Credit Risk Underwriting Process

Underwriting – as it is applied to commercial income-producing property capital financing transactions – is the process of reviewing, investigating and analyzing the income-generating ability of a given commercial income-producing property in terms of RTU Summary Screenshotits debt support characteristics, its collateral value, the supporting credit issues that pertain to liquidity support for the future operations, and the issues that may result in a default.  This underwriting process is undertaken by the INVIZEN RTU program model in light of current capital market conditions and expectations, as well as the realities of the impacts that are likely to occur as a result of forecasted near-term market conditions.  Capacity underwriting is the most important part of the underwriting process as the chief means of creating wealth and value for commercial properties is derived from the income-generating capacity of the property once the raw land has been converted into a commercial use via improvements.  Accordingly, in a market economy such as that of the United States, capacity underwriting is the most important component to the overall underwriting regimen, with the results of said capacity analysis acting as important drivers for the three (3) remaining underwriting analyses that are routinely conducted to determine the overall risks and rewards potential a given property or business may present to the capital markets.

RTU Technical Report Screen ShotThe key issue that cannot be eliminated pertains to market disruptions.  By their very nature, market disruptions are not foreseeable and are therefore outside of the scope of consideration, as this portion of market risk is not manageable by any means in 100% of cases.  That aside, the market feasibility analysis process pertaining to a specific class of business operations within a given geographical marketing area, provides a strong basis for better decision-making where the latest data is available at any point in the decision-making process.  The INVIZEN approach is predicated upon the idea that continual updates of data sets throughout the project life cycle will, over time, allow capital market participants to make better decisions regarding the deployment of capital funds by focusing on a forecast window of only 24 months, as this period is the longest period of a forecast that is likely to have a predictable outcome and provide the opportunity for an orderly sale of the business in cases where the market opportunity is expected to continue to deteriorate and have an execution risk impact.

The RTU reporting series credit underwriting component analysis uses a set of defined means and methods that are intentionally designed to support the INVIZEN Real-Time Status (“RTS”) Investment Protection Program requirements.  These requirements serve as the conditions precedent to helping prevent materially-significant loan loss severity risk (or investment loss severity risk in the case of equity investors and investments, as the case may be) from accruing for the full term of the entire capital investment (loan and equity capital).  The entire purpose of the INVIZEN Real-Time Analytics (RTA) program is to support the end-result of investment protection maximization for the benefit of all the financial stakeholders in a given business enterprise.

The second key components of this process is the credit underwriting review.  The INVIZEN program model relies upon a combination of the following elements to complete the cr review:

RTU Full Report ScreenshotCommercial entities frequently issue securities to fund their capital finance obligations, with the majority of funds being accounted for in debt transactions.  Loans raise the specter of loan loss severity risk due to the borrower defaulting on the loan covenants, leaving the full repayment of the debt a matter of speculation or actual loss.  Credit underwriting has attempted to address the loan loss severity exposure by the use of subjective measures to attempt to quantify the risk exposure a given sponsor presents regarding repayment.  This approach has largely failed to create the outcome sought by commercial credit providers (i.e.: lower overall loan loss severity risk levels in loan portfolios), as the loss severity risk measurements of commercial loan portfolios show increased levels of exposure over the last decade when the availability of information and analytics-driven models would suggest the actual results would be the opposite.  The credit underwriting approach is further compromised by the fact that the process is largely dependent upon the totality of the three (3) remaining risk underwriting regimes employed to the overall underwriting, thus its utility is largely diminished to that of a process that can only provide cold comfort after a loan loss has already been experienced, and the fact the credit scoring approach can only be used after the fact, making its value extremely limited in terms of protecting a given investment.  INVIZEN recognizes these shortcomings to the underwriting process and largely leaves credit risk underwriting out of the underwriting approach INVIZEN offers.  This strategic decision was made due to the fact that subjective measures must always lead to business decisions being made based upon a reliance of subjective opinions, rather than decisions being made based upon the totality of facts a given matter presents for consideration.  As a result, the credit risk underwriting analysis presented in the Report is limited to the findings of the Altman Z-Score[1] formulaic test for bankruptcy risk exposure. Credit underwriting process graphic

The Altman Z-Score Test (the “Z-Score”) has a practical limitation in that the formula does rely, in part, upon the assumption that a public securities market exists to support the market value of the equity securities of a given entity being examined.  In the case of commercial income-producing property transactions, this market does not largely exist, but is addressed with a simple modification to the original Altman formula and commonly referred to as the “Altman Z’-Score” (note single quotation mark following the letter “Z” that denotes this formula as being different from the original).  The resulting 4 financial ratios are weighted to provide an overall statistical measurement of the likelihood of a near-term liquidity crisis that would result in a bankruptcy.

 

[1] – Refers to the theory for predicting bankruptcy of a publicly-traded company posited by Edward I. Altman in 1968  (Altman, Edward I. (September 1968). “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy”. Journal of Finance: 189–209. doi:10.1111/j.1540-6261.1968.tb00843.x).