond.
How Credit Data Changes
We do not yet know the total duration or magnitude of the economic impacts of the pandemic although we can examine the economic impacts up to this point and balance these short-term effects with observations from prior economic events. This approach is useful and can only be directional because today’s drivers differ from prior economic distress events. The 2008 mortgage-driven recession and Hurricane Katrina in 2005 are good examples where the downturn had specific antecedents and consequences. These events can provide a guiding light for what may occur in this economic event even though the drivers and outcomes from this event could prove vastly different.
We have seen declines during COVID-19 in underwriting in general with activity surges associated with government programs such as PPP (Paycheck Protection Program) small business lending. These surges have typically been by lower risk profile consumers and businesses pursuing bridge loans to get through the crisis.
What has changed in the applicant mix? The increase in low-risk applicants led to changes in how lenders perceive and process applicants. We also noticed that fraudsters and fraud patterns have continued, leading to an overall increase in suspicious activity as a percentage of all activity even in the midst of overall declines in applications. We saw the most notable increase in synthetic fraud and charge-back fraud schemes. We also saw a dramatic increase in digital transactions, particularly the utilization of new devices to transact. Payment platforms adjusted as well as cash transactions migrated to online payment processors.
These changes will surely affect how consumers, small business owners, retailers and financial services companies do business in the future.
We cannot easily pinpoint the impacts of the pandemic since many factors change daily. Multiple global and regional factors influence this change. A highly complex set of macro and micro effects impact credit defaults, including geography, the consumer’s job, the health of immediate and extended family and local government restrictions and assistance. We also see a fracture between the effects on Wall Street, where the stock market has so far reclaimed some of its losses but remains volatile, and the effects on Main Street, where consumers and businesses continue to experience economic hardship.
Here is what we do know so far: It could take a long time for our economy to recover. We could see the rise in consumer and business credit balances, credit utilization and repayment delinquencies elevated for months. Financial services companies need to apply thoughtful risk controls that balance both best practices for risk management and compassion for customers navigating a challenging economic climate.
Some good news is that financial institutions are in a position to help mitigate the impact of COVID-19 through the U.S. government’s request to help facilitate the delivery of stimulus programs like the PPP. They are also in a position to help consumers with new loans or lines of credit during this time. Many of these products have deferred payments, which provide short-term relief but could increase long-term risk as payments come due for those with reduced income during 2020.
The Impact to Credit Scores
Economic stress tends to increase overall credit risk when unemployment rates increase and incomes decrease. Lenders should monitor various impacts in credit scores during economic recessions by relying on the credit risk tools in their toolbox.
We saw in the 2007 recession that default rates increased for each credit risk score band. The magnitude of the change in overall risk is likely to vary depending on the lender, portfolio, consumer segment and other factors. Increased default rates do not mean that an algorithm has failed; it could be the result of consumers prioritizing their payments, such as opting to pay various debts through alternative methods or electing to pay essential bills first.
Past recessions tell us that defaults will increase although it is impossible to calibrate these scores precisely to account for changing behavior on a specific portfolio. Historically-based policy changes may be less effective over time if the economic situation changes rapidly, particularly if different markets like auto, real estate and unsecured revolving trends are driven by different disruptive factors.
For example, auto surpluses can drive auto prices down, which leads to more auto loan risk due to customers replacing upside-down loans with purchases of heavily discounted automobiles. This macro-economic trend would affect auto-loan repayment behavior but would have less impact on credit card or mortgage portfolios.
We learned in prior recessions that while actual default rates fluctuate with economic changes, credit scores continue to rank effectively whether a consumer will default: While the default rate of a 700 may increase, for example, a 700 score continues to be less risky than a 650 score and riskier than a 750 score.
Creditors and lenders can track customer performance over time to see short-term changes in consumer risk. They can also adjust their cutoffs in real-time by understanding the changing relationship between score and default rate in rapid test cycles to avoid costly redevelopments based on forecasting volatile information. Lenders could use this empirically derived and statistically sound information to adjust their risk exposure without concern for inaccurate adjustments.
Understanding the Overall Risk to Your Credit Portfolio
Federal and state governments, creditors and lenders have announced a variety of programs to reduce credit report updates for newly occurring delinquencies during the pandemic. This offers creditors and lenders an important role in protecting the short-term financial health of consumers and businesses.
These pro-consumer policies reduce the efficacy of score solutions that rely heavily on credit bureau data. Lenders cannot accurately forecast portfolio losses or develop proactive outreach to customers experiencing financial distress if they underestimate this risk due to non-reported delinquency information.
Creditors and lenders need accurate data solutions to assess credit and help consumers. It is important for lenders to use a variety of sources other than credit bureau data scores to assess credit risk.
The financial industry must take advantage of the full data and analytic capabilities at their disposal to understand and adjust to market conditions. Then creditors and lenders can truly mitigate the risks that come from a catastrophic economic event like this one.
Jeffrey Feinstein, Ph.D., vice president of global analytic strategy, LexisNexis® Risk Solutions