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
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
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
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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.
------
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.
------
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.
------
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
@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
