topic Re: Opinions differ on effectiveness of FICO score in Understanding FICO® Scoring

Opinions differ on effectiveness of FICO score

Barry — Tue, 01 May 2007 01:18:19 GMT

Hi All,

Just a little food for thought and discussion....

Today's Minneapolis Star Tribune reports that a mortgage lender and credit-rating agency have taken to blaming FICO scores for the rising number of subprime mortgage defaults in their article, Opinions differ on effectiveness of FICO score.

Any opinions from the FICO scoring experts here as to the validity of this claim?

-Barry

Re: Opinions differ on effectiveness of FICO score

smallfry — Tue, 01 May 2007 01:21:52 GMT

I think income to debt is more important than a score which seems to defy logic at times.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Tue, 01 May 2007 02:38:02 GMT

Someone can have a score of 850 and have a devastating life event and be unable to pay their bills, including mortgage. They could wind up in foreclosure in a minute and find that they have to redeem themselves for years to come as a result. This is something that FICO nor creditors take into account. While someone who has perfect credit will be more likely to find a way to pay their bills at any cost, some things in life just aren't guaranteed, even for the best of the best.

I think it's very unfair to blame FICO for the historic rise in foreclosures. If you're dealing with sub-prime customers who have a long history of defaults, the risk is far greater, as can be expected, and that's the lenders' faults.

I think this is just a ploy by the CRA's to promote their horrid scoring systems.

NOTE: I'm definitely not an expert, just offering my opinion.

Message Edited by HouseHunter on 04-30-2007 10:38 PM

Re: Opinions differ on effectiveness of FICO score

hdporter — Tue, 01 May 2007 02:49:41 GMT

I had hoped YOU were the expert here, Barry

Obviously article details are sketchy, at best. The underlying variables are complex.
I'm inclined to find a certain parallel in the subprime mortgage market to the below investment grade (junk) bond market in the '80s. While conventional wisdom had been for prudent investors to avoid purchase of subprime bond issues, analysis found that those who invested in them consistently generated income superior to that of standard issues, even after taking defaults into account. (In other words, investors were being overcompensated for risk.)

Thus was born a raging market that grew to proportions which the theoretical analysis could hardly be expected to reflect. It was an entirely different environment (among other things, shaky firms that formerly would never had access to the debt markets now found a market for their bonds).

So, my first inclination is to wonder whether some mortgage companies (such as HSBC) may have looked a little too eagerly at the profitability prospects of the subprime mortgage market -- again, ultimately expanding subprime loan portfolios to a degree that weakened the assumptions under which FICO scores might be applied to that subcategory of borrowers in predicting default risk.

Plus, quite frankly, we only have HSBC's word that they diligently underwrote mortgages, and didn't extend loans more aggressively than what would be warranted by respective FICO scores.

It should be apparent that, given the underlying motivations of lenders vs. FICO, I suspect that lender profit objectives would be more likely to lead them to misuse scoring information than for FICO to fail in its product analysis.

That said, FICO is impeded in product development for this particular borrowing sector by the fact that it's relatively young and less established than other mortgage segments. That puts considerable risk that should subprime mortgage portfolios swell, FICO's models may be impaired in predicting default risk.

There are no absolutes involved here, but I assign the bulk of default responsibility to the lenders in any event.

As an aside, it would be useful to clarify what's under fire re FICO here? There's a big difference between observing that overall default rates are unexpectedly high vs. that FICO scoring isn't adequately predicting which borrowers pose the greater default risk. The former seems to be the focus of the article, but it would be the latter that would be the truer measure of FICO scoring effectiveness.

- Harry

Re: Opinions differ on effectiveness of FICO score

Anonymous — Tue, 01 May 2007 05:21:41 GMT

@Barry wrote:
Hi All,

Just a little food for thought and discussion....

Today's Minneapolis Star Tribune reports that a mortgage lender and credit-rating agency have taken to blaming FICO scores for the rising number of subprime mortgage defaults in their article, Opinions differ on effectiveness of FICO score.

Any opinions from the FICO scoring experts here as to the validity of this claim?

