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Dare to Think Beyond a Credit Score

By Amaresh Gautam

The choice of many bankers to ignore or degrade their weighting of credit scores became rampant during years leading up to the subprime lending crisis of 2007-08. After the housing loan bubble burst, many pundits trying to unravel the causes used their hindsight analysis trying to place the blame of the fiasco on someone. One of prime parties blamed were lenders who were lending money to borrowers with subprime credit scores, or credit ratings below the conventionally accepted level.

Ideally those loans should have not been approved since subprime credit scores were pro-Giving Clients More Informationactive evidence that someone had a negative repayment history or were already highly leveraged before entering an additional obligation. But now that sufficient time has passed, memories of the crisis are gradually fading and we are entering a stage where loans are again being given to some people who do not even have a credit scores. And that’s not necessarily a bad thing.

It’s not necessarily true that a person having no credit score means they are not creditworthy. Rather, there are many cases where there is not enough history of past borrower transactions to assign a credit score. FICO recently announced a pilot program that will help individuals establish a credit history, using utility and other reoccurring payments to develop a performance opinion.

PayPal lends $2 million of working capital each day to small businesses without relying on credit scores. JadeFunding has found an alternative way to access the health of a business without using credit scores. Other new alternative lenders are emerging in the peer-to-peer channel and online marketplace that use innovative underwriting techniques and other data to predict the likelihood of repayment for a business, while the sector has grown to more than $8 billion in lending volume annually.

But most of these lenders do view the credit score as part of a an algorithm, which means their credit decisions take into account information across a broader list of potential factors.

This trend brings us back to my original thread of thought–-if it turned out to be unwise to give loans to people with low credit scores, how wise is it to give loans to people or businesses with no credit score? Are we forgetting the lessons of subprime crisis too early by daring to give a boost to alternative lending?

Not necessary, since the loans that were given to people with subprime credit scores were not the illness in themselves, rather a symptom of the actual disease–-loosening financial morals due to bad incentives.

Alternative lenders are proving that people and businesses without a credit history can still be evaluated positively for a successful loan that’s granted with a proven repayment record that matches the conventional rates at most banks. So, in a sense, they are making the case that we can move beyond the sole reliance of credit scores to deliver debt capital to worthy recipients, who can access it based on other qualifying metrics.

And that paradigm shift need not lead to any crisis.

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Credit Reporting Companies to Improve Functioning

By Ravinder Kapur

Credit bureaus Experian, Equifax and TransUnion have agreed to revamp their processes for correcting errors in credit reports and also report medical debts only after a lapse of 180 days. Although these and other measures to improve the working of the credit bureaus will take place over a period of three years, most improvements will be carried out in the next six to eighteen months and the vast number of individuals who suffer because of incorrect credit scores can expect better service because of these changes.

The New York State attorney general, Eric T. Schneiderman, has reached a settlement Credit Reporting Companieswith the three bureaus who have agreed to implement a range of measures to improve their response to complaints. A report in The New York Times gives details of how the bureaus agreed to make changes after several New Yorkers complained that they were having difficulty correcting errors in their reports.

The current practice followed by credit bureaus to solve complaints made to them by individuals, is to have these forwarded to overseas agents who are trained to allot a numeric code and this is, in turn, routed to the creditor to whom it pertains, along with the documentation, if any, which was submitted by the consumer. If the creditor verifies the information the matter is closed.

Hence, in the existing complaint management procedure, the bureaus play the role of a middleman who does not take part in solving the problem raised by the consumer. This process is now set to change and the bureaus will have to play an active role in first understanding the consumer’s complaint and then interacting with the creditor to help solve it. The improvements to be implemented will entail substantial personnel costs and a reworking of the bureau’s role in resolving such matters.

Referring to the steps to be taken by the credit bureaus, Mr. Schneiderman said, “They are going to have to hire a lot of people. It’s going to cost a substantial amount.”

