“FICO”, appropriately, is an acronym for Fair Issac Credit Organization because Fair Issac developed this credit-scoring system that lenders use to evaluate the credit-worthiness of their borrowers. As such, a borrower’s FICO score is supposed to predict the default risk of a loan. The problem of late is that it isn’t working very well.
Historically, credit scores have worked so well that lenders rely on them as the most basic arbiter of credit-worthiness. But as lenders have added more layers of risk to a loan, such as adjustable-rates, stated income loans, interest-only loans and the like, the borrower’s FICO score has steadily become less predictive.
In Kathleen Pender’s May 20th column in the San Francisco Chronicle, she cites the Fitch Ratings (of mortgage-backed securities) which says that for borrowers taking “common sense” mortgages in 2003, those that who became 90 or more days delinquent had an average FICO score of 589, 31 points below the average of 620. In 2006, however, that margin narrowed to 10 points: 615 vs. the average score of 625. Glen Costello, a Fitch managing director says, “The loans that are defaulting now have higher FICO scores”.
So now Fair Issac seeks to make their FICO more predictive by a calculus that divides the population into 12 segments – eight for good credit people and four for bad credit people. Fair Isaac spokesman, Craig Watts, says that the new FICO will deliver better results for those in the lower end of the credit spectrum.
Whether or not it does, I think the Federal Reserve study frequently cited in this blog got it right when it concludes that the primary predictor of default is the equity in the property. Give a high FICO scorer a 100% loan-to-value loan (no equity) and if things get tough, he’ll get out and leave the keys for the lender.