In the run-up to the financial collapse, Toyota Financial Services in Torrance, Calif., was experiencing a common problem–a modest but worrisome increase in losses on loans originated between 2004 and 2007. Then the crisis put the umbrella Toyota Financial Services (TFS) lending operation on the hot seat. Credit risk shot up. Other lenders fled the auto lending market, and TFS had to find a way to continue to finance the sale of Toyota automobiles at a time when Toyota was increasing market share while other automakers faltered. It had to simultaneously fund active lending and reduce loan losses. "The worst economic climate since the Great Depression," says Reddy Pakanati, chief risk officer, "put extraordinary pressure on our sales and profitability. Banks retrenched, abandoning dealers on higher risk loans. Our mission to enable auto sales through financing became critical."

The problem called for precision surgery. So the credit and risk pros identified what they called Grade X loans, the ones most likely to go bad, and started to turn down these X loan applications. They had to define the group narrowly. Moving too drastically could squelch auto sales and deny TFS the profitability it realized from making higher-margin, higher-risk loans that would perform. "We needed to identify loan combinations with extremely low risk-adjusted return and volume that could be carved out of the purchasing pool," says national consumer risk manager Adem Yilmaz. With a sophisticated analysis of thousands of segments and attributes, including Monte Carlo simulations, TFS was able to isolate on paper the loans that it thought would be high-loss, low-volume and very low profit. Particular combinations of consumer credit scores, loan terms and vehicle collateral could draw an X rating. Analysis showed that the loss on X loans would be more than nine times greater than losses across the whole portfolio. Precision analysis meant that these loans could be identified and rejected with little impact on high-credit-risk loans that were projected to perform. On average only one or two more loans would be rejected per dealer per month, Yilmaz says. So the loan origination system was re-coded to reject applications for X loans in phases from January through August 2008. In the first year using the new standards, Toyota's loss rate was cut considerably and it saved more than $100 million in bad debt write-offs, savings it expects to realize year after year. The project's cost: under $300,000. With the worst loans identified and excluded, TFS was able to continue purchasing a full credit spectrum of loans at acceptable risk. "The program was a game-changer," notes Pakanati. "We strengthened our relationship with dealers at a time when other lenders were retrenching. Being able to lend with confidence meant that we could support Toyota/Lexus/Scion sales during this critical period. In fact, our share of the market rose to a record 59%." The additional clarity provided by the reprogrammed loan origination system left credit analysts free to spend more time restructuring marginal deals, he notes, further improving TFS' financial performance and support for sales.