-Barry

Well, any system that dings someone for being honest and trying to settle a past debt is suspect.

Seriously, the whole credit scoring system is in dire need of reform. At the very least:

1) Quality control needs to be enforced on items listed in credit reports. Any listing on a credit report should have to include, accurately: the account number, the balance, the date of last delinquency, the current status of the account, the type of account, the original creditor, the current creditor, and full contact information for both. No exceptions. If ANY of this information is missing, the credit bureaus should be BANNED from accepting the listing in the first place.

2. No account should be listed more than once. Say you have a power bill and you don't pay it. The power company lists it as 30, 90, 120 and finally charges it off. They should be allowed to list it and update the status as it changes. Two months later they turn it over to a collection agency. The collection agency should NOT be allowed to start a second listing of the SAME debt! The EXISTING listing should be updated, the account changed to "charged off," and an entry in the listing added for the current creditor: the collection agency, with full contact information. At that moment, an "anchor" should be dropped at the first date of delinquency, and that date will be PERMANENTLY fixed as the effective date as far as FICO is concerned. No endless re-reports and re-listings. The debt is there, the default is there, and that's where it remains. If the consumer comes along and pays the charge-off, this does NOT affect the anchored date, and therefore does NOT ding FICO. The status is merely updated to "paid charge-off" and that's that.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Tue, 01 May 2007 05:46:45 GMT

Think about this: "rising number of subprime mortgage defaults" OK, what makes them "subprime"? A LOW FICO SCORE. Which INDICATES A HIGHER RISK OF DEFAULT. And these people are complaining about a higher rate of default on higher risk loans? ? FICO may be accurate, or it may not be accourate, but it has nothing to do, I think, with the subprime mortgage problems. Those problems came from bad lending practices. What shelters a lender from loss more than anything else? A borrower who has and accumulates equity in his house. What happened during the last 2 or 3 years or so? There were a whole bunch of new kinds of loan where the borrower didn't have any equity going in, and didn't build any equity for many years. And FICO is to blame for this? REALLY? I hold no brief for FICO, all I know about it is that it seems to be accurate in my case. But blaming anybody or anything (including supposedly "deadbeat" borrowers) for irresponsible lending practices is just a cowardly ducking of responsibility.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Tue, 01 May 2007 09:02:04 GMT

S/P or prime your still taking a risk. Nowadays people want to get into a home so bad that all that anyone seems to focus on is the score to look good coming in the door. Then they have no doc no income verification based on score. So I could have a 760 or higher and make 28k trying to get into a 300k home. How can I pay for this? If that is your only income the answer is you can't! some people are not educated enough on the total cost of a home and the expenses that come with it. It still comes down to the almighty dollar my friends. Lenders would not make the loan unless they are making money. They don't care six months down the line when they are foreclosing!

Re: Opinions differ on effectiveness of FICO score

hdporter — Tue, 01 May 2007 09:15:01 GMT

Mike, you make some good points. However, in closing my post I raised a question that should be given some consideration -- what is it that's being criticized?

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An HSBC exec is quoted in the article as saying that FICO scores were "less effective or ineffective" in predicting behavior during a period of aggressive lending and low interest rates.

I doubt there was any question in HSBC's mind that they would suffer a higher default rate in their subprime portfolio than with higher credit borrowers. But the HSBC statement suggests that they feel the FICO product in question didn't appropriate identify that risk.

We don't know what FICO asserted for this product. We do know that when FICO profiles our personal scores that it cites very specific default risk for each credit score band. I don't think it's unreasonable that thie FICO product did as well for this subset of subprime borrowers -- quite possibly in a very well defined manner.

HSBC may have relied upon this data to determine what mortgage risks they would underwrite and at what rates - FICO offering up a fairly specific indicator of expected default cost under their model. If the model proved to be inaccurate and a higher than indicated default rate occurred (taking into account economic conditions), then there's room for lenders to hold FICO at fault, at least in part, for the unexpected poorer loan performance.

