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A NYLX WHITE PAPER
Approaches for
Compliance with the
January 31 Interagency
Guidance on Risk
Management Practices
The Fed, OCC, FDIC and the NCUA
jointly released an important policy
guidance letter on January 31, 2012.
The letter provides guidance on calculating Allowance for Loan and Lease
Losses (ALLL) estimation for portfolios of second liens in particular, though
the guidance applies to loans of all types.
The agencies have concerns that the institutions they regulate will require
higher ALLL in the coming years. The reason for the concern is the continued
deterioration of residential values and the potential for payment shock as home
equity lines of credit exit their draw periods and become amortizing loans.
This paper will review the requirements set forth in the guidance letter and
explore methods for complying with those requirements. For convenience,
we will refer to all federally regulated institutions as banks, though we recognize
both credit unions and thrifts are afected by the new guidance.
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
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Loss Estimation Using
Segmentation and Trending
Banks must recognize a charge against income when two key conditions
are met for a loan:

As of the date fnancial statements are issued, it is probable that an

asset had been impaired or a liability had been incurred.

The amount of the loss can be reasonably estimated

Methodology for defning an impairment pool and reasonably
estimating loss.
The impairment pool should be populated with those loans which have an
elevated risk profle. These require a risk-weighted reserve in anticipation
of losses. The risk weighting should factor in recent delinquent payments,
probability of delinquency and default, and the potential loss severity of
each individual loan.
Loans should be considered impaired under a combination of at least 3
circumstances due to the correlation of these factors and default. The frst is
when a loan has been delinquent at any time in the prior 12 months. Many
banks use this condition as an impairment fag, knowing that if a missed
payment is more than a mere oversight, another missed payment is far more
likely within the next 12 or 24 months. This information is typically readily
available in your servicing platform, and payment histories can usually be
extracted for either 12 or 24 months.
The credit profle of the borrowers is the second factor. There are many
ways to arrive at a 680 FICO score. Because of this, banks should
monitor all credit quality indicators." Your bank should derive a waterfall
scenario for credit stress. A primary threshold might be the current FICO or
VantageScore, but the screen should compare this score with prior credit
refreshes or the score at origination. A borrower with a highly drawn HELOC
and high balance-to-limit ratios on revolving consumer trade-lines might still
have a 720 FICO score, but be one paycheck away from a complete credit
collapse. Some banks use increases in balance-to-limit ratios, delinquencies
on non-mortgage accounts, and newly opened accounts as early warning
indicators. As a borrowers leverage increases, so does the likelihood of
default. Therefore, monitoring credit-score migration and updating credit
profles is a best practice.
Finally, when the LTv (for frst mortgagesj or CLTv (for both frst and
second mortgages) exceeds your banks threshold for risk, a loan should
be considered impaired. The precise threshold is highly dependent on local
factors such as the spread between arms length and distressed sales prices
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
Trends and Extrapolation for
ALLL adjustments
Banks have begun in recent years
tracking interest rate trends, FICO
migration, and YoY changes to
property values. Their ALLL
calculations now need to incorpo-
rate that data, extrapolating clear
trends. These ALLL adjustments
should be supported by the analysis
that underlies the adjustment, and
management must not cherry-pick
favorable trends while discounting
or ignoring others.
The good news is that trends
and analysis cut both ways.
As economic, credit, or housing
conditions ultimately begin to
improve, ALLLs can be reduced,
and a rigorous analytics output
can help defend those reductions
to examiners.
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in the portfolio's geography, the 6-month outlook for real estate values,
and your banks tolerance for risk. When a loan at 90% LTV has a junior
lien held by another institution that pushes the CLTV to well over 100%,
the risk of loss on the frst increases substantially. Therefore, it is critical to
perform lien searches on all real-estate-backed loans on at least an annual
basis and cross reference that information with the borrower's credit profle
to understand the additional layers of risk introduced by the silent liens.
Metrics such as a collateral integrity analysis can defne market-level stress,
and when overlaid with CLTv information, puts a fner analysis on risk of loss
than just looking at the current value.
Monitor All Credit
Quality Indicators
The primary guidance is for risk managers to monitor all credit quality
indicators relative to credit portfolios. The traditional metrics for mortgage
portfolios are FlCO scores and Loan-to-value ratios (LTvsj. For decades,
