At a time when lack of affordability is a major concern for potential homebuyers, eliminating minimum credit score requirements on automated GSE underwriting may seem like a great idea to expand access to credit. However, there is a reason why the GSEs have had such requirements for decades. They acted as an important workaround against errors in the analytical underwriting models that may fail to distinguish between loans that are likely to default or not for certain types and thresholds of risk characteristics.
Loans with a credit score lower than 620 carry significantly higher default risk for credit investors, and as a result, the 620 limit became a well-known credit score. benchmark for subprime loans used by the industry, including the CFPB.
Both GSEs went into receivership in 2008, partly because of them purchase of non-agency mortgage-backed securities for their retained investment portfolios that include many Alt-A and subprime mortgage loans. Notably, on the single-family side of the business, both GSEs never relaxed their minimum credit score requirements during the mortgage boom. No doubt the GSEs suffered heavy losses on their purchases of single-family loans, but imagine the additional losses if they had chosen to drop their minimum credit score requirements in 2005.
With the advent of automated underwriting in 1996, the GSEs revolutionized the mortgage lending process. It ushered in an era of quantitative modeling in which a machine could effectively simultaneously process a large number of borrower, loan, property and other risk attributes and determine the probability of default for a borrower within a second.
But these models had an ‘Achilles heel’; their ability to distinguish between good and bad loans depended on the historical data fed into them. Because sufficient credit performance data was not available for loans with credit scores lower than 620, the models were exposed to errors in estimating credit risk for these borrowers, leading to higher losses for both GSEs.
At the time these AUS models were deployed, the GSEs recognized the higher risk of borrowers with credit scores below 620 and so implemented a series of overrides, essentially a kind of scorecard safety net to limit the chance that bad loans would be considered acceptable by the model. As a result, the minimum credit score of 620 became a mainstay of AUS transfers for decades.
Today, advances in data and credit scoring have expanded access to credit for a segment of borrowers that have historically turned away from the mortgage market. Borrowers with limited or no credit history from which to develop a reliable credit score had few alternatives available. Both VantageScore And Honest Isaac have built new credit scores that use this information.
Tapping into non-traditional sources of credit, such as rent and utilities, among others, is a game-changer when it comes to expanding credit access for so-called credit invisibles. However, GSEs must exercise great caution to protect against potential blind spots in the models not used to assess borrowers with subprime credit scores.
This concern is further compounded by FHFA‘s recent announcement allowing lenders to choose between VantageScore 4.0 and Classic FICO when submitting a loan to the GSEs. The GSEs integrate these scores and other credit information into their underwriting models Fannie And Freddie perform extensive diagnostic testing on these models before deployment, which eliminates the minimum credit score requirement while new credit scores such as VantageScore 4.0 that incorporate non-traditional data sources pose increasing credit risk to the GSEs.
A more prudent approach would have been for the GSEs to maintain minimum credit score requirements for a period of time during which borrowers’ credit performance could be observed and determined to be within the GSEs’ risk appetite. Ideally, credit score transfers are intended to remain in effect until there is sufficient performance to demonstrate that the underlying credit score card model can handle the risk currently excluded by the transfer. Only then could the minimum credit score requirement be relaxed.
Expanding access to credit for mortgage borrowers is absolutely an important goal for the GSEs, especially at a time when many borrowers face enormous financial hurdles in purchasing a home. Still, FHFA and the GSEs must guard against the possibility of significant credit losses from loans purchased with subprime-like credit.
Under the Enterprise Regulatory Capital Framework, both GSEs remain undercapitalized by approximately a combined amount of $375 billionThis indicates that if a major economic downturn were to occur in the mortgage market at some point in the future, Freddie Mac and Fannie Mae could face significant headwinds from mounting credit losses in such a scenario.
At a time when the privatization of the GSEs is being considered in what could be the largest IPOs of all time, the last thing investors need to worry about is the possibility of a wave of unexpected credit losses from subprime-like borrowers.
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