Credit score changes would saddle banks with risk to help nonbanks
Some believe the time is right to make it easier for people to get access to home loans through a change to credit scoring policy: The economy has largely recovered from the financial crisis, the housing market has stabilized and a new administration has begun rolling back a number of financial regulations.
But it is not.
Recently, the Federal Housing Finance Agency has been evaluating whether to allow originators that sell loans to Fannie Mae and Freddie Mac to use something other than the currently mandated FICO model. Specifically, the FHFA is evaluating whether originators can also use the VantageScore model offered by a company owned by the three credit bureaus — Equifax, Experian and TransUnion.
VantageScore contends that its model will provide credit scores on more than 30 million additional consumers and make 7.6 million of these scores eligible for a loan sold to Fannie or Freddie because of the model’s supposed ability to more accurately assess blemished and dormant credit histories and accommodate thin credit files that most often effect younger consumers. VantageScore also argues that, since the model consolidates data from all three credit bureaus, it eliminates scoring differences caused by data discrepancies. The result, the company maintains, will be expanded home ownership, a more vibrant housing market, more consistent underwriting and faster economic growth.
The real issue, however, is not whether enhancements to credit scoring models or increased competition would carry some economic and social benefits (they would and they do), but who is making the request, to whom, and why.
The major proponents of the alternative credit scoring model are large nonbank originators and credit reporting firms — companies that make their living from the quantity of loans they originate, not the quality. Their business models shield them from ongoing credit risk and require ever-increasing volumes to achieve scale economies. In short, nonbank originators generally don’t eat their own cooking — either in the form of loans or in the form of securities backed by the loans they originate. Therefore, they have everything to gain from this FHFA change, and very little to lose.
Not only do these lenders not originate loans for their own portfolios, but they retain little ongoing performance risk. They are also not subject to the same capital requirements as insured financial institutions. These differences are particularly dangerous for loans and securities that carry the seal of approval from agencies with either the explicit or implicit backing of the federal government — and, ultimately, the American taxpayer.
True, VantageScore is not a new product. Developed in 2006, it has been adopted and used by more than 2,500 financial institutions and vetted by the major regulatory agencies, according to the company.
Yet the banking industry and its major trade organizations are united in opposition to the FHFA request. The banks are clear in their concerns: The proposed solution is designed to address problems that don’t exist, the use of multiple scoring systems may create confusion among investors in securities backed by Fannie and Freddie, the model has not been truly tested in a serious credit downturn and using it could create fair lending and equal credit compliance problems. Importantly, because of the sheer volume of loans purchased by Fannie and Freddie, the industry believes that any model that has the potential to reduce the credit quality of these loans will increase overall systemic risk. As we saw in 2008, the burdens of a significant increase in systemic risk fall primarily on the banking industry.
Innovation and competition in the credit scoring world is necessary and long overdue. However, banks and other entities that shoulder the ultimate credit and regulatory risk of any credit process should make the final decision on which credit scoring model to use and when.
Banks that are originating mortgages for their own portfolio or selling pools to private investors should, and do, use whichever scoring model they feel is most appropriate to making the best decision possible — for both the bank and their customers. The growing acceptance of VantageScore for a variety of types of loans and purposes indicates that banks are feeling comfortable using the model.
However, until the banking industry is united in its need and support for the use of multiple scoring models in the origination of Fannie and Freddie mortgages, the FHFA should reject the request.