Mortgage: Fed Finds that Scoring Can Promote Adverse Selection

Credit scoring has been promoted by government sponsored enterprises, or GSEsoFederal National Mortgage Association (Fannie Mae), Government National Mortgage Association (Ginnie Mae) and Federal Home Loan Mortgage Corp. (Freddie Mac)oas a good way to lower mortgage underwriting costs by identifying good and bad applications. But that enthusiasm may be coming back to bite them. A study by Federal Reserve senior economist Wayne Passmore and Mills College economics professor Roger Sparks makes a strong case that scoring gives an information advantage to underwriters who might in turn be keeping some of the good quality mortgages for themselves and passing more of the mediocre ones to the Mae family in a process called adverse selection. Adverse selection could lower GSE profits by creating an underlying pool of mortgages that had different probability characteristics from the model used to predict defaults and prepayments. The models used by the MAEs assume a normal distribution of good, bad and ugly mortgages; if underwriters keep more of the good and pass on more of the ugly, the pool would perform differently from the model, creating securities that don't perform as advertised. Investors would, in turn, discount the securities accordingly, forcing higher pricing and, for the GSEs, lower profits. "There's really nothing theoretical about the study," says Passmore. "It's mostly common sense." Reaction to the study has been predictable, with most market participants, including rating agencies, denying the study has much to it. But Ginnie Mae officials, at least, admit that they've been aware of the possibility that credit scoring could encourage adverse selection for some time. Passmore's study appeared at the beginning of May, and Nicholas Shelley, senior advisor to Ginnie Mae president Kevin Shelley, acknowledges that the GSEs were aware of the possibilities raised by Passmore's study before it appeared. "We are addressing the concerns that are addressed in the study," he says, adding that he couldn't be specific about what solutions might be pursued. "We're sorting through the issues now and have been for about six months." Among the possible solutions, according to other industry sources: computerized screening systems to test for smooth distribution of credit quality throughout the pool prior to securitizing it. -reinbach tfn.com

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