Explain the Five C's of Credit, and discuss why soft information on borrowers can be important for depository institutions to carefully underwrite a loan. Also, discuss incentives for loan underwriter during the period prior to the Subprime Loan Crisis that contributed to poor underwriting practices that contributed to the crisis.

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The Answer is The 5 C's of Credit include character, capacity, capital, collateral, and conditions.
• Character (the willingness of a customer to pay). Character includes soft information on a customer in determining the willingness of a customers to pay, often assessed by loan officers using their experience to evaluate the character of individuals during a loan interview. Other evidence of character includes past credit history, credit ratings of firms and individuals, and for firm's reputation from customers and suppliers.
• Capacity (the ability of a customer to pay in terms of cash flow). Capacity is often evaluated by looking at current and projected cash flow statements of corporate customers to determine if cash flow will be adequate to cover loan payments.
• Capital (the soundness of a borrower's financial position in terms of equity). The net worth or equity position of a corporate borrower relative to assets provides information on the cushion that the borrower has to absorb potential losses. For consumer customers, net worth is estimated as personal assets less personal liabilities.
• Conditions (the industry and economic conditions that may affect a firm's ability to repay a loan). For instance, during recessions, mortgage delinquencies also tend to rise, and real estate booms and busts in particular areas can affect the likelihood of foreclosures, such as occurred during the U.S. Subprime Loan Crisis.
• Collateral (secondary sources of repayment) (asset-based lending). Collateral and at times for private firms' personal guarantees based on personal assets are used as a secondary source of repayment for the bank, particularly for more risky company loans. However, taking possession of the collateral is expensive, so lenders should reply on cash flow for primary payment of a loan, with collateral only as a secondary source of repayment, and independent appraisals need to be made.
Incentives for loan underwriter during the period prior to the Subprime Loan Crisis that contributed to poor underwriting practices that contributed to the crisis included bonuses for underwriting more loans versus the quality of loans, and since loans were sold for securitization, no responsibility for loan officers to monitor or be responsible for loan defaults. Hence, a moral hazard problem was created encouraging poor quality loans to be made and incentives for predatory lending and taking on subprime loans. Heavy reliance on quantitative models for loans and the use of low doc loan documentation for qualifying for loans that was popular including applying for online loans with quick decisions, failed to incorporate soft information including character, the willingness to pay, capital, and conditions, with loan officers assuming that market values of properties would continue to rise and failing to consider adverse conditions with very low down payments for loans required and high loan to value ratios. Thus, when the market values of properties fell, many borrowers with loans now greater than the value of the properties, walked away from their loans.

Explain the Five C's of Credit, and Discuss Why Soft