Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iimahd.ernet.in

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Thu, 21 Feb 2008

FICO scores and subprime defaults

Thomas Brown has an interesting article at bankstocks.com which indicates that US mortgage defaults might not be driven by low FICO scores at all. Brown compares the various mortgage pools underlying the widely tracked ABX index and shows that in many cases, the worst performing pools have higher FICO scores than the best performing pools. In some cases, the average FICO scores of the worst pools are around 640 so that they do not even count as subprime according to the standard definition. Until last year, subprime was generally defined as FICO scores below 620, but after the subprime turmoil began, some lenders have raised the cutoff to as high as 680.

In some sense, this is not surprising. FICO scores are not about creditworthiness as measured by income, assets or cash flows. They are simply about past credit histories. If a household with an impeccable credit history is given a housing loan that is well beyond what it can afford in terms of its income levels, the FICO score would be excellent, but the default risk would be high.

Brown’s data shows a clear pattern where pools originated by some lenders like Wells Fargo have the lowest default rates while those originated by other lenders like WMC have the highest default rates. Geography matters too – the worst pools have high exposure to some of the most frothy housing markets of 2006.

Brown interprets his data to mean that mortgage losses are not likely to be as high as feared because many subprime mortgages will not default. While I grant this, an equally valid conclusion from the data is that many non subprime mortgages will default because the trajectory of housing prices matters more than FICO scores.

All this has implications for India where many hopes are being pinned on the creation of credit registries and similar agencies that would make FICO-like scores possible in India as well. In a country where recovery is even harder than in the United States, excessive reliance on credit histories might not be such a good idea at all. The smartest crooks will build excellent credit histories with a series of small loans until they can take out a large loan. Long ago in the United States, the term Brazilian straddle was used to describe a huge market position which the trader intended to run away from if it proved unprofitable (the other leg of the straddle was supposed to be a one way air ticket to Brazil). What the equivalent straddle should be called in India is left to the imagination of the reader. I would confine myself to the observation that credit histories provide little protection against such straddles.

Posted at 17:01 on Thu, 21 Feb 2008     View/Post Comments (3)     permanent link




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