Rortybomb has some fascinating data points on FICO scores, RMBS, CDOs and subprime lending.
FICO scores, which range from 300 to 850 and are provided by Fair Isaac Corp, were a key feature in the boom of subprime lending.
The scores were a quick and useful way for lenders to evaluate borrowers’ credit worthiness and risk. The Fair Isaac definition was “FICO gives ranking of potential borrowers by the probability of having some negative credit event in the next two years”.
According to this paper, FICO scores were made even more quick and useful by lenders when they set up a cut-off point to distinguish between “good” and “bad” borrowers. In the mid-19902 Fannie Mae and Freddie Mac, the US’s two biggest mortgage lenders, decided that cutoff point was 620, according to the paper.
And so, these two charts, taken from this presentation, are very interesting.
The charts show that default rates jump slightly between FICO scores hovering around 619 and those at 621 or so. Here’s Rortybomb on the difference:
The only difference between the 619 and the 621, besides a marginal increase in credit quality, is that the 619 had more soft skills used in it and it was very likely that the loan would not be resold but instead would stay on the originating bank’s balance sheet. So in the first chart we should expect 621 to have a slightly lower delinquency rate than the 619. If your FICO is 621, you are 2 points more credit trustworthy than 619. Instead we see a much higher rate. It is even more dramatic with the 615-619 versus the 620-624; the 620-624 should have a lower rate of delinquency, since they have a higher FICO score and are less of a credit risk. Instead we see the exact opposite.
There are various theories about why borrowers with FICO scores at the low end of the cutoff point may have had a higher default rate than those just below it (including for instance, that those with just above the cutoff point were gaming the system), but the point here is not the cut-off limit itself but the way in which creating that cutoff and the general reliance on FICO scores helped lenders ignore other — still important — factors in their evaluations of potential borrowers.
We should note that the cutoff point also had massive implications for structured finance, particularly the construction of RMBS. Like the GSEs, underwriters clubbed mortgage loans together based on FICO scores, ignoring other things like what type of loan products were actually involved (rationale: a loan with 30 per cent deposit probably has a lesser chance of default than a piggyback loan with 15 per cent down, even with the same FICO score).
This Infosys paper on subprime and credit risk measurement has a good illustration (emphasis ours):
In 2006, a large Wall Street firm solf a $1.2bn sub-prime loan portfolio in which the borrowers had an average FICO score of 631, within the upper range of subprime borrowers. Around the same time another portfolio was sold by another large mortgage company with borrowers scoring an average of 600, putting them in the depths of sub-prime. The investors were told that based on the credit cut off scores, the portfolio sold by [the] Wall Street firm was less risky. But 18 months into both pools lives, 15% of the borrowers defaulted in the first case while only 4% in the second case. The reason given was poor documentation for the former case — which obviously was not taken into consideration during the process of creating tranches. Clearly cut off scores are not sufficient. They rate an individual’s risk over time but do not necessarily provide the best assessment of credit risk of the loan, still that of a portfolio.
Related links:
VantageScore vs FICO - Nomura Fixed Income research
Did securitization lead to lax screening? - Paper by Benjamin Keys, Tanmoy Mukherjee, Amit Seru and Vikrant Vig
