FICO and the securitization boondoggle

[newnewthing]

For the last decade I have lived in ignorance of one of the most important but abused numbers, the FICO score. I had dropped all my credit cards and lived on just a single debit card simply for convenience. I had lots of cash, savings, no mortgage so whats to worry. It turns out a lot. On a whim I decided to check my credit score and I had none! Upon investigation I stumbled upon one of the big factors in the housing bubble collapse. It turns out that the packaging and securitization of credit card and mortgage debt was based almost entirely on credit scores. Credit scores purport to project risk of default. They do, but within the limits of the data they consider. This is the basis of FICO:

1. Paying debt on time. Gotta have debt to pay it.
2. Utilization, or the ratio of current reported debt to credit lines extended. You don't have debt - you're screwed.
3. Length of time of existing debt accounts.
4. Presence of negative public records.

Notice what FICO doesn't reflect. These include:

1. Savings, bank balances.
2. Fully owned real estate including paid off mortgages over 10 years old.
3. Income
4. Real estate equity.

This is not the fault of Fair Isaac rather this data isn't reported under the federal rules of what credit reporting companies are allowed to collect and disseminate.

So what happened?
http://www.infosys.com/FINsights/Subprime-Crisis.pdf

Mortgage loans were bundled together based on FICO scores largely without other obvious considerations. A loan would be bundled the same whether or not a piggyback for a zero down net was obtained.

Liars loans (no income or capacity verification) were common and accepted since FICO alone was used to assess risk and establish interest rates. HELOCS grew without impairing common risk models.

The infosys Tech. linked document is copy protected but can be read and printed. Fascinating read. Check it out.

[WildspitzE]

Re: FICO and the securitization boondoggle

I always thought this was funny for many reasons. Aside from FICO vintage analysis being so easy to manipulate through cherry picking, FICO scores are better indicators of the willingness to pay and not the ability to pay. Of course this is based on prior performance (based on past economic conditions ;)) and on the willingness to borrow (LOL ;)).

I've looked at billions and billions in loan and securities portfolios, and as I've said it here before (as I used to in credit committees): as systemic leverage approaches infinity, the correlation in these portfolios approaches one --- because of the ability to pay. Nothing like this is factored into the analysis. Meaning, as systemic consumer credit goes up, credit protections should also increase. The opposite happens, which only adds fuel to the behavioral fire that ultimate leads to everybody trying to run out of the same exit.

In other countries, where credit scores are really non-existent (or relatively new), securitization arrangers couldn't really piggy back off of FICOs or something as easy to analyze. This absence, coupled with an american or european centric view or distrust of the emerging markets, led to more robust credit work, analysis, and tighter structures than those in the "mature market" that is the US. The market that all these other countries were trying to emulate. Irony.

[newnewthing]

Re: FICO and the securitization boondoggle

Well all those financial engineers found the Holy Grail in FICO. Mama don't let your babies grow up to be quants.

[zoog]

Re: FICO and the securitization boondoggle

Well all those financial engineers found the Holy Grail in FICO. Mama don't let your babies grow up to be quants.

As c1ue said a couple years ago:

One consequence of the present unfolding events is that credit scores as we have experienced them are going to be relegated where they belong: in the trash bin.

The credit scores were an easy way for the ratings companies to quickly and easily determine a relative risk for loaning money to an individual.

It is now quite clear given the present stress test that any such system is worthless because it is too easy to game.

While the ratings agencies will modify their criteria, the 'credit score gamers' will also continue the arms race. It won't take much for lenders to realize that this type of system is no longer workable - both in the fact that borrowers can see (thus manage) their score and that the ratings agencies ultimately don't care if the ratings work or not (except in the most generic long term sense).

It is this feedback loop which has comprised one of the major legs of this present real estate bubble.

Thus trashing a worthless score is not a big deal!

And this from seekingalpha last fall.

Lenders knew that FICO has already failed. They knew it was gamed. Their data showed it conclusively. As if the data weren't enough, they could see the sudden profusion of new "Credit Reporting Agencies" and all the "score borrowing" and "rapid readjust" nonsense going on.

They didn't want to see it. The FICO cohort that was falling apart represented the bulk of their profitable borrowers. This was not the sub-620 extreme or the low-profit Prime book. This was the thick part of their bell curve. FICO was gamed. FICO was junk. But question FICO and you yanked the emergency brake on the Gravy Train. So not only did they not question it, they started to rely on FICO almost exclusively. They started to insist on having as little OTHER data on borrowers as possible. When they asked for the Equifax reports, they stopped asking for the employment and income data. They started pushing "low-doc" and "no-doc" paper out the door as fast as they could. See no evil, hear no evil and make a buttload of money.

