Sunday, March 18, 2007

Tanta on FICO "Inflation"

by Bill McBride on 3/18/2007 02:47:00 AM

From CR: At the OC Register, Mathew Padilla interviews Glenn Stearns of Stearns Lending. Here is an excerpt:

Stearns also said there has been an inflation in credit scores, known as FICO scores. He said some consumers with a maximum of $3,000 in credit had a FICO of 700, which generally is considered a good score. Such a first-time buyer had no proven history of making a house payment, he said. In his own business, he said customers that went into default tended to have credit scores greater than 700.

“Everyone is having to rethink credit scores,” he said.
This makes it sound like FICO scores are undergoing a process like “grade inflation” in college. Tanta explains that the problem isn't with the FICO score itself, but that using the FICO score alone is insufficient for first time homebuyers.

The following is from Tanta:

Some of us (OldFart Mortgage, LTD) used to require a first-time homebuyer to have a 24-month rental history, and to verify that with a direct verification from the landlord or property management company. First, we would make sure that the borrower had a history of making housing (not “house”) payments on time. Then, we would calculate the borrower’s current housing expense as a ratio to gross monthly income, and compare it to the borrower’s proposed monthly housing expense (including taxes and insurance). The result of this comparison is actually what old-timers mean by the term “payment shock.” (The term for potential future issues on an ARM was “rate shock”; the press has completely muddled the terms now so much that it’s hopeless.) Anyway, the traditional rule of thumb was that a first-time homebuyer was limited to a proposed house payment no more than 150% of the current housing (rental) payment. That extra 50% allowed owning to be more expensive than rent, but also was conservative enough to allow for things like maintenance and other expenses that renters aren’t often in the habit of paying for. If you let them double their monthly housing payments, they can get into terrible trouble the first time they have to call a plumber. The theory is that second-time homebuyers have already learned this awful lesson and so they can be allowed more “shock” (as long as they still meet the total DTI max).

In any case, this verification of the rental payment history and “payment shock” test was on top of the required minimum FICO. So those borrowers described in the article—a nice pretty 700 FICO derived from one $3000 card balance—would not get the loan if they didn’t meet the other two tests. For instance, this old rule eliminated FTBs who were going straight from mom & dad’s place (or the dormitory) to a mortgage: they were ineligible because they couldn’t show a 24-month history of being responsible for their own housing costs. Ditto for someone “renting” a condo owned by the parents but not actually paying anything near a real housing cost burden. I used to get those “kiddie condo” deals a lot when I worked for a lender with branches in a college town.

In my view, it is among the most irresponsible of the irresponsible lending we’ve seen lately that FTB rules were relaxed to allow either 1) no history of making one’s own rental payments required or 2) not counting late rental payments as a reduction to FICO (they won’t affect the FICO if the landlord doesn’t report to the credit bureau, and small-time property owners don’t) or 3) the payment shock limit was increased to 200% or more.

That said, it’s not so much that FICOs get “inflated,” it’s that their importance to the loan qualification process is inflated. For anyone who has already owned a home, the mortgage payment history is already taken into account in the FICO (because mortgage servicers report to the bureaus). But first-timers present a cautionary tale in not letting the FICO bear more weight in your decision than it should.

I’m sure that’s probably what the guy in the newspaper meant, but as usual, the newspaper only deals in sound bites, so my version is just the one that shows the work as well as the answer, as it were. There are some other issues a lot of us have with FICOs; they can in some cases “reward” heavy debt users over limited debt users. That’s why a sane underwriter (yeah, right) reads the credit report instead of just looking at the FICO. The other side of this, you see, is that the borrower with $3000 on the cards might have a FICO of 700, but the borrower with $8000 on the cards might have a FICO of 750 (because that person’s credit record is older, or has more tradelines—the $8000 is split over three cards instead of one, and the more trades you have, generally, the higher your score until you get to the point where you’re maxed out). So just having stricter FICO rules for FTBs would end up setting the very perverse incentive of encouraging them to get into a lot of consumer debt so they can prove they’re good enough to get a home. I would rather go back to the (“inefficient”) old days where we used FICOs, but only as a guideline that had to be backed up with other considerations, positive and negative. I certainly don’t want to see young borrowers locked out of mortgage credit because they don’t have enough plastic in their wallets or because they bought an old beater for cash instead of taking out a car loan or lease for something new, for the love of Peat. But I fear that’s the message some of them have gotten.

And that gets us back to my long-standing problem with subprime lending becoming predatory lending. A lot of folk end up in subprime because they don’t have access to the kind of credit that would improve their FICOs enough to get them into prime. If you come from the side of town where the available credit is mostly payday lenders or rent-to-own stores—who don’t report to the bureaus—you are not only getting screwed on whatever borrowing you’re currently doing, because the rates are just usurious, you’re also screwed because paying those cruddy rates in a timely fashion doesn’t offer the reward of a good FICO score. My solution to a lot of the predatory lending problem is to make sure that depositories are offering “entry level” credit to low-to-moderate income people, including young people. If the banks get ahold of them before the sleazy credit card mailers or the local loan sharks do, they can get some debt experience in a safer and sounder manner. But some banks seem to have taken the position that they’ll let Providian or the local loan shark take the risk on entry level borrowers, and then they’ll pick out the few survivors for their prime loans, while putting the others into those high-yield subprime loans. When we focus exclusively on borrower behavior, without looking at lender behavior, we get a skewed view of how you “create” a subprime borrower in the first place.