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Washington | Some of the housing industry’s largest trade groups reportedly want housing finance agencies Fannie Mae and Freddie Mac to look at using new types of credit scores for assessing default risk on residential mortgages. These groups argue that existing scores are "unfair" to low income borrowers.
Housing Wire reported last month that the groups sent a letter to Federal Housing Finance Agency Director Mel Watt, the Mortgage Bankers Association, National Association of Realtors, the National Association of Home Builders, and other groups pressing Watt on the issue.
Watt, a former congressman from North Carolina and long-time member of the House Financial Services Committee, threw cold water on the idea that Fannie and Freddie would begin using alternative credit scoring models at any point in the next two years.
“Watt said that making any changes to the government-sponsored enterprises’ credit scoring models before 2019 would be a “serious mistake,” reports HW. Ditto.
FHFA chief Mel Watt is nobody’s fool and in particular understands the state of pay to play in Washington. The push for new credit scores is not really about competition or access to credit for low income households, but rather the corporate ambitions of the major consumer credit bureaus.
“In 2006, VantageScore Solutions was introduced as a joint venture between three national credit bureaus – Experian plc, Equifax Inc. and TransUnion – aimed at providing an alternative solution to the widely used FICO score through the introduction of the VantageScore,” writes DBRS in a June 2017 report. “Recently, evidence points at VantageScore gaining traction in consumer lending and, by extension, in structured finance.”
The three national credit bureaus or data “repositories” share a monopoly on individual credit reporting in the US. Yet as we’ve learned recently with Equifax (NYSE:EFX), the repositories take no responsibility for protecting consumer data or even telling consumers when they have been compromised. Nor do the repositories take any responsibility for the accuracy of data gathered or how it is used, as with identity theft and credit fraud.
Because the GSEs require three credit reports for conventional and government mortgages, the repositories apparently decided to come together in an anti-competitive alliance to promote the new VantageScore as a way of displacing Fair Isaac Corp (NASDAQ:FICO), publisher of the FICO score traditionally used to assess consumer credit.
By spending money on marketing and Washington lobbying activities, the three credit repositories have orchestrated a seeming groundswell of support for the VantageScore. But to us, the combination of the three data monopolies in the world of housing finance sure looks like anti-competitive behavior.
Of course there are instances where an anti-competitive business combination constructed as an ancillary restraint will survive antitrust tests, but this situation with the three incumbent consumer credit repositories looks like an illegal attempt to stifle competition – namely FICO -- and create a vertical monopoly atop the existing horizontal data franchise shared by the three firms.
In the rest of the world of consumer credit, there is competition between the three credit rating bureaus. By maintaining an accurate profile of a consumer’s credit, auto lenders, employers and other parties can quickly assess a subject’s basic credit standing with one report. Only because the GSEs require credit reports from all three agencies is a competitive market transformed into a murky, monopolistic alliance between the three incumbent credit data repositories.
Some consumer advocates and Washington policy organs, including many that receive direct financial support from the owners of VantageScore, argue that the new score is more fair than the multiple versions of FICO scores, which are tuned for different industries and can vary by as much as 10% either way depending on the credit type. They also argue that the inclusion of limited rental payment data gives lower income borrowers a better chance of approval.
Both private research and internal assessments reportedly conducted (but not published) by the GSEs, however, raise significant doubts as to the numbers of additional low income borrowers that might be approved using VantageScore vs FICO for mortgage lending. Some policy advocates have claimed that seven million new borrowers might be added to the mortgage rolls by wide adoption of VantageScore.
“The credit score model used by the GSEs needs to be updated,” writes Laurie Goodman at Urban Institute. “The credit score model the GSEs essentially require mortgage originators to use for mortgage lending— FICO 4—is outdated, based on models estimated in the late 1990s. Both FICO and VantageScore have much more recent models, including FICO 9 and VantageScore 3. VantageScore is also rolling out VantageScore 4.0 this fall.”
Goodman and other market participants note that the GSEs and the rating agencies are still using antiquated versions of the FICO model in their own models, versions that ignore advancements in new data and how events such as medical expenses are weighted in credit models.
Credit professionals operating in the ABS market also wonder whether either the GSEs, the rating agencies or bond investors are ready to make a change, especially if it results in any expense to make the transition. Many policy advocates in Washington are innocently unaware of the magnitude of change that shifting to, say, FICO 9 would entail for the housing agencies, the credit rating firms and for major bond investors.