portfolios were commonly graded at the pool level based on the origination
data. ALLL calculations were generated using that information, and
for decades, this approach sumced to bufer banks from recession-
induced default increases.
However, as the subprime contagion spread into fnancial markets around
the world, banks that had seen no losses whatsoever in a decade or more
on mortgage portfolios began to experience charge-ofs in signifcant
amounts. ln reviewing their impaired and charged-of loans, many banks
found that the credit scores and LTVs at origination were materially
degraded at the time of the frst missed payment.
Proactive risk managers began refreshing FICO scores on their borrowers
and Automated valuation Models (AvMsj on the collateral securing their frst
and second mortgage portfolios. As losses on second mortgage defaults
began to consistently approach 100%, the regulating bodies realized that
banks have not been monitoring all of the factors that afect collectability
on these junior-lien portfolios. As a result, the guidance requires banks to
make use of all reasonably available" information, which includes the
payment status of senior liens not held by the institution, CLTV, credit
scores, and occupancy, documentation, and property type, and to
refresh that information as often as necessary considering housing
and economic conditions.
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
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Methodology for refreshing information that is
reasonably available.
If information is out there, you should be using it! But the frequency with
which you refresh that information depends on the data itself. For credit,
most banks refresh information quarterly, in conjunction with preparing their
call reports. Refreshing credit profles rather than just scores allows you to
monitor payment status of senior liens not held by your institution, as is now
required. Increasing liabilities, too, are good indicators of stress. For this,
quarterly analysis is frequent enough to capture change, but not so frequent
as to be cost-prohibitive.
For property valuations, while it is not clear whether housing has truly
bottomed, values have certainly stabilized and though they may continue
to fall somewhat, the rate of decline in all areas of the country has slowed
dramatically. As a result, in todays environment, semiannual valuations and
lien searches can be appropriate.
Oosts and Benefts
of Compliance
One of the sections of the guidance letter actually saves banks money on
risk management if diligently applied. If we presume a portfolio of 10,000
junior liens, for easy math, and a quarterly credit refresh and semiannual
collateral analysis, this means 40,000 credit profles and 20,000 AvMs and
liens searches. While expensive, they are far less expensive than the losses
that might be incurred on a poorly managed junior-lien portfolio.
However, the guidance requires banks to segment their loans based on
risk levels, and monitor accordingly. This segmentation should enhance
the bank's ability to track default rates and loss severity for high-risk
segments. The great news here is that once a baseline risk level has
been established for the portfolio, the bank can move high-risk loans into
separate pools for enhanced analysis, while leaving the lower-risk loans in
pools that have lower frequency and depth of analysis.
Practically speaking, this means you can segment your risk analysis as well.
Data analysts can focus eforts where they make the greatest impact.
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
Federal Reserve Recent Study
In a fascinating study, the Federal
Reserve
1
found that 620 was a very
signifcant threshold for default
predictions, particularly with
respect to strategic defaults.
In fact, for borrowers between
620 and 680, strategic default is
as much as twice as likely as for
borrowers with either lower or
higher scores.
The study contains several
interesting conclusions, includ-
ing that borrowers who missed a
payment but cured the delinquency
were less likely to default than those
who never missed a payment prior
to termination. This means that if
a bank can get a borrower current,
they work harder to remain in their
homes. This information, coupled
with an Ability to Pay model, can
lead to loss mitigation decisions
that might be counterintuitive at
frst blush.
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Methodology for achieving a better cost/beneft approach
for compliance.
Rather than spending your budget performing the same level of analysis
on all loans, you can achieve better results by segmenting your loans and
conducting more in-depth analysis where risk is higher. Here is a simple
example to illustrate the point.
Lets assume your directive is to run quarterly credit and semiannual
collateral. For our easy math, well assume $1 for credit and $5 for AVM
and Lien Search combined. Given a pool of 10,000 loans and no other
costs, the total investment would be $140,000. Money well spent to manage
losses, but let's see if there is a better approach that is more cost efective.
Assuming a full 20% of the portfolio is high risk" once segmented; let's
examine the impact of conducting the same analysis on those loans,
but an annual review of the low risk pool.
Un-segmented Analysis:
10,000 Total Loans Credit AVMs/Liens Total Cost
@ $1 / run @ $5 / run

