FICO Score and the Downfall of the Subprime Industry February 1, 2008Posted by robzel in Business, Housing, Mortgage, Risk Management, Uncategorized.
Tags: credit risk, FICO, lending. mortgage crisis, Mortgage, Risk Management, risk score
Chances are if you ever applied for credit, you have come across your FICO score. It may have been called your credit score or even more simply your score. With very few exceptions these are one and the same. When used the right way, FICO score is a very useful tool for helping a lender make a credit decision. However, the score was never designed to support all of the ways that it used today. Not only is the score used for underwriting, but it also used to make decisions about insurance premiums, by employers to make hiring decisions, and investors to determine how to price pools of assets. It is this last use that I want to expand further.
Recently, I did some consulting for an investment firm. Their simple question to me was, “how come FICO score doesn’t work anymore for sub-prime mortgage assets?” The simple answer is that FICO score does work, but the way it has been used to evaluate mortgage-backed assets goes beyond what the score was designed to do as a stand-alone tool. Using any type of scoring tool such as FICO score requires an understanding of what the score is designed to do, what limitations exist on the scores usage and above all careful monitoring and vigilance.
Simply put, FICO score is an evaluation tool designed to predict the performance of an individual who applies for a loan or who has an existing loan. While the exact algorithm and development is proprietary, the generic form of the score is designed against the general populations that exist at each of the three national credit bureaus. The score has become the de facto standard that defines whether a person qualifies for a prime loan, sub-prime loan or does not qualify at all. During times of economic stability, the score can provide accurate predictions of future loan performance. During times of economic instability, this same score can seem to stop working.
The reality is FICO score still works. However, a given score no longer has the same performance level. As many investors have found, sub-prime assets with a FICO score of 620 no longer perform at the same level they did a year ago. While the deterioration in performance will vary by portfolio, in general the same score will perform worse; e.g. a 620 might perform more like a 600, a 600 like a 570, etc. In fact performance year over year has gotten worse across all score ranges. The shift is most severe at lower scores, and much less severe at higher score levels. However, it is still true that higher scores perform better than lower scores. So, on a relative basis FICO score still ranks! It is the shakeup in the housing market and the shaky economic times that has caused this shift in performance.
So, FICO score can still be used as it was designed to measure the probability of default, but even for this usage it needs to be calibrated to accurately reflect the current performance of any given portfolio. What FICO score was not designed to do was measure the amount of loss given default. The rapid changes in housing values in almost all markets have caused the severity of losses to climb well above what almost all lenders anticipated. With many years of rising housing prices lenders assumed that even if they were forced to foreclose on a property, they would be able to recoup at least part of their loan because of housing appreciation. This clearly was a bad assumption.
To summarize: Like any tool FICO score (and other similar scoring tools) can be very useful when used properly. FICO score was designed to predict future delinquency levels of groups of individuals on various loan products. When using any score based tool, it is imperative to monitor and calibrate performance by score. This is especially true during times of economic change. Finally, FICO was never designed as a tool to measure asset value or the magnitude of loss. It is only a way to determine the probability that the loss may occur.
To reflect back upon the current mortgage market it is easy to see how simple rules and uninformed decision making led to the current situation. The question, “how come FICO score doesn’t work…” is naïve for anyone who understands how scores work and how to underwrite loans. And yet, billion of dollars were securitized and traded based upon the misuse of this tool and a lack of fundamental understanding of the value of the value of mortgage assets and the sensitivity of these assets to changes in economic decisions. See my blog entries:
What is the solution? Get the right people on board at both the rating agencies and in the securities firms who can properly evaluate and represent the value of these assets. One of the principles of an efficient market is the notion of having the right information to make investment decisions. I can’t help but think that if the right information was available, our current mortgage crisis and subsequent economic slowdown might have been averted.