Underwriting a loan is simply legalized gambling.
During the first part of my career, I bragged about the fact that I had never had a real estate loan go into default. It was a sense of pride to me until one of my mentors retorted “that just means you aren’t making enough loans!” He was right. We tend to look at the quality of our loan decisions based on the outcome and not the decision-making process itself. It’s virtually impossible to predict that a borrower will be stricken with an illness or get involved in an auto accident. Luck does, indeed, play a factor in the performance of loans.
There is a banking axiom that states “All loans are good loans when you make them.” That isn’t necessarily true. Some lenders will not follow sound underwriting procedures and will get a bad outcome because they overlooked a key point in the underwriting process or, in their exuberance to “make a deal” they ignore sound principles of underwriting. Look at all the “No Income Verification” loans that blew up in the crash of the late 2000s. Overlooking the fact that a customer doesn’t have the income to make their payments is not bad luck, it’s stupidity, but many loans go bad in spite of a lender employing sound underwriting principles.
Game Theory is the study of how players in a scenario are likely to act using mathematics and logic. Sports franchises watch vast amounts of their opponents’ game films in order to understand how those opponents will react in different situations and then plan accordingly. A sports team might be more likely to call a certain play in a certain situation if they understand how the other team tends to act when faced with the situation. A prepared opponent can take advantage of that knowledge. Economists and business leaders use Game Theory to make educated predictions on issues that confront them. In the same way others use game theory, good lenders use similar philosophies when making sound loan decisions.
Whether you are making loans, purchasing loans, purchasing real estate, or undertaking any sort of investment, you will sustain losses. The key is to understand your probability of loss and act accordingly. Getting struck by lightning might be an extremely rare occurrence, but fire departments respond on average to more than 22,000 lightning-related fires each year. Understand that you will sustain losses. You simply need to spread your risks out and avoid going “all in” on any investment. Accept that loss is part of your business model…just be smart to mitigate those losses.