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