When credit-risk scoring came into usage in the 1970s, it ushered in an era of science-based decision making that was primed to end the judgmental and biased lending decisions of the past. As the recent mortgage crisis has exposed, the science of risk scoring needs some tweaking. The industry needs to add critical measures of financial soundness to scoring and re-embrace common-sense judgment. Doing this won't turn back the clock to the days of restrictive lending-or demonize creative lending products - but will lead to sounder lending practices that will help the housing market recovery more quickly.
The magnitude of the current crisis makes it abundantly clear that there is significant room-and need-for improvement in current credit-assessment approaches. There are two fundamental problems that contributed to the weakened underwriting standards and degraded loan quality. First, credit scoring has not done an adequate job of assessing risk in the subprime mortgage market. Most subprime mortgage underwriting systems were not, in fact, capturing the full range of risk factors in the market. This was particularly true when their conventional risk models were applied to non-conventional loan products, which are associated with different payment terms and behavior. Lenders who depend on these credit-scoring systems were measuring credit risk inaccurately and incompletely. Second, there is a blind spot in today's underwriting practices. Current practices rely too heavily on quantitative models and automated underwriting systems. Technology has a vital role to play in boosting efficiency and helping measure and monitor credit risk, and the models have their place and role to play. However, institutions must control the models instead of the other way around. Loans need first to be properly classified, and then risk rated. Today's process has that backward.