The reporting of medical debts in a credit report is another area which leads to a lower credit rating for many consumers. The changes agreed to by the bureaus include one that will require them to wait 180 days before inclusion of these debts on the report. In addition to this, medical debts that were reported earlier and subsequently paid by the insurer will be removed from credit reports.

The changes agreed to be implemented by the credit bureaus will make the credit reporting process more accurate and fair to consumers. The extended time frame available to the agencies should enable them to roll out revised procedures that address the current problems in an effective manner. All in all, the changes were long overdue and their implementation, even if it is over a period of time, is a major victory for consumers.

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As the Economy Goes, So Goes the Housing Market

By Charles H. Green

Is the economy actually dragging housing upward with it? That’s the observation of economist Douglas Duncan, who recently discussed housing trends recorded over the past few economic cycles. He sees trends in job growth, wage levels and consumer confidence as the ultimate drivers of a modestly improving housing market, and he should know.

Duncan is Senior Vice President and Chief Economist at Fannie Mae, and spoke before an Home Builderaudience gathered for the second quarter economic forecast presented by the Robinson College of Business at Georgia State University recently.

For the past five years, the lack of income growth has been an important contributor to the stagnation of housing growth, as consumers remain stuck in the housing they live in and don’t see a path to move to a better option. During most previous recessions, consumer’s net expectation were that there incomes would still grow, but following the Great Recession, that expectation went negative first time, and only became positive in mid-2014.

In 2014, when three million new jobs were added in the U.S., there was real income growth for the first time since the financial crisis, and those results started being seen in the housing figures. The housing connection is obvious–people won’t move if they don’t expect income growth, hence there’s not a new house on their horizon.

Another trend that was severely depressed following the Great Recession was household formation growth, which fell off to its lowest level since WWII. Growth in that metric is expected to surge back in the next five years, but presently driven only by racial and ethnic minorities, who account for all net household growth.

Currently the U.S. has the largest portion of adult children living at home with their parents, caused principally by the rising cost of college. But as the parents suffered financially during crisis, many older children actually began contributing to household costs. This trend will be directly impacted (and reversed) by job growth. Note to Millennials:  a. Get job; b. Make money; and c. Move out of parents house!

The recent housing expansion has been restricted to certain markets where housing has correlated better to job creation. Multifamily housing construction is outpacing single family, while other markets are stuck with inadequate housing inventory. Consider Sante Fe NM, where housing is so tight, landlords don’t just get security deposits for tenant pets–they’re charging monthly rent for the pets too.

While interest rates and rate expectations figure into home sales, the interest rates are market-driven, managed as well as can be expected by the Fed, albeit limited as that may be. As the Federal Reserve began their quantitative easing program (QE1, 2 & 3)  to encourage more lending, the Fed asserted the position that they wouldn’t sell any purchased mortgage-backed securities, thereby making the effort to keep investors confident about the stability of housing rates.

But in 2013, in what was labeled the ‘taper tantrum,’ the mere mention in the FOMC minutes that the Fed “needed to talk about securities,” led mortgage rates to rise 1.1% over the following six months, and home sales fell accordingly.

What do you think? Comment on this page or write me at Director@SBFI.org.

 

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Small Business Plays a Big Role in the Economy

By Ravinder Kapur

In the United States there were 28.2 million small business enterprises as of March, 2014, which as a sector, collectively contributed 63% of all the new jobs created between 1993 and mid-2013, according to a report in FinChannel.com. While precise data is not available at an international level, the World Bank estimates that SMEs form around 95% of existing businesses and employ approximately 60% of the private-sector work force.

In addition to the massive share in new job creation, small businesses in the U.S. account Small Businessfor 49% of private-sector employment and 43% of private-sector payroll. The rapidity with which small businesses start and ramp up their employment is equaled by the speed with which they close down and lay off employees. About half of new businesses survive the first five years and about one-third survive for ten years. Survival rates increase with the passage of time and have changed little over the years.

