We’re already beginning to forget the lessons of the financial crisis.
Fannie Mae and Freddie Mac—the two government-sponsored enterprises that support much of the U.S. mortgage market—guaranteed and purchased a significant number of nonconventional mortgages in the run-up to the crisis, more than a decade ago. As a state regulator at the time, I was working with colleagues around the country to rein in mortgage originators and reduce or eliminate the volume of these loans made on predatory and unsustainable terms.
As my colleagues and I targeted the worst excesses in the mortgage market, such as waived down payments and the acceptance of lower credit scores, we faced the near constant criticism that we were standing in the way of the extension of credit to more potential homeowners and their fulfillment of the American Dream.
We all know what eventually happened: The housing market deteriorated and Fannie and Freddie were placed into conservatorship, due in part to the nonconforming loan books of the GSEs. And while the crisis impacted Americans across the socioeconomic spectrum, borrowers who had been granted access to credit as a result of lowered underwriting standards were more likely to miss their mortgage payments or default on their loans.
I subsequently served as monitor of the national mortgage settlement, and in the years since the crisis, we have seen genuine attempts to redress at least some of the attendant damage and to nurse the market back to health.
Unfortunately, today we see a renewed call for reduced underwriting standards—this time in the form of an alternative scoring model for Fannie and Freddie that does not meet the minimum scoring criteria of the current model, the FICO score. Quite simply, lower standards generate less predictive scores, which mean higher risks for the lender. And in the case of Fannie and Freddie, that lender is ultimately the taxpayer.
The Federal Housing Finance Agency is currently soliciting input on these proposed changes. Once again, the proponents for changing underwriting standards do so in the name of increasing access to credit.
But it does not seem that the proposed alternative, VantageScore (owned by the three credit bureaus — Equifax, Experian and TransUnion), would actually achieve this result. While VantageScore claims to be able to score millions of additional borrowers, a recent analysis of its approach found that, even if that claim is accurate, it would result in a fraction of those estimates leading to actual mortgage originations. This is primarily because VantageScore uses identical data sources as the FICO score and only generates additional scores by dropping FICO’s minimum scoring requirements regarding both the length and currency of a borrower’s history. (Editor's note: The analysis was funded by FICO, although the conclusions represent the author's views.)
There are also calls to allow mortgage originators to choose a FICO score or a VantageScore — but authorization of multiple credit scoring systems will inevitably lead to arbitrage between or among them.
Before the financial crisis, when subprime mortgages were securitized, the sales of the securities hinged on their ability to obtain AAA ratings. Sellers rebuffed by one rating agency simply took their business to another one. Over time, the economic incentives of attracting and maintaining seller business incrementally, but inexorably, drove all rating agencies to lower their standards. I fear that the same would happen if mortgage originators are suddenly able to use the score of their choosing.
When a borrower is approved for a mortgage that he or she ultimately cannot repay, the consequences are serious for the market generally and disastrous to families and to communities in particular. If the financial crisis has taught us anything, it is that a mortgage origination process that churns out loans to borrowers without responsibly factoring in their ability to repay them is no favor to the borrower, the housing market or taxpayers.
Am I saying that moving to an alternative credit scoring system will single-handedly usher in the next financial crisis? Of course not. But approving otherwise ineligible applicants starts us down a path of once again moving such applicants and the market toward an inevitable reckoning. And when the moment of reckoning arrives, it will undermine the FHFA’s mission. And the taxpayer will, once again, be left holding the bag.
This is not to discourage the pursuit of new and innovative ways to strengthen our credit scoring and reporting system. Rather than weakening the standards of existing scoring methods, there is great promise in initiatives which tap into new, rigorously validated alternative data sources outside of the credit bureaus. This has real potential to bring Americans out of the shadows of credit invisibility and serve as a bridge to more complex credit decisions like mortgages.
The FHFA would be wise to stay with established and tested credit scoring methods, expanding them slowly and in light of market knowledge built over decades. Credit scoring is an essential part of our entire housing market. Resisting the temptation to increase market access by altering the scoring system is a hard decision. Nevertheless, as FHFA Director Mel Watt recently stated, “none of the decisions we make at FHFA are easy decisions.”