Redesigning Credit Risk Modeling Chapter3

Continuing my serialization... Chapter 3: Profit Models

When I run training courses on credit risk modeling, I am often surprised that the most popular section is just walking the attendees through a cash flow model in Excel in order to compute yield, NPV, or IRR. Finance must have similar spreadsheets, although perhaps simpler, but credit risk teams rarely see them. Just understanding what inputs are needed from Credit Risk in order to project yield is an A-ha! moment.

But perhaps the real eye-opener is seeing that PROFIT IS ABOUT TIMING. Early defaults or prepayments are far more expensive than later defaults or prepayments. This is the most important failing when creating cross-sectional (fixed outcome period) credit scores. Not all defaults are the same. WHEN a loan defaults is vital information for a product's profitability and will be a key insight toward making better credit risk models in later chapters.

Most Finance teams take CDR and CPR inputs to their cash flow calculations, but these rarely have the level of detail and accuracy that could be obtained from the credit risk team, if appropriately structured for a cash flow model. So, this chapter walks through cash flow models for loans and lines and the role of timing.

Thank you to those who have been asking about a print version. That will be available Jan 20, 2025 on Amazon.

Joseph Breeden
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