The importance of SMEs in job creation and employment is an accepted fact, but a subject that draws a fair amount of debate is the means with which to give a push to the establishment of SMEs, and their growth and survival thereafter. Obviously, the provision of timely and an adequate amount of finance at reasonable terms is a prerequisite.

Despite the lack of consensus on the other factors that give rise to the establishment of small businesses, the increased use of International Standard Organizations (ISO) can go a long way in promoting them and helping them to compete on equal footing with larger, more entrenched companies.

Khemraj Ramful, Senior Adviser of Export Quality Management at the International Trade Centre, explains that facilitating SMEs access to information on technical regulations and standards, and helping them meet the stipulations of International Standards can help small businesses compete in the global market. SMEs would benefit as their products would meet international specifications and they would also gain from the resulting operational efficiencies.

As small businesses thrive and prosper, many of them become suppliers to or consumers of other small businesses. Thus the requirement for financing that all businesses have, gets multiplied and a ‘virtuous circle’ of healthy private enterprises, which have a requirement for finance and the capability to pay it back is created, leading to even greater business opportunities for the small business lending community.

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SBA Loans to Minorities Grew 28% Since FY 2009

By Charles H. Green

Each week the U.S. Small Business Administration publishes information about the loan volumes it has approved for participation through either the 7(a) loan guaranty program  or the 504/CDC loan program. This information tracks the dollar and numerical statistics of approved financing volumes throughout the SBA’s fiscal year, which starts on October 1 annually, as well as demographic information of the small business owners that benefit.

SBFI has been tracking this loan approval data over the past year to develop trend SBFI Money Treeanalysis, and as part of that effort, has been developing graphical illustrations to map trends in the various demographic categories that are tracked by the SBA. While we follow overall loan approval volumes monthly, for the demographic categories, the information is compared year-over-year. Hopefully, you’ve already seen some of these results in our Capital-Views pages, where SBA loan approvals for rural, veteran and women borrowers have been illustrated.

This time our attention is turned to the distribution of SBA loans to minority borrowers, and learning more about how they have been trending over time.

As a group, minority business owner’s SBA participation has grown since 2009 from 32% of all SBA loans to over 41% in FY 2014, a 28% gain. But this growth has varied widely within different ethic categories, as those as “Asian” rose from 16.3% of the total dollar sum of SBA loans in FY 2009, to 20.5% of SBA loans in FY 2014. During those same years, “Black” business owner’s share of SBA loans fell from 4.7% to 1.7%, while “Hispanic” business loans rose from 4.6% to 5.4% during the same period.

Certain categories were combined in our analysis due to space limitations and relative low reported lending volumes in these categories. For example, ‘Hispanic’ and ‘Puerto Rican’[i] categories were combined into one “Hispanic” category; ‘American Indian,’ ‘Eskimo or Aleut,’  ‘Multi-Group’ and ‘Undetermined’ categories were combined into “Other.”

In FY 2009, the “Other” category represented 7% of all SBA loans, which rose to 13.7% by FY 2014. The largest sub-category in our combination was “Undetermined,” which may have reflected a growing number of borrowers who refused to disclose their ethnicity, or participating lenders that did not gather the information.

Read more at Capital-Views.

What do you think? Comment on this page or write me at Director@SBFI.org.

[i] Apparently the SBA made this same combination of Hispanic and Puerto Rican borrowers, since FY 2009 is the only year that approved loan balances are reported.

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Technology Revolution in Finance is Upon Us

By Amaresh Gautam

Technology has changed our life in remarkable ways. Can you imagine waking up in America 100 years ago, in a house without a computer, smart phone, internet connection, microwave or even a refrigerator to store fresh food in from the field? For that matter, imagine milking a cow in the morning to have fresh milk! But one sector that hasn’t been exactly revolutionized by technology is finance.

