Lenders Benefit from Soft Information in Underwriting Process

During the credit underwriting process, lenders have the opportunity to obtain hard and soft information from borrowers. Hard information is easily observable and verifiable, such as income and consumer credit scores. Soft information, like what the borrower plans to do with the loan proceeds, may be obtained by a loan officer taking a prospective borrower’s loan application or acquired via relationships with customers. Either way, it isn’t easily obtained, yet can be quite valuable in lending decisions.

Recent research from a professor at the Penn State Smeal College of Business finds that, by using soft information, financial institutions can reduce credit losses overall and increase profits. The use of soft information allows the lender to tailor the contract to the borrower’s risk. If a loss occurs, the lender is fairly compensated for it.

Brent Ambrose, Smeal Professor of Real Estate and director for the Institute for Real Estate Studies, and coauthors Sumit Agarwal of the Federal Reserve Bank of Chicago, Souphala Chomsisengphet of the Office of the Comptroller of the Currency, and Chunlin Liu of the University of Nevada, Reno, analyze more than 108,000 home equity loans and lines-of-credit applications to study the role of soft and hard information in underwriting.

Of the 108,000 applications, the lender immediately accepted 57.6 percent, rejected 11.1 percent, and referred 31.3 percent to secondary screening. The loans referred to secondary screening were sent to a loan officer. At that point, the loan officer gathers soft information from the borrower.

Based on the hard information from the application and the soft information obtained during the negotiation phase, the loan officer proposes a counteroffer contract. At this point, the borrower either accepts or rejects the offer.

The researchers then determine the effectiveness of the lender’s use of soft information in designing a counteroffer to reduce ex post credit losses. They find that a counteroffer that lowers the annual percentage rate (APR) reduces the default risk ex post by 11 percent, while a counteroffer that raises the APR increases the default risk ex post by 4 percent.

However, the counteroffers also impose costs in the form of higher prepayment rates. From the lender’s standpoint, this is troublesome. If a borrower pays off the contract early, the bank is accruing less interest over time than they would if the borrower made regularly scheduled payments on the loan.

Ambrose notes that previous research has used relatively poor proxies for soft information, like geographical distance and length of relationship between borrower and lender. He says that their data set enables them to study the complete underwriting process.

“By examining the complete underwriting process (from loan application to ultimate origination), we directly see the use of soft information on the borrower-lender negotiation during loan underwriting process,” adds Ambrose. “To our knowledge, no study has direct evidence on the actual utilization or effectiveness of soft information.”

The researches’ results from their analysis are applicable to a wide variety of financial contracting environments and dynamic markets, like insurance, managerial incentive compensation, and corporate governance, where lenders and borrowers interact during loan origination.

Their paper, “The Role of Soft Information in a Dynamic Contract Setting: Evidence from the Home Equity Credit Market,” is forthcoming in the June 2011 issue of the Journal of Money, Credit & Banking.