In tactical terms, the GSEs are the source of the problem when it comes to antiquated credit scores in the world of housing finance. By mandating universal usage of raw credit reports from all of the three repositories, on the one hand, and then dragging their feet on adoption of new credit scoring models – from either FICO or Vantage – the GSEs have created an intellectual and operational bottleneck in the US mortgage industry.
But ultimately this Washington conversation is ignoring the most important constituency, namely global bond investors in the US and around the world. One of the dirty secrets of the pro-VantageScore, access-to-credit crowd in Washington is that not all consumers have enough of a credit history to get a FICO score.
If you can fog a mirror, you can pretty much get a VantageScore. In fact, VantageScore 3.0 can generate a score for up to 35 million more people than conventional models, according to company claims. And the VantageScore model is about to get even more forgiving, according to The Washingtton Post.
The basic credit models used by FICO and VantageScore are similar, but not comparable. An 800 FICO is not the same as an 800 VantageScore. The rental and utility payment data included in Vantage is limited and, to the earlier point on FICO, really does not tell you about the obligor’s ability to pay a 30-year mortgage and take care of the house.
These differences between FICO and VantageScore make the credit rating agencies, lenders and servicers, and end investors in residential mortgage backed securities (RMBS) nervous about depending upon newer scores to judge default risk. Think about the folks at the Bank of Japan, for example, who are traditional and size buyers of GNMA securities.
Goodman notes that the newer version of FICO and VantageScore are more closely aligned, but the fact remains that you cannot compare a FICO and VantageScore because of differences in the data and methodology. Yet the GSEs could do a great deal to help illuminate and clarify these issues. She writes:
"In their 2017 Scorecard, the FHFA directed the GSEs to 'Conclude assessment of updated credit score models for underwriting, pricing, and investor disclosures, and, as appropriate, plan for implementation.' In addition, 'The Credit Score Competition Act of 2017,' HR 898 in the House and an expected companion bill in the Senate, would encourage the GSEs to consider alternative credit risk scoring models when making mortgage purchasing decisions. In particular, the GSEs would be required to establish and make public their procedures for validating and approving credit scoring models."
Watt told an industry group last month that the FHFA is supposed to issue a request for information this fall addressing the impact of alternative credit scoring models on access to credit, costs and operational considerations. We agree with Goodman and others that it would be helpful to understand the rationale behind how the GSEs assess different consumer credit agency models for the purpose of default probability.
But we also think that the GSEs moving from FICO to VantageScore is probably not practical either. There is not enough of a significant positive difference between the two models to make a change worth the time and money. We also think the idea of the lender selecting the credit score to be used in the underwriting process is a non-starter with investors – and prudential regulators. Real simple: the answer is no.
More, there are some far bigger analytical issues that must be settled before the industry moves forward to new credit scores. Last week, Jack Kahan and Steve McCarthy of KBRA wrote an important research note on this issue of default risk estimates in residential RMBS:
“Investors and originators alike tend to use the 2001-2003 mortgage origination vintages to establish underwriting standards and to benchmark base case default expectations on newly originated loans. Many industry participants have expressed the view that the market struck the perfect balance between credit availability and prudent underwriting during this period, pointing to pristine mortgage performance for those loans as evidence. Indeed, depending on the metric chosen, defaults for crisis vintage loans were 5.9x that of loans originated between 2001 and 2003. However, our research suggests that credit standards seem to explain only a fraction of this increase when judged through the lens of expected default rates. Based on the Urban Institute‘s HFPC Credit Availability Index, average GSE default risk due to borrower attributes was five percent between 2001 and 2003 and six percent between 2005 and 2007, a 20 percent increase.”
More that just a request for information, we’d like to see a public, head-to-head comparison of the different scores supervised by the GSEs and their respective regulators, and with input from the credit community. The last word on this topic is not going to come from Mel Watt or anybody in Washington, but from the bond investors who hold $9 trillion in RMBS.
Remember, if the GSEs were to mandate VantageScores, the entire analytical infrastructure of the credit, ratings and regulatory community would need to be revamped. And then the SEC would need to evaluate and validate the new models, especially given the new rules governing RMBS in Dodd-Frank. But of course this all implies that the three monopoly credit repositories would allow their “private” data on millions of consumers to be exposed to the public. Stay tuned.