Sure, they now have your data backed up on systems rather than in filing cabinets and they In-Depth Analysisuse sophisticated software, but the basic banking products really haven’t changed that much. Savings account and demand deposit accounts offer the same kind of benefits they did 100 years ago. Most of the innovation in finance has been incremental at a snail’s pace, rather than disruptive, and it’s only been in the most recent two or three years that financing innovations have really begun.

This recent wave of innovation is finally taking hold in finance, with new startups coming up with financial products that are technology enabled, like payments applications and lending platforms. And don’t worry that these unlikely products/services will make banks go out of business. In fact many of these new products will be complimentary to traditional banking offerings and will increase their market, as they affect the financial landscape in multiple ways.

First, these innovators will cut costs and improve the quality of financial services. These cost savings will be passed to the customers thus setting new expectations. Second, these new players will have data driven and technologically enabled ways of assessing risk. For example usage of social media reviews, machine learning and the track record of using vendors can all be used to arrive at some sort of credit score. Third, by adding diversity in distribution to the lending landscape they will make it more stable.

With this business model centered in a technology-enabled channel, financial firms are likely to be much less geograhically concentrated than the business of brick and mortar firms. Moreover they are likely to avoid two risks of traditional financial institutions–mismatched maturities and leverage.

If these technology companies succeed in becoming bigger than the traditional institutions, finance will be transformed in a major way. Borrowers and lenders would be matched directly using technology and leverage in economy would be greatly reduced. But before that happens, technology companies will force traditional institutions to cut costs, and the clients will emerge as the winners.

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OnDeck Steps in Where Banks Shy Away

By Ravinder Kapur

Online lending to small businesses is a nascent industry which has an outstanding loan capital of $10 billion, compared to $700 billion in credit assets held by the banking sector. But this alternative lending source is growing fast and OnDeck Capital, one of the major players in this rising technology-dominated sector, is expanding its portfolio exponentially. How? By exploiting its non-traditional business model, which relies on speed and  innovative credit appraisal techniques than those used by banks.

A recent article in Inc.com reported that OnDeck has made loans to more than 30,000 Websmall businesses since 2007, and in 2014 originated loans totaling $1.2 billion, an increase of 152% from 2013. In the first quarter of 2015, the company’s origination volumes increased to $416 million, reflecting 83% growth over the prior year. The average APR that the company lends at is estimated 51.2%, which is a reduction of 10% from the earlier year.

An important reason for the rising volume of loans made by online lenders like OnDeck has been the reluctance of banks to extend finance to small businesses since the financial crisis. This reluctance stems from several reasons including the fact that, for banks, the transaction costs to service a $100,000 loan are the same as for a $1,000,000 loan. This makes loans to small businesses by banks an expensive proposition.

Since the financial crisis, banks have tightened credit underwriting to small businesses, which has resulted in lower lending to this sector. As reported in a July, 2014 working paper by Karen Mills, former SBA Administrator and currently a senior fellow at Harvard Business School, small business loans on the balance sheets of banks are down by 20% since the financial crisis, while loans to larger businesses have risen by 4% over the same period.

While small businesses may need weeks or even months to access funds when sourcing them from a bank loan, OnDeck tries make money available within a day through its online platform, which to them is a competitive advantage. The loans and lines of credit are uncollateralized and based on the subject business having a proven revenue track record, usually a minimum of $100,000 for at least one year.

Noah Breslow, Chief Executive of OnDeck has carved out a niche for the company in the low value segment of small business loans. OnDeck’s average loan size is $44,000 and small business borrowers are increasingly turning to the company because of its speed and credit appraisal method, which analyzes thousands of variables to arrive at an “OnDeck score” that is used to decide the loan terms.

OnDeck has performed well in the loan origination area and has also been successful in charging high rates for the money it lends. Time will tell if it can do equally well in controlling its loan losses and becoming profitable.

