Editor's note: This story was originally featured in the February issue of DS News, out now.
Following the credit crisis of 2008, the economic recovery has stabilized consumer credit markets and led to a rebound of credit availability for consumers. Despite a revival of consumer credit and underwriting standards returning to a more normal range today, here are still challenges.
For the housing industry, the biggest trepidation is determining whether some consumers are being left behind and locked out of a chance to achieve homeownership due to their lack of access to traditional credit.
Millions of Americans don’t have credit. In fact, nearly 45 million American adults do not have a traditional credit score, according to a 2015 Consumer Financial Protection Bureau (CFPB) study. Additionally, the study notes an estimated 26 million adults that had no credit bureau records at all. Although 19 million reportedly had credit records, they were still deemed as “unscorable” at that time by the Fair Isaac Corporation (FICO).
While the Federal Housing Finance Administration (FHFA) is currently evaluating the costs and benefits of using updated FICO Scores as well as considering VantageScore for government-sponsored enterprise (GSE)financed mortgages, expanding the availability of credit to those who can handle it is good, but burdening people with credit they cannot handle is counterproductive for both consumers and investors.
So, is there a best credit model to expand the American Dream to borrowers that are creditworthy, yet unscorable?
MODEL ONE, OR MODEL TWO
FICO and VantageScore have taken quite different approaches to expanding the scorable population. FICO uses additional data from outside the credit rating agencies (CRAs) while VantageScore—a collaboration between the three major CRAs Experian, Equifax, and TransUnion—uses similar scoring methods to FICO, but lowers the requirements for the CRA’s based score.
According to FICO, their existing algorithms already capture all of the relevant information from the CRAs. Meanwhile, FICO determined that any loosening of scoring standards resulted in unacceptable model fits and less reliable rank ordering of creditworthiness.
Therefore, FICO developed FICO Score XD, utilizing data from outside the credit bureaus to score consumers who are not scorable by traditional methods. FICO Score XD has been validated and made available for credit card lending. With Fair Credit Reporting Act (FCRA)-compliant alternative data, FICO has successfully scored over 50 percent of the people previously considered unscorable.
Importantly, this group contains millions of people with no credit bureau record at all—the truly invisible. Scoring this group enables borrowers to quickly build a credit history through credit card use that can then be reliably scored for mortgage lending.
VantageScore takes a very different approach to expanding the scorable population. Rather than looking outside of the credit bureau files, they lowered the thresholds at which they are willing to create a VantageScore for a consumer. Whereas FICO requires at least one credit trade line open for six months or more, and activity on at least one trade line within the last six months, VantageScore altered these requirements entirely.
However, this adds risky credit files to their scored population. Lower scoring standards increases the risk exposure of anyone lending based on scores because when a lender receives a VantageScore for a particular consumer, they cannot tell if the consumer had a very thin or very old credit record without actually looking into the full credit bureau file. Loosening requirements increases the risk exposure of anyone lending based on these scores because the reliability of credit risk ordering is reduced.
Conversely, if a borrower doesn’t have a long history of credit, VantageScore is the better fit—as it only requires one month of history and one account reported within the past two years. Because VantageScore allows a shorter credit history and a long period for reported accounts, it’s able to issue credit ratings to millions of consumers who wouldn’t qualify for FICO scores. Borrowers that are new to credit or haven’t been using it recently could benefit from VantageScore, as it might be able to prove trustworthiness before FICO has enough data to issue a rating.
DIVERSE APPROACHES TO CREDIT ACCESS
Not every consumer who has a credit score obtains a mortgage every year. Especially in the lower end of the credit score spectrum, many consumers are rejected for loans due to excessive debt-to-income ratios and other underwriting criteria. Of course, many consumers simply choose not to take out a mortgage because they prefer to rent or already own a home.
VantageScore’s approach of lower scoring standards falls short of the promise of increasing access to homeownership for millions of Americans. VantageScore claims that up to 10 million consumers previously unscored would have access to credit if standards for score creation were loosened. Quantilytic analyzed VantageScore, FICO, Home Mortgage Disclosure Act (HMDA), and GSE data to estimate how many new mortgages might be originated out of that population.
According to VantageScore, the group of 10 million consumers with a VantageScore above 600 is referred to as “near-prime and prime.” In fact, at least 2 million of the consumers are subprime even by VantageScore’s definition as they fall under VantageScore 620. Nearly all of the remaining consumers in the expanded category have scores less than 700.
As a result, FICO estimated likely mortgage origination rates by looking at the proportion of consumers in each FICO Score bucket who actually obtained mortgages in 2015, including only purchase loans as refinance customers already have credit records and increased refinance volume does not constitute expansion of the borrower universe.
Applying the appropriate origination percentage in each score bucket to the number of newly scored consumers under VantageScore’s loose requirements resulted in approximately 45,000 new mortgages per year.
WHY COMPETITION MATTERS
The ownership structure of VantageScore under the three CRAs creates significant barriers to true competition in the conforming mortgage space. While it’s not normally expected for competition to increase innovation, while reducing prices, the structure of the credit scoring industry is anything but normal.
VantageScore is owned and controlled by the three credit bureaus, who each, individually, have power to control access to and pricing of their data. As this data is an absolutely critical input to credit scoring models, the ownership structure of VantageScore could result in either limited or very expensive access to the data for competing firms such as FICO. Increasing the use of VantageScore, particularly through a GSE mandate, could dangerously obstruct true competition.
Score competition could also push score providers to loosen standards under pressure from lenders and real estate agents looking to increase volume. This could start a race to the bottom similar to that which occurred among bond rating agencies during the housing bubble. In the years immediately preceding the crisis, an AAA rating on subprime mortgage bonds was essential for marketability; when deal arrangers could not convince one rating agency to issue an AAA, they simply went to the next agency.
This “rating shopping” became the norm so quickly that all of the major rating agencies lost sight of the true risk of the bonds as they became caught up in the race for revenues. The same could happen very easily with an uncontrolled move towards multiple credit scores, particularly when lenders who do not retain default risk select the score.
QUALITY OVER QUANTITY
Policymakers must remember that a credit score is but one input into the underwriting decision. While lack of score can be a barrier to entry, lenders must not overestimate access to affordable credit that the mere presence of a score would generate.
Many of the newly scored would be rejected for credit based on prudent underwriting practices. While expanding the availability of credit to provide more opportunities for homeownership is good, it is risky to provide people with credit they cannot handle—for both consumers and investors. Furthermore, to protect the financial system, it’s crucial to utilize models that are reliable and accurate, rather than simply expansive.
The consumer credit scoring industry has a unique structure with the three credit bureaus dominating the collection and sale of credit data while FICO provides the scoring engines that drive the vast majority of consumer credit decisions. While the three credit bureaus’ joint ownership of VantageScore might provide more access to homeownership to a greater number of borrowers, it raises conflict of interest and fair competition issues that would need to be resolved to allow for true competition in credit scoring.
Editor's Note: FICO has supported some of the research of Parrent’s firm, Quantalytic, on the topic of credit scores in the conforming mortgage market.