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The article gives good indication that this perceived ineffectiveness in predicting defaults is the crux of the matter. Note the following statement from Vantage:

"Absolutely, it helps us," said Barrett Burns, VantageScore's chief executive. "It offers us a great opportunity for lenders to look at VantageScore. Since our score is more accurate and predictive, there would have been improvement" in mortgage defaults had the industry used VantageScore instead of FICO, he said."

The gist is that the Vantage product is asserted to more accurately predict default rates for these borrowers then FICO. To the extent that Vantage should more accurately identify a stronger default risk vs. FICO, lenders would reign in lending (using the same underwriting standards) and, thus, experience lower defaults -- or, at least would price loans more accurately and thus not suffer the adverse profit consequence of the higher default rate.

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What's problematic here is that we don't have any data whatsoever from which to assess whether the FICO product was inaccurate in predicting degree of default risk. Short of that, we're in an inadequate position to make a reliable call on the situation.

Still, the statement from Fitch Ratings in the latter part of the article gives good credance that the FICO product isn't likely at fault. Fitch argues that lenders, anxious to assume these loans, weakened underwriting procedure by, amont other things, requiring less income documentation. The consequence of inadequate income doc is that if borrowers successfully misreprented their income as stronger that the actual case, the lenders put themselves in the position of likely overextending loan amounts.

In other words, FICO default predictions are based upon a given underwriting process (those standards prevalent during the period over which data was compiled and analyzed). If lenders should then become more aggressive in pursuing the subprime market (presumably because they have new confidence in possessing a new tool that will more accurate predict defaults) and make the application process less stringent in the process (e.g. lower loan doc reqs), then actual default rates will necessarily vary from those predicted by the FICO model.

Consider this analogy: We're told in our myFICO score report analysis that 14% of borrowers with scores between 650 and 699 will "get into serious credit trouble". This assumes that lenders continue existing lending practices. However, if lenders began assigning much higher credit limits for applicants in this credit band, or simply approve a higher percentage of applicants, there's no question that default rates would rise. The FICO score predictor would be meaningless in light of a change in lending practice.

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We don't have sufficient data to make a definitive call on the questions raised here; we can only make some reasoned guesses, at best.

Personally, I find it much more probable that lenders have inapporpriately applied the FICO data in making underwriting decisions than that the FICO model predictions were inaccurate.

But I'd be deluded if I thought there wasn't good room for things to be just the other way.

- Harry

Re: Opinions differ on effectiveness of FICO score

hdporter — Tue, 01 May 2007 09:35:07 GMT

@Anonymous wrote:
Then they have no doc no income verification based on score. So I could have a 760 or higher and make 28k trying to get into a 300k home. How can I pay for this? If that is your only income the answer is you can't!

This suggests that no doc loans are a bad business practice. Bear in mind that they legitimately serve a borrower subset. This includes borrowers such as contractors who can't simply turn over a w-2 and may, with good reason, find it undesirable to turn over their tax return. The key is that such loans aren't extended irrationally.

Bear in mind that, among other things, high equity rates are required. Frankly, if someone pops down $100K on that $300K home, the mortgage company isn't going to hurt too terribly in the event of default ... there's ample room from which to recover all expenses from the sales proceeds -- even at a depressed price from an attempt to unload the home quickly. Plus, such loans are priced at a premium over others, allowing greater profitability despite a marginally higher default rate than standard loans. In general, this is a product that likely yields a high confidence of profitability.

Remember, it's not the bank's role to protect you from overextending yourself. It's simply their mission to profitably lend.

- Harry

Re: Opinions differ on effectiveness of FICO score

Tuscani — Tue, 01 May 2007 10:29:49 GMT

What load of crap. The lenders just need a scapegoat for their greediness to give anyone a loan.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Tue, 01 May 2007 17:45:25 GMT

There has been alot of finger pointing going during this sub-prime mortgage downturn/foreclosures. consumer advocacy groups blaming the lenders. The lenders blaming the scoring system so for and so forth.