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Tightening Ahead by the Fed–What Past Says About Future

By Charles H. Green

According to economist Kevin Kliesen, there’s a high likelihood that the Federal Reserve will begin its interest rate normalization process sometime in 2015, but to be certain, that decision will ultimately depend on the data and resulting economic forecasts. As a means of trying to understand what to expect, he suggested reviewing previous tightening cycles employed by the Fed may reveal evidence about what effects lie ahead.

Kliesen is Business Economist and Research Officer at the Federal Reserve Bank of St. Treasury Yield Curve After NormalizationLouis, and spoke before an audience gathered for the second quarter economic forecast presented by the Robinson College of Business at Georgia State University recently.

It’s widely known that the Fed removed the word ‘patience’ in it’s March statement concluding the FOMC meeting, which had been used at end of QE3 program as an expression of the pace they expected to proceed. However in March, Fed Chair Janet Yellen remarked that conditions “may warrant an increase in the fed funds rate target sometime this year.”

Historically the Fed’s decision to raise rates has always been more difficult than lowering rates and is always debated intensively. Former Fed Chair Arthur Burns described it as the anguish of the central banking, how raising rates evoked violent criticism. Yet more often, the Feds are accused of favoring the financial markets at the expense of the public and savers.

The Fed’s debate usually plays out through speeches offering various viewpoints of the twelve district presidents, all of which are monitored intensely. In their April survey, the majority (74%) of Blue Chip forecasters expected a rate increase in September, a major revision from the January survey when 65% believed that rates would rise in June.

Why all the uncertainty? It seems as though the data is not cooperating. As more data is collected, any decision to raise the Fed funds rate seems to be pushed farther out, indicating that both the Fed’s and private forecasts have been too optimistic. Inflation has continued to be much weaker than expected. But recall Chair Yellen’s remark earlier this year: “Don’t wait for the 2% inflation target.”

History suggests that monetary policy makers have stayed ‘too easy’ too long in the past. With as many economic factors affected by monetary policy–such as spending on interest-sensitive goods, bank lending, corporate balance sheets, household net worth and asset prices,–it’s easy to understand how the macro economy can be heating up faster than traditional economic factors can track.

In previous cycles, rate tightening always exceeded the market’s expectations, particularly during 2004-2006 (+4.25%), which carries its own risks and exposure. Normally, credit risk spreads and stock prices fall early in the cycle, with risk spreads rising later. But it takes about a year for industrial production and consumer spending to fall off. And in three of the four last cycles, it took about a year for the Treasury rate yield curve to to invert.

Net effect: the year following liftoff of the normalization, the economy generally improves, followed by slower growth later.

And it’s worth noting that Kliesen related that “history suggests that long expansions with low inflation tend to have smaller increases in the Fed’s policy rate, so keeping inflation low and stable is key. But history also suggests that each tightening cycle depends significantly on underlying economic conditions, and oil shocks have been important in the past.”

What do you think? Comment on this page or write me at Director@SBFI.org.

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Economy Will Grow in 2nd Quarter: Dhawan

By Charles H. Green

Real GDP grew at a paltry 0.2% for the first quarter of 2015, but economist Rajeev Dhawan doesn’t think the factors that drove this stagnation are here to stay. “After I read the GDP report, the word WOW escaped my lips,” Dhawan said. “WOW here stands for weather, oil and the world economy. The report showed clear damage from these three factors.”

Dhawan heads the Economic Forecasting Center at Georgia State University in Atlanta, Rajeev Dhawanand spoke before an audience gathered for the second quarter economic forecast presented by the Robinson College of Business on Wednesday.

It was unusually cold Northwest weather that drove nondurable goods consumption growth down to negative 0.3% (especially grocery purchases) in the first quarter, but on the flip side, spending on utilities (heating) rose. Conversely, overall gasoline savings were socked away into savings accounts, denying the previously forecasted upswing in consumer spending.

