Credit underwriting decisions are a cornerstone of any economy. Made wisely, they can assist entrepreneurship, promote economic growth, and generally ensure that capital is allocated to its highest and best use. On the other hand, poor credit underwriting decisions can negatively impact an industry or the economy as a whole.  Recent troubles in the U.S. economy are directly tied to the poor credit decisions of lenders to support prospective home owners who had little money and provided little information about their financial strength in an over-inflated housing environment. Recent failures of banks such as IndyMac are partly tied to poor credit underwriting decisions and over-leveraging.  The failure of banks to consider the full range of construction risk is leaving many banks high and dry due to the recent spate of construction business failures, with many more to come. The five consecutive years of recent losses in the surety industry was directly related to poor credit underwriting decisions. With all of these losses you have to wonder what is going wrong. The answer is twofold: an unusually high tolerance for risk and credit decisions based upon insufficient data.

Creditors

In the case of mortgages that went bad, because loans could be packaged and resold, an anything goes atmosphere developed and many risk management practices were thrown out the window. Many loans were provided based on simple applications that provided minimal financial information. The fallout of this lending environment is showcased on Mortgage Lender Implode-o-Meter. In the case of IndyMac, a large portfolio of non-performing Alt-A loans, sometimes called liar loans, and risky construction and land development lending, left the bank with very little cushion in a falling housing market. Other banks impacted by losses only relied on financial data, failing to consider all the risks of lending to high risk industries such as construction and auto dealerships.

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Companies usually find themselves in one of four quadrants of the ERM/Business Success matrix:

1. A company has proper risk controls in place and is successful/profitable
2. A company does not have proper risk controls in place and is successful/profitable
3. A company has proper risk controls in place and is unsuccessful/unprofitable
4. A company does not have proper risk controls in place and is unsuccessful/unprofitable

The Success Paradox

The term “Success Paradox” has been used to refer, among other things, to individuals that are economically successful not being as happy as those less economically well-off, to the increased vulnerability of developed countries to diseases such as measles, and to the concept that an enterprise, such as a poverty NGO, can put itself out of business if it is successful.

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Effective Enterprise Risk Management is not rocket science.  In fact, most risk controls turn out to be very simple policies or procedures that will prevent adverse shocks to a business.  Oftentimes, though, it’s hard to cut right to the core of a problem and separate the effects from the root cause.  In Construction Positions and Responsibilities, one of our advisers discusses drilling down to determine the root cause for the difficulty a client was experiencing trying to grow its business.