Overall the bottom line of who to blame is the people who signed on the dotted line. Yes alot of these Sub-Prime lenders share some of the blame for their marketing and advertising but the bottom line people were just too anxious to get themselves into a home before they were ready. Though the lenders should have been a little more stingy in the amount they approved based on someone's income and credit history, the person accepting the mortgage should have been more fiscally responsible of what to do with what was approved. If I go to my bank for a car loan and they approve me for a $100,000 that doesn't mean I go out and buy the new Lexus or Mercedes. You buy what you can afford. People weren't getting themselves educated on the home buying market. If you go to your own bank to try to get a loan and are turned down, but were approved by a mortgage broker from the internet, right then and there shoud have been a red flag to the buyer that this is not going to be a great deal.

Buying a house for the most part is going to be the largest purchase you are going to make in your life and you have to be ready and you have to understand what you are signing. If you already budgeted away x amount of dollars for the down payment, you should also budget in a few more hundred dollars to have a real estate attorney explain to you the terms you are about to sign. and understand that once you get the mortgage, that taking out home equity loans are not a free ride to get some extra cash to pay off old debts and what exactly ARM are and PIM's and every other confusing abbrev. involved in home buying.

Though I know this doesn't apply to everyone in foreclosure, circumstances beyond their control could have accounted for some of their financial hardship such as an unexpected medical expenses etc. But the bottom line people weren't understanding what they were signing. Just because and interest only for the first five years on your mortgage looks great on paper, you have to realize that once the five years is up paying on the principle is going to be very costly and you need to have saved for that day.

Overall sub-prime homebuyers were too anxious to get themselves into a home and were not ready for the huge financial responsibilty that comes with being a home owner,(no landlord to call when the pipes burst). People love to blame the Sub Prime lenders, and Yes they are some that have some shady advertising but also at the same time they were there for people who did turn their debt around and were on financial stable ground but their scores were too low to qualify for a Prime Loan and could be able to now get into a house with the understanding of what it is going to take. Now it looks like those days are going to be gone for people like me an my wife who have turned our debt around but due to people not getting themselves educated on these types of loans everyone is going to suffer.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 06:38:42 GMT

Yeah. FICO predicts risk, given a particular set of circumstances surrounding the loan. You change the loan all around, and what on earth to you expect?

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 07:11:07 GMT

I know someone who makes around 45K with over a 300k mortgage. She was able to get in with a decent fico, past paid mortgages and no income verification. If income was a factor she would never get in the house, on paper she can't afford it. However, the lender got around it by using no ver. She is low risk based on fico but high risk considering her income.

I understand your point as well as to why it is still needed. But shouldn't only pertain to self employed or special cases?

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 07:16:50 GMT

How is fico ineffective it is measuring risk? Those s/p lenders are targeting s/p borrowers fully understanding what their score is! So if fico says this person has a 500 and they are a 50% risk why are you approving the loan? Money! Simply money.

They really need to educate borrowers more like they do for student loans (mandatory training). We will all feel the effects of these foreclosures as it may stiffen requirements in the near future.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 08:11:45 GMT

Oh, the foreclosures are going to do a lot worse than that. Look at how the banks and lenders are so desperately trying to keep people in their homes, to prop up loans all over the place. Can you say "desperate and scared to death?"

They know full well that once the foreclosures begin in earnest, home prices will plunge. As home prices plunge, their collateral withers away. As their collateral erodes, other people on the edge will teeter. The economy will stall, which will lead to more defaults, and even lower home prices. These people are like the kid with his finger in the dike.

Re: Opinions differ on effectiveness of FICO score

hdporter — Wed, 02 May 2007 10:24:21 GMT

Bottom line, there are two variables here.

that sub-prime borrowers default is obvious. But, again, you expect defaults on loans extended to any credit quality borrower ... just more on sub-prime. You price according to risk, where the higher the price the more reserve there is to cover defaults. We're talking basic economics and there's nothing irrational in lending to sub-prime.

The issue is the pricing. If it's inadequate to cover default risk then there's a problem. There are two means by which inadequate pricing can be introduced.

