Why build a Proprietary Default Model ?

Default Modeling has been the backbone for all credit decisions in the Banking industry for nearly five decades. The models can vary from as rudimentary as simple bucketing to sophisticated models that use derived risk factors, Markov chains and Machine Learning.

At Croudify Ratings when we started looking at the risk ratings available at various platforms we soon realized that we need a risk model of our own. All platforms have proprietary models that use different criteria to rate loans. This creates a problem for most investors how to do an Apples to Apples comparison ?

The second issue we faced with proprietary ratings from the platforms was of stale ratings. Each platform rates a loan at the time of origination but never re-rates a loan once it starts paying. This lack of updated ratings makes it nearly impossible to get a real picture of the portfolio risk and returns. This creates accounting problems at year end and makes it impossible to create any kind of tax efficient investment strategies.

Another issue we faced was around pricing of mature loans. If we try to sell or buy loans on a secondary market there was no way to price the loans as per their current risk bucket. This deprived us from liquidity and a great source of short term investments.

All these issues convinced us that a proprietary loan default model that is built focused on investors is the way to go. An investor default model allows us to use Machine Learning that might be prohibited in origination models of the platforms.

Benefits of a investor default model:

  1. Uniform Investment Criteria: A single ratings model allows us to create uniform ratings for various loans originated on various platforms thus allowing us to use a single investment criteria (which is more than simple return/loss bucketing).
  2. Fair Portfolio Valuation: An experience model in addition to an origination model allows us to get a  fair valuation analysis of our portfolio thus giving us an opportunity to reserve for possible losses that might come towards the year end.
  3. Tax Efficient Investing: Fair valuation of assets allows you to sell losers or winners depending on your needs thus improving your returns.
  4. Portfolio Concentration analysis: Updated ratings allows you to monitor your ratings distribution across the portfolio at all times. This makes your ongoing investment decisions easy.

With all these benefits we are certain that we can achieve much better returns by combining a proprietary default and prepayment model compared to a simple bucketing approach.

2 thoughts on “Why build a Proprietary Default Model ?

  1. Hello! This is my 1st comment here so I just wanted
    to give a quick shout out and say I really enjoy reading through your posts.
    Can you recommend any other blogs/websites/forums that deal with the same
    topics? Many thanks!

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