A California couple who lost an underinsured home to fire and then foreclosure were eager to buy another house a year later. A bankruptcy filing that followed the loss clouded their mortgage prospects.

The couple bought the home they wanted because First Franklin Financial Corp. of San Jose used credit scoring rather than traditional underwriting and came through with a $193,500 mortgage, requiring only 10% down and no mortgage insurance.

In helping this couple, First Franklin has also helped itself by expanding from A lending into the more lucrative subprime market with heavy reliance on credit scoring.

"These were good people who went through a tough bout," said Glenn Stuart, an originator with mortgage broker Tower Funding Corp. in Santa Clarita, Calif., who arranged the loan. Underwriting the loan on those terms required seeing things differently from the way many mortgage lenders do, he said. Other lenders probably would have demanded 20% or more in equity, as well as mortgage insurance, he said.

The difference, he said, is First Franklin's use of credit scoring. In the California couple's case, a medium-level credit score, based largely on years of faithfully repaying loans, suggested somewhat less of a risk than traditional underwriting would have indicated, Mr. Stuart said. Credit scoring focuses on a borrower's long-term use of credit, including delinquencies, whereas in traditional underwriting, factors such as loan- to-income ratio weigh more.

Scoring is gaining favor among mortgage companies, but few lenders give it the weight that First Franklin does, especially in subprime business, where interest rates are set on a case-by-case basis, Mr. Stuart and other mortgage brokers said. Notable is First Franklin's use of scoring in quoting firm rates at origination, brokers said.

With A-credit lending becoming virtually a commodity business, prime lender First Franklin two years ago shifted heavily to the subprime market. It intends to differentiate itself from other subprime lenders by relying on a scoring system developed by Fair, Isaac & Co. to predict defaults, said William D. Dallas, president and chief executive officer of First Franklin.

The transition to subprime - about 30% of the company's loans remain in the prime market - is paying off handsomely, and the reliance on scoring is yielding multiple dividends, Mr. Dallas said.

"We've gone from losing $5 (million) to $10 million a year to making $25 million," he said, comparing results from 1994 and 1995 against his estimate for 1997.

Along with its predictive ability, scoring helps to contain costs and lets brokers price loans right in the office and determine early what credit enhancement will be required to get an AAA rating when the loans are securitized, Mr. Dallas said.

The push toward credit scoring in the mortgage business came initially from Fannie Mae and Freddie Mac, which use it to categorize loans.

First Franklin, observers say, has been a pioneer in using scoring on subprime loans. When Freddie Mac wanted to test its automated underwriting software, Loan Prospector, in conjunction with a Standard & Poor's product, Levels, for subprime loans last year, First Franklin was among the first aboard. Now First Franklin is counting on scores to distinguish B loans from C and D loans.

By all accounts, a Fico (named for Fair, Isaac) score above 680 represents an A-plus risk. Scores from 660 to 680 have nearly as low default rates, Mr. Dallas said.

"Our product is designed to decipher what happens below 660," Mr. Dallas said.

Based on its analysis of scores and performance, First Franklin distributes pricing sheets. Brokers find rates at the intersection of a row of credit scores and a column of loan-to-value ratios - the second major component in First Franklin's decision-making system.

"I have not had a deal go over that they had to deviate from," said James McClenahan, president of Eagle Home Loans in San Jose.

So much the better, if the matrix provides a better deal than another lender using more traditional subprime underwriting, as Mr. Stuart, the Santa Clarita broker, said he occasionally finds.

The California couple had a Fico score of 630, Mr. Stuart said. The mortgage they obtained carries a fixed rate of 9.75% for two years, after which it adjusts every six months. It's not a great deal, he said, but the borrowers' alternative would have been waiting until they had saved enough for a much larger down payment. The borrowers likely will refinance when the first adjustment comes, in order to avoid a steep rate increase, he said. "I call it Band-Aid finance," he said.

Founded as a mortgage brokerage in 1981 by Mr. Dallas and his brother, Steven D. Dallas, First Franklin moved into mortgage banking and eventually originated $4 billion in loans a year and serviced a loan portfolio that reached $8 billion. It is on track to lend between $1.5 billion and $2 billion this year from 12 offices in five Western states. It lends solely through independent brokers.

Mr. Dallas sold a majority stake in the business in August 1994 to DLJ Merchant Banking Inc., a unit of Donaldson, Lufkin & Jenrette Inc. His relationship with DLJ didn't last long. Margins in the prime loan market were getting tighter and tighter, and DLJ was unwilling to fund a plunge into the subprime business, where Mr. Dallas saw troubled borrowers paying steeper rates.

Mr. Dallas began subprime lending in November 1995 and a year later found a new investor in Continental Illinois Venture Corp., a unit of BankAmerica Corp.

Attractive to Continental Illinois, said Sue Rushmore, managing director with responsibility for the First Franklin investment, was the mortgage company's intention to do subprime business through brokers who also brought in prime business.

"They have very long-standing relationships with these brokers," Ms. Rushmore said. By contrast, she said, competitors courted brokers specializing in subprime lending.

First Franklin's first steps into the subprime market were an extensive analysis of credit scoring and participation in a pilot project using Freddie Mac's Loan Prospector software along with Standard & Poor's Levels. Levels divides loans into seven risk grades for determining how much credit enhancement will be needed to turn subprime loans into AAA bonds.

The next step, Mr. Dallas said, was teaching brokers used to working on A loans about credit scores.

"They didn't know how to pull it, how to read it, how to manipulate it," he said.

Then came convincing Wall Street about scores' reliability in forecasting loan performance.

With a $113 million mortgage-backed bond issue given an AAA rating by Standard & Poor's, underwritten by Merrill Lynch & Co., and completed in February, Mr. Dallas said the investment community is on board.

The bond issue is backed by 791 mortgages with an average principal of $145,000, a weighted average rate of 9.247%, and a weighted average original loan-to-value ratio of 76.3%. Of the total, 368 borrowers took cash out on their homes, 321 financed purchases, and 102 refinanced earlier loans. Mr. Dallas said he envisions selling packages of loans every two to three months.

As occurred in the prime market, automating the underwriting process and employing more objective standards will drive subprime margins down, Mr. Dallas and industry observers said.

In the short-term, however, there's money to be made. Mr. Dallas said First Franklin's margins have improved in the last two years, largely because of more accurate pricing and increased operating efficiency.

Long-term, he said, consolidation is under way even as new players enter the subprime market. Calling First Franklin a low-cost provider, Mr. Dallas said he is better prepared for a shakeout than others. He said he intended to create brand-name identity for First Franklin, enjoyed in the industry to date only by Money Store and Countrywide Mortgage. But he conceded he'll be looking for new lines of business within several years.

Diversification likely will include other high-margin consumer lending, such as automobile and credit card financing, he said.

To many observers, First Franklin's heavy use of credit scoring brings more objectivity to underwriting, traditionally a very subjective undertaking. Mortgage brokers say they're generally happy with moves toward more objective standards, except when it limits their ability to explain extenuating circumstances of a subprime borrower.

Mr. Stuart, the broker who obtained a loan for the California couple less than a year out of bankruptcy, expressed reservations about credit scoring. He said it isn't always clear how the score will be affected by various actions, such as repaying an outstanding debt.

On balance, he said, First Franklin's use of scoring works for him: "It's opened the door for me as a broker to say yes more often."

Mr. Stoneman is a freelance writer based in Albany, N.Y.

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