10,000 run $40,000 $100,000 $140,000
quarterly for
credit, semiannual
for collateral
Segmented Analysis:
10,000 Total Loans Credit AVMs/Liens Total Cost
@ $1 / run @ $5 / run

8,000 low risk run $8,000 $40,000 $48,000
annually

2000 high risk run $8,000 $20,000 $28,000
quarterly for credit,
semiannual for
collateral

Grand Total $16,000 $60,000 $76,000
The result from using segmented analysis is more than a 45% savings, and
allows you to allocate dollars to deeper analysis on the risky pool while still
maintaining compliance with the guidance letter.
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
Page 5 nylx.com
Using a more segmented and focused approach, risk managers can actually
gain more insight into their loan portfolios, calculate more accurate ALLLs,
and reduce their cost of compliance. This is a much better alternative
for cost management than cutting back to semiannual credit and annual
collateral analysis for all loans, regardless of risk profle - an approach that
wont likely sit well with examiners in light of the reasonableness standards
set forth in the guidance.
New Guidance Drives
Increased Complexity
One of the challenges posed by the new guidance is the requirement to
monitor so many more variables in the portfolio. In addition to a simple
two-dimensional FlCO/LTv matrix that sumced for decades, examiners are
asking banks to factor in geographic concentrations, payment status of
senior liens, origination channel, property type, CLTV, and even potential
payment shock of ARMs resetting and HELOCs entering fxed amortizations.
The spreadsheets are becoming numerous and getting cluttered.
In order to digest the level of complexity new regulations have introduced,
many banks have built or bought platforms into which they can load loans
and apply data. Efective platforms allow for easy reporting, efective
segmentation, and visually oriented output.
Assessing the pros and cons of build vs. buy risk
management platforms.
Building a proprietary platform allows a bank to build in just those data
feeds they decide to use, to use the best-of-breed source for each data
feed, and to develop the exact output, user interface, and reports they want.

Key challenges: Adequate transparency measurements, integration of data

from the various sources, and the upfront cost of building and maintaining
such a platform.
Buying a platform eliminates the development time necessary to create
one in house, and streamline the process of bringing in multiple data
sources seamlessly.

Key challenges: Integrating with IT environments, potential security

concerns, data that may or may not be best-of-breed (especially if the
platform is provided by a data vendor), timeliness of getting data into
and out of the system, control of the data and access to it, and lower
levels of customization.
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
Complex Models
The model for predicting foreclosure
and delinquency is complex, and
looks like this:
Clearly, from this, we can discern
that any help a bank can get in
reducing multiple complex variables
into a readily digestible format is
valuable.
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Conclusion
We dont believe Microsoft designed and built Excel expecting it to be the
risk management tool of the fnancial industry, but for the last 20 years,
it has. Whether you choose to build or buy a risk management platform,
the complexities of the data are now beyond the capabilities of Excel,
even with the vaunted Pivot Table.
The regulatory environment has forced banks to look beyond
the spreadsheet.
Compliance with this guidance will require banks to incorporate new data
into their analysis, but segmentation of the portfolio can reduce the cost
impact of compliance. Smart banks are using this deeper knowledge not
only to improve their loss-mitigation decisions, but also to cross-sell their
quality borrowers, enhancing revenue and customer loyalty.
1
The Depth of Negative Equity and Mortgage Default Decisions
http://www.federalreserve.gov/pubs/feds/2010/201035/201035pap.pdf
About NYLX
NYLX is a software-as-a-service application provider to Banks, Credit
Unions and Mortgage Bankers. Our oferings include LoanDecisions
product eligibility and mortgage loan pricing and LoanHD life-of-loan
performance analytics and monitoring. These solutions aggregate
information from a robust set of sources and deliver it through a
user friendly, highly intuitive user interface. Our clients use these
applications to improve mortgage loan origination, secondary marketing
and consumer/mortgage loan portfolio management functions. NYLX
technology is supported by client service expertise, case management
technology, online training webinars, and partnership resources to deliver
complete solutions and help our clients achieve high return on investment.
Our commitment to compliance and security aligns with our customers
need to address their own highly regulated environments.
A NYLX WHITE PAPER
Approaches for Compliance with
the January 31 Interagency Guidance
on Risk Management Practices
Page 7 nylx.com