Dhawan predicted that the weather factor is temporary, except for the drought being experienced in the West, but in any case, the low oil prices will start to creep upward again as U.S. fracking production declines. “We’ve almost reached the bottom, with oil rig counts having dropped sharply with only a little bit to go,” said Dhawan. “But prices will not reach the heights of $120 a barrel anytime soon. I expect oil to start creeping up to $70/barrel by year’s end and stay in that range for the coming year.”

Dhawan Expects Economy to Bounce Back in Second Quarter

The world economy is facing problems on two fronts: First, China’s economy has failed to recover after a planned slowdown to curb inflation, affecting many emerging economies because of their supply chain connections. Second, the Eurozone is strangely experiencing negative government bond yields, due to the repeated threats of Greece’s exit from the Eurozone, during the trillion dollar bond-buying program (quantitative easing) of the European Central Bank.

Overall, these issues played out with a 7.2% decline in early 2015 exports. “The three WOW components shaved off close to 2.5% of U.S. growth in the first quarter,” Dhawan said. But, he asserted that these negative effects can be offset as the country rebounds in the second quarter.

“Weather is a temporary factor. As the seasons progress, it will soon reverse course and add to nondurable consumption. Most of the numerical damage to the GDP is now behind us,” said Dhawan.

Another side effect of the stagnant first quarter GDP results is the delay in a potential Federal Reserve interest rate hike.  “Oil, the global economy and investment should have stabilized by the end of October,” Dhawan reported. “This means that December is the earliest the Fed can raise rates.”

Highlights from the Economic Forecasting Center’s National Report

  • Following a gain of 2.4% in 2014, real GDP grew at a stagnant 0.2% in the first quarter of 2015. Growth of 3.3% is expected for the second quarter, bringing the overall rate to 2.5% for 2015. It will expand at a better rate of 2.8% in 2016 and grow 2.7% in 2017.
  • Business investment will grow a weak 3.2% in 2015, recover to 5.8% in 2016 and 6.4% in 2017. Expect jobs to grow by a monthly rate of 254,000 in 2015, 240,000 in 2016 and 232,000 in 2016.
  • Housing starts will average 1.107 million units in 2015, rise to 1.194 in 2016 and 1.253 in 2017. Expect auto sales of 16.8 million units in 2015, 16.9 in 2016 and 17.1 in 2017.
  • The 10-year bond rate will average 2.1% in 2015, and should rise to 3.3% before the end of 2017.

What do you think? Comment on this page or write me at Director@SBFI.org.

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It’s All About Incentives, the Rest is Just Commentary

By Amaresh Gautam

That people respond to incentives is one of the most fundamental economic principles. A correct incentive system for employees can be the difference between a successful and a failed business enterprise. An incorrect incentive plan for the C-Suite, can lead to fraud by the management of a large corporation. And tDollar

Incentives in a financial system as complicated as that of United States can get distorted at multiple levels. The incentive of a lending manager can be to motivate them to distribute as many loans as they can within their territory, and they may not be getting penalized for making bad loans. But one potential result will be that they won’t be bothered about credit quality, and will become too aggressive in meeting the target numbers.

Likewise, the CFO of a large financial organization may know that the risk of going bankrupt is minimal, since the institution will be presumably be rescued by the federal government, but the reward of making a successful risky bet has no limits. Thus they may be incentivized to take excessive risks.

According to remarks in a recent speech by Janet Yellen, Chair of Federal Reserve Board of Governors, a combination of responses to distorted incentives throughout the financial system created an environment conducive to a crisis.

It’s not possible for a single small business lender (or borrower) to do anything about perverse financial incentives corroding the system, even if they become aware of them. Correcting them lies within the job of the financial regulators. However, it’s still within the realm of self-preservation that one should maintain some degree of rationality when encountering perverse incentives.

Meaning? If another financial instituion reaches out to hire you, and offers compensation with incentives that sound unrealistically too good to be true, do a sanity check in your head before responding. Are you really worth that much more than what you are currently compensated, or are there some perverse incentives at play?

Remember the old adage: if it sounds too good to be true, it usually is.

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