Crunch leads to renewed scrutiny of credit scores

On the Money
From the December 7, 2007 print edition

The mortgage credit crunch not only is affecting interest rates quoted to home buyers, but also is triggering changes in less-visible areas, such as minimum credit scores — specifically, the ubiquitous FICO score.

FICO scores are the product of the Fair Isaac Corp. (founded in 1956 by engineer Bill Fair and mathematician Earl Isaac). The three major credit-reporting agencies supply them. Though there are other scores available, the majority of lenders still rely on the FICO.

FICO scores range between 300 and 850. In the past, traditional ratings were as follows: excellent, more than 750; very good, 720 or more; acceptable, 660 to 720; uncertain, 620 to 660; and risky, less than 620.

The “Classic FICO” risk scores rank consumers according to the likelihood their credit obligations will be met.

However, any model used to predict the future has only one source of information — the past. Credit performance by consumers is no different. In other words, given that the overall environment remains relatively constant, past behavior may be cautiously relied upon to predict the future.

Imagine how quickly the past would become obsolete in the face of a dramatic change in the fiscal environment. An extreme example might be the nationalization of all property. (Nationalization is the act of taking assets into the public ownership of a national government, without compensation.) A FICO score would, of course, be rendered useless in the face of such a dramatic transformation.

On a smaller scale, increasing influence by external sources such as the Federal Reserve, politically inspired regulation, underwriting shifts that limit borrowers’ behavior and even injection of international cash can alter environmental circumstances — breaking the link between past and future necessary for reasonable predictive modeling.

Furthermore, companies that supply information to Fair Isaac are changing their practices, compromising some of the calculations. For example, a class-action suit filed in March in U.S. District Court for the Southern District of Florida charged that American Express and

Citibank are depressing large numbers of clients’ scores by withholding credit-account limits from the three dominant credit bureaus. Without credit limits or account maximums, the plaintiffs say, the FICO software often penalizes the borrower.

In response to increasing uncertainty and possible unreliability of predictive FICO scores, underwriting criteria are shifting. Though the FICO score may be unstable, higher is still better than lower.

Therefore, the traditional cutoff point between prime and subprime loans, previously 620, has moved upward. Some mortgage companies are posting 680 as the new demarcation line.

Webster Bank, a wholesale lender based in Connecticut, increased its cutoff to 680 last August, with full documentation of applicants’ income and assets.

For the average borrower, that means a renewed scrutiny of their FICO score.

The score is comprised of: 35 percent on payment history (timing), 30 percent on the total amount currently owed, 15 percent on length of credit history, 10 percent on the number of new credit accounts (fewer is better) and 10 percent on the mix of credit accounts, mortgages, credit cards, installment loans, etc.

The best way to improve the score is to pay bills on time. Installment loans, borrowing a set amount to purchase nonperishable goods, are given more weight than credit cards.

The FICO model gives the majority of weight to mortgage payments. Therefore, it’s easy to see why turmoil in the mortgage lending markets can magnify and increase overall credit problems. Lenders raise FICO minimums; borrowers have difficulty obtaining overall credit creating late payments, which reduce their FICO scores; and the credit gap inordinately widens.

For those in the middle of a crunched-up credit transaction, it’s important to remember some of the other key underwriting factors, such as:

• Loan-to-value ratios and combined loan-to-value ratios (CLTVs) — Some lenders are abandoning zero-down-payment programs; others are requiring 10 percent minimum equity stakes. Some are restricting maximum CLTVs to 80 percent or 85 percent when a second mortgage or credit line is proposed on a home that has a first mortgage.
• Financial reserves — Rather than a minimum of two months’ worth of loan payments verified as on deposit in a bank, some lenders now want to see six months’ worth for certain loan categories.

In a credit negotiation today, press lenders to look beyond just the FICO score. Emphasize the statistically compromising nature of the current environment, and focus on all of the classic Cs in lending: capacity, capital, collateral and, the most essential of all, character.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.