If FICO purports to accurately measure risk of a borrower, assuming given underwriting standards, pricing becomes inadequate if FICO actually understates risk. This is the premise of lenders complaints.

On the other hand, if lenders weaken underwriting standards (e.g. inappropriately extend no doc loans), the lenders undermine FICO assumptions and are responsible for any inadequate pricing. This is FICO's defense.

We don't have the information from which to assess how accurately FICO measures risk. But the possibility that the problem largely lies with FICO is a distinct possibility that shouldn't be dismissed.

On the other hand, we do have anecdotal evidence that lenders have become too aggressive in targeting sub-prime. But, again, we don't have the data at hand to assess whether this is the predominant cause. There is good reason to suspect this is more likely to be at the root of the problem than any FICO inaccuracy.

- Harry

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 13:38:12 GMT

The bottom line it all comes down to you ( the homebuyer) getting yourself as educated as much as possible on the home buying process on what it is going to take to actually afford these types of mortgages. And not just siging willy nilly just because you got approved. I can't reccomend enough to anyone who is confused about this buying process to budget enough money to hire a Real Estate attorney who can explain this all to you and what you are going to expect to pay each month and in the future. . And also buy a house based on your income and what you can afford realistically and not be struggling each month to make payments as opposed to how much you have been approved for.

Not buy Champagne if you can only afford beer.

This is not FICO'S fault or even the sub-prime lenders( to a certain extent) fault, it's the home buyer biting off more than they can chew and not waiting until they are actually financially ready to take on the huge finacial burden that is owning a house.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 14:02:16 GMT

@Anonymous wrote:
There has been alot of finger pointing going during this sub-prime mortgage downturn/foreclosures. consumer advocacy groups blaming the lenders. The lenders blaming the scoring system so for and so forth.
Overall the bottom line of who to blame is the people who signed on the dotted line.

I'm sorry, that's just ridiculous. The Sup-prime mortgage "problem" is usually defined as SUB-PRIME LENDERS NOT GETTING PAID BACK. That's the perspective from which the discussion usually occurs. Not the perspective of the borrower, but the perspective of the lender. So what you are saying is that the evil borrower is responsible for the plight in which the innocent lenders found themselves, because the evil borrower failed to closely examine the mortgage products that the innocent lenders were falling all over themselves to give him. It was the responsibility of the borrower to protect the lender, and he failed to do so. Look, all the advantages were with the lenders. From their perspective, they are not looking at one borrower, but at the great mass of borrowers, and they could used or developed statistical tools to predict what would happen (not that it would be difficult to predict). The only reason you market products like they marketed, where there's negative amortization and substantial jumps in the payment after a time, is because it is OK with you if borrowers can't make the payments, and you are counting on them refinancing or selling the house, or you taking it. They expected continuous rapid increases in housing prices, it looks like, and when that slowed down a bit, the whole house of cards collapsed. And you want to blame this on BORROWERS??? Borrowers didn't design the loans. They didn't market the loans. They didn't draft the agreement. They just signed the agreements and pledged their homes as security. If YOU draft an agreement, where someone else agrees to pay you, and to give you their HOUSE if they can't pay you, it is not THEIR fault if the agreement YOU DRAFTED doesn't protect you from loss, or is not profitable for you; it is YOUR FAULT.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 14:32:34 GMT

Never called them evil buyers, not once. Never called them innocent lenders. Most people got into bad mortgage loans because they were too anxious to get into a home and were too willing to sign anything. Nobody put a gun to their head and made them sign it. Mortgage lenders are guilty of approving too much but at the same time it is up to you to know what you can afford and what you can't. Nobody is going to hold your hand, you are an adult and have to know exactly what you are signing, these were bad term loans but people weren't educating themselves enough to realize it and just signed their lives away without reading the fine print or have someone like an attorney going over it with them and explain it to them.

Re: Opinions differ on effectiveness of FICO score

Anonymous — Wed, 02 May 2007 15:47:59 GMT

How is the FICO score at fault? It hasn't changed the basic parameters. It's not like suddenly the score indicates that someone with a 550 score has only a 2% risk of defaulting.