Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

FICO scores and subprime defaults

Thomas Brown has an interesting
article
at bankstocks.com which indicates that US mortgage defaults
might not be driven by low FICO scores at all. Brown compares the
various mortgage pools underlying the widely tracked ABX index and
shows that in many cases, the worst performing pools have
higher FICO scores than the best performing pools. In some
cases, the average FICO scores of the worst pools are around 640 so
that they do not even count as subprime according to the standard
definition. Until last year, subprime was generally defined as FICO
scores below 620, but after the subprime turmoil began, some lenders
have raised the cutoff to as high as 680.

In some sense, this is not surprising. FICO scores are not about
creditworthiness as measured by income, assets or cash flows. They are
simply about past credit histories. If a household with an impeccable
credit history is given a housing loan that is well beyond what it can
afford in terms of its income levels, the FICO score would be
excellent, but the default risk would be high.

Brown’s data shows a clear pattern where pools originated by
some lenders like Wells Fargo have the lowest default rates while
those originated by other lenders like WMC have the highest default
rates. Geography matters too – the worst pools have high
exposure to some of the most frothy housing markets of 2006.

Brown interprets his data to mean that mortgage losses are not
likely to be as high as feared because many subprime mortgages will
not default. While I grant this, an equally valid conclusion from the
data is that many non subprime mortgages will default because the
trajectory of housing prices matters more than FICO scores.

All this has implications for India where many hopes are being
pinned on the creation of credit registries and similar agencies that
would make FICO-like scores possible in India as well. In a country
where recovery is even harder than in the United States, excessive
reliance on credit histories might not be such a good idea at all. The
smartest crooks will build excellent credit histories with a series of
small loans until they can take out a large loan. Long ago in the
United States, the term Brazilian straddle was used to describe a huge
market position which the trader intended to run away from if it
proved unprofitable (the other leg of the straddle was supposed to be
a one way air ticket to Brazil). What the equivalent straddle should
be called in India is left to the imagination of the reader. I would
confine myself to the observation that credit histories provide little
protection against such straddles.

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