[LorenS]

Re: FICO and the securitization boondoggle

I think Fair Issac does share a large part of the blame. Their algorithm is fundamentally flawed and even a toddler could tell you some of the reasons. The "no credit history" one is one prime example - that's just plain lazy. Here are two more examples of Fair Issac fraud:

I have asked for reduced credit limits on my credit cards often, it's basic fraud deterrence and cheap insurance against ID theft. The geniuses at Fair Issac consider that prudent step to be a "risk".

We've had friends who got penalized on their Fair Issac score for closing out unused credit cards - again prudent behavior punished by "Fair" Issac.



Do people really ask for credit limit reductions before they default? Do people really close out unused credit cards before they default?

I don't know who came up with the FICO algorithm, but they need to get some real life experience and then try again.

[newnewthing]

Re: FICO and the securitization boondoggle

I think Fair Issac does share a large part of the blame. Their algorithm is fundamentally flawed and even a toddler could tell you some of the reasons. The "no credit history" one is one prime example - that's just plain lazy. Here are two more examples of Fair Issac fraud:

I have asked for reduced credit limits on my credit cards often, it's basic fraud deterrence and cheap insurance against ID theft. The geniuses at Fair Issac consider that prudent step to be a "risk".

We've had friends who got penalized on their Fair Issac score for closing out unused credit cards - again prudent behavior punished by "Fair" Issac.



Do people really ask for credit limit reductions before they default? Do people really close out unused credit cards before they default?

I don't know who came up with the FICO algorithm, but they need to get some real life experience and then try again.

Something may well be prudent for an individual yet statistically correlate with increased risk. The major effect is utilization factor which goes up when an account is closed. Now if they had any idea whether your net worth was positive on negative, or even whether you are currently working or have a saving account they could assess account closing with less false positives (or negatives). But they don't and it is because Credit Reporting Agencies are restricted as to what information they are allowed to track and high utilizations is one of the strongest correlates to default risk.

The idea that one could just substitute higher FICO scores for income and collateral documentation borders on the bizarre.

[karim0028]

Re: FICO and the securitization boondoggle

Something may well be prudent for an individual yet statistically correlate with increased risk. The major effect is utilization factor which goes up when an account is closed. Now if they had any idea whether your net worth was positive on negative, or even whether you are currently working or have a saving account they could assess account closing with less false positives (or negatives). But they don't and it is because Credit Reporting Agencies are restricted as to what information they are allowed to track and high utilizations is one of the strongest correlates to default risk.

The idea that one could just substitute higher FICO scores for income and collateral documentation borders on the bizarre.

I would shudder at the thought that a credit rating agency would be able to track my assets.... That would be so 1984... For them to publicly know all your bank accounts and saving and 401K, that would be alarming....

You would always be on the grid with no financial privacy what so ever....

[newnewthing]

Re: FICO and the securitization boondoggle

I would shudder at the thought that a credit rating agency would be able to track my assets.... That would be so 1984... For them to publicly know all your bank accounts and saving and 401K, that would be alarming....

You would always be on the grid with no financial privacy what so ever....

Well, they don't track any of them let alone all of them. I share your concern but imagine my shock at getting my first credit report and not seeing the bank I've done much business with for the last three decades. Nor any employer at all listed (they get can employer info from the places you ask for credit with but it is rarely complete). Nor the fact I own real estate free and clear (that IS a public record). I just hadn't bought anything on credit for over 10 years so any record dropped off.

One very good thing was no one was about to steal my identity based on my report.

[karim0028]

Re: FICO and the securitization boondoggle

Well, they don't track any of them let alone all of them. I share your concern but imagine my shock at getting my first credit report and not seeing the bank I've done much business with for the last three decades. Nor any employer at all listed (they get can employer info from the places you ask for credit with but it is rarely complete). Nor the fact I own real estate free and clear (that IS a public record). I just hadn't bought anything on credit for over 10 years so any record dropped off.

One very good thing was no one was about to steal my identity based on my report.

You should be thankful... I personally like my privacy... if i owned real estate out right i wouldn't want any one to know i owned it; bc i would make sure my name wasnt attached in public record. It would be in trust or in a corporate entity... You simply open yourself up to frivolous law suits. I don't want anyone knowing my bank account numbers aside from me and my bank, i don't want them knowing what my stock account is worth....

The less they know the better.... If you only knew who had access to those credit reports, you would understand why i think its not worth the hassle.....

If they were to ever begin compiling that type of data and you were ever in a lawsuit it would be very easy to essentially pull up your entire net worth and all your assets via a credit report and that is not something i would want.... Especially seeing how easy it is to pull someones credit file.