Decision Tree Analysis: Formalizing the Workout Decision

Article excerpt

In the Land of Oz, an intersection in the Yellow Brick Road proved confusing for the bewildered Dorothy. The Scarecrow guarding a nearby cornfield wasn't much help, pointing out that no one way was better or worse than another.

Lenders, too, can feel that way--puzzled over the many roads available in workout situations and uncertain where they'll lead. This article, based on techniques used at American Security Bank, Washington, D.C., presents an organized method for evaluating all the options that workouts present and deciding the best way to go.

The typical credit decision, stripped of its particulars, is simple: approve or reject a loan application. Although the calculations may be complex and the underwriting efforts not trivial, the bottom line is that bankers will not knowingly make a loan they feel cannot be repaid. If there is doubt about the continuation of the operating cash flow, a banker will obtain supplementary sources of repayment, which can include additional assets, equity infusions, and guarantees. If there is still doubt, the banker will reject the loan application.

Workouts

A workout situation, however, is not so clear cut. Bankers typically face sequential decisions, and each decision often reveals new ones. Available options include more than just simply approving and rejecting loans; rather, distinct alternatives exist. Typically, not one of these alternatives is completely satisfactory.

Problem Loan Options

As an example, consider the options available in resolving a problem loan:

1. A lender can choose to restructure the loan or to call the loan and begin foreclosure proceedings.

2. If the lender chooses foreclosure, the debtor can voluntarily give up the assets or refuse.

3. If the debtor refuses to voluntarily give up the assets, the debtor will most likely file a bankruptcy proceeding.

4. In bankruptcy, the court may release the property or not.

5. The court decision can lead to an additional decision--appeal or accept.

The decisions continue to branch out from one another in a tree that, if represented graphically, might resemble Figure 1.

Time Pressures

Further compounding workouts are time pressures, which can force decisions to be made with less than complete information. Because a defaulted loan is typically very visible to senior management and the regulators, proper justification of any decision is imperative. There will be second-guessing, regardless of the decision.

The dilemma is how to choose from the best possible alternatives when working in an environment of sequential decisions with unknown or probabilistic results, as in the typical workout situation.

Decision tree analysis is a method of formalizing the decision-making process. It quantifies and organizes the officer's decisions for both bank managers and regulators.

Numerical Analysis

Banking relies heavily on numerical analysis. Financial reports cover desks, figures abound throughout credit applications, and within a bank, individual and group performances hinge on various numerical parameters. Likewise, the problem with workout situations is not a paucity of numbers, but typically too many showing conflicting results. Which numbers should be used? Which should be rejected? Why?

Because of the "fish bowl" atmosphere of a workout, a technique is needed to sort quickly through this morass and arrive at the correct decision. The decision tree analysis makes quantifying the expected results of these decisions straightforward.

Advantages of Decision Tree Analysis

The advantages of using this technique are:

* The decision process takes on a structure, forcing the analyst to approach the problem in an orderly, sequential manner.

* Investigation of all possible results (desirable and undesirable) ensures that nothing will "slip through the cracks."

* Displaying the results in a logical (visible) format helps to communicate decisions. …