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Residential Department: BackSpace: May 2016

 

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Lawmakers and industry players debate changes in credit scoring

The FICO score, a benchmark used for decades by underwriters to assess mortgage borrowers credit-worthiness, remains the nation’s definitive credit-evaluation tool, but it’s facing some challenges from government players and from within the lending and credit-monitoring industries.

A proposal in Congress would allow Fannie Mae and Freddie Mac, the government-sponsored entities (GSEs) that securitize billions in home loans annually, to consider FICO alternatives when setting lending standards. At the same time, the Federal Housing Finance Agency (FHFA), which oversees the GSEs, has directed them to create plans for adopting “alternative or updated credit scores.” Credit-reporting companies also are pushing their own alternative measurements, and some private lenders boast of their ability to do business without relying on FICO scores.

Critics complain that FICO unfairly hinders those with little or no credit history and ignores the types of nonbank transactions that might be useful in determining whether applicants will pay their bills. The inclusion of those transactions — such as rent, utility and cellphone payments — could improve the scores of many homebuyers, especially first-time buyers and minorities, who are now often shut out of the housing market.

Fannie and Freddie own or back $4.6 trillion in residential mortgages, about 46 percent of the market, so their underwriting standards and reliance on FICO make it a critical factor in residential mortgage lending. U.S. Rep. Ed Royce, a California Republican who is co-sponsor of the congressional legislation calling for alternatives to FICO, says the bill is not a commentary FICO scores per se, but that the GSEs’ “use of a single credit score is an unfair practice that stifles competition.”

For its part, FICO says the legislation is not necessary because of the GSEs’ own work on implementing credit scoring alternatives, including new FICO-devised scoring methods that are currently being tested.

“We were well underway with our testing and validation before the bill was introduced, and [FHFA Director Mel Watt] has every ability to make this decision” without Congressional action, Joanne Gaskin, FICO senior director, says.

Old and new disrupters

Some upstart private lenders make the rejection of FICO-score reliance a selling point. Social Finance Inc. (SoFI), a San Francisco lender created in 2011, advertises itself as a “FICO-free zone” that caters to, among others, millennials who have comparatively few credit cards and scant credit history.

Fair Isaac Corp., FICO’s proprietor, is a 60-year-old Silicon Valley software company that was once an upstart itself. The company created its first-credit scoring system before Silicon Valley or the word “software” were in vogue, and introduced the FICO score in 1981. In the decades since, the credit-scoring system has become essential to mortgage, credit card and automobile lenders.

There is a reason the FICO score is so widely used, according to Todd Baker, managing principal of Broadmoor Consulting LLC. “For all its faults, it’s still the best predictor for mass-market lenders,” says Baker, who worked as an attorney for underwriters that evaluated Fair Isaac’s initial public offering in 1987.

Although FICO may have some blind spots when used to assess the creditworthiness of those with little credit history, Baker says the score is “the gold standard” for large-scale lenders that process thousands of applications yearly and require a system that is dependable no matter what the economic conditions.

Scoring methods developed in the last half-decade may seem reliable, but they will not really be tested until the next financial downturn, Baker adds. “Until you’ve seen them go through a cycle, you won’t know how predictive they really are,” he says.

Credit-scoring alternatives

The credit reporting agencies — Equifax, Experian and TransUnion — devised their own scoring model a decade ago and created an independent company (VantageScore Solutions LLC) to offer that product, as well as FICO scores, to lenders. The VantageScore model is designed to capture and score a larger number of prospective borrowers, including those with thin financial histories, and also to provide a credit-rating tool that is consistent across the reporting agencies, says VantageScore Solutions spokesman Jeff Richardson.

VantageScore ranks otherwise unrated consumers, Richardson says, by, among other factors, looking at a longer period of credit activity than does FICO. Although it is not included as part of the GSEs’ underwriting standards, over a 12-month period ended this past June 30, VantageScore was used more than 6 billion times by some 2,000 lenders — including seven of the 10 largest banks in the U.S., according to the company.

FICO also offers its own alternative-scoring products, including a predictive tool called FICO Score 9 — under which medical collections have a lower impact than other credit blemishes. Scores typically increase by about 25 points for consumers whose only major credit-score negatives are medical collections, the company says.

In addition, FICO’s Gaskin says a product developed in partnership with LexisNexis, Risk Solutions and Equifax is designed to better track cellphone and utility payments, property data and other records. The product, called FICO Score XD, is being used in a pilot program by large credit card issuers to rate previously unscorable consumers, creating “a pathway to credit for those who are credit-invisible today,” Gaskin says.

Measuring millennials

Many of the new scoring methods are aimed at millennials, a demographic segment that many Realtors and mortgage originators have so far found difficult to gauge. VantageScore and FICO, as well as private lender SoFi, cite the difficulty of gathering information about millennials because of their relative lack of credit history. About 25 million consumers have no records at the credit agencies. “The median age for this group that is not scorable is 25,” Gaskin says. “And they are looking for credit.”

Finding new ways to track a given demographic, or making other changes in credit scoring, isn’t as daunting as it might seem. Some lenders update their credit-scoring models periodically, Richardson says, but mortgage lenders are unable to because of the GSEs’ reliance on traditional FICO scores.

That reliance may lessen eventually, but not likely in the near future. The FHFA warns that “migration of any new model will be costly, complicated and will take considerable time for Fannie Mae and Freddie Mac, and lenders of all sizes to implement.”


 

Bill Lewis was editor of Scotsman Guide Commercial Edition. For questions about this article, call (800) 297-6061 or e-mail articles@scotsmanguide.com.

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