Looming Risk for Mortgage and MBS Investors from ‘Lender Choice’

Since Freddie Mac introduced the industry to the first automated underwriting system (AUS) for GSE-eligible mortgages in 1996, a borrower’s credit score has been one of the most important predictors of mortgage delinquency. For many years afterward, FICO Score was the sole provider of scores for both GSEs’ AUS scorecards. The arrival of VantageScore as a competitor to FICO has fueled the use of credit scores in mortgage underwriting with FHFA’s decision to let lenders choose between FICO and VantageScore when making loans to the GSEs. This “lender choice” policy carries risks for both credit and MBS investors.

Lenders clearly have an economic incentive to make loans that have the best chance of being purchased by the GSEs. Loans that involve higher risk may be subject to additional fees (LLPAs) or may not pose an acceptable risk to the GSE. Since GSE introduced automated underwriting, lenders have always been looking for ways to find weaknesses in these scoring systems.

In economics, this practice is known as adverse selection, where one side of a transaction has more information than the other and sells a product with a higher credit risk without the buyer’s knowledge at the time. In the specific case of lender choice, while the technical definition of an information advantage by lenders may no longer exist over time as the GSEs expect such a strategy from lenders with respect to their AUS, giving a lender the ability to select which credit score to provide results in a form of adverse selection that creates greater credit risk for the GSEs. Don’t take my word for it, other analysis, including a recent one from Milliman finds evidence of this strategy.

In one new study of the effects on credit risk for the GSEs due to lender choice, I examined the possibility of adverse selection by conducting a statistical analysis of GSE mortgages that was consistent with how a sophisticated and analytically oriented lender would approach the problem. In this analysis, I developed two statistical scorecards similar to those used by the GSEs to estimate the likelihood of mortgage delinquency (defined as a loan ever being 90 days delinquent or worse in its term (D90+)). One model used FICO as a measure of creditworthiness, and the other used VantageScore along with a range of other borrower, loan and property characteristics. That hypothetical lender would then choose to send the credit score that generated the lowest expected default rate between the two scorecards for a borrower. In some cases that could be VantageScore, in other cases it could be FICO.

There is a fair amount of uncertainty about the degree of adverse selection that would be observed, so I looked at a range of possible scenarios, from full (100%) acceptance of adverse selection (the extreme scenario) to variations in between (25% – 75%), and compared the actual D90+ rates of those adverse selection scenarios to a base case for random credit score selection.

What I found is that across a range of credit score categories shown in Figure 1, each adverse selection scenario results in higher D90+ rates than the random score selection baseline, and that the difference widens as credit scores decline. On a weighted average basis of loans across all credit score categories from the loan sample, the 100% adverse selection scenario would increase D90+ rates by 0.44%. Compared to the actual D90+ rates for the sample period, this is an increase of approximately 18%.

Figure 1: Actual D90+ rates in lenders’ choice scenarios by credit score category

The D90+ estimates from this analysis underestimate the effects of potential adverse selection for several reasons, including the failure to take into account another policy that eliminates the minimum credit score requirement for loans originated through the GSEs’ AUS process, which together with lender choice could further increase credit risk.

To be fair, the GSEs will implement controls to monitor any potential for adverse selection over time. However, there is a fair amount of uncertainty for credit investors, such as private mortgage insurers and credit risk transfer security (CRT) investors, about the impact that the choice of lenders will have on credit risk and their investments. Similarly, MBS investors should be concerned about the impact that larger involuntary prepayments (defaults) in lender choice would have on mortgage bond prices. While the intent of lenders’ choice to bring competition to the market in credit scoring appears well-positioned, this ultimately has the potential to backfire and actually impose higher costs on borrowers over time. FHFA would be wise to suspend lender selection until a comprehensive assessment of its impact on the mortgage market and borrowers has been completed.

Clifford Rossi is a principal at Chesapeake Risk Advisors, LLC.
This column does not necessarily reflect the opinion of HousingWire’s editorial staff and its owners. To contact the editor responsible for this piece: [email protected].

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