Subprime problems and credit scoring

A Bizzyblog post today mentions the lowering of credit standards as a big part of the issue with subprime loans currently having problems. Tom would like to see Fannie Mae and Freddie Mac get their share of the blame, since they led the move toward more relaxed standards.

Tom's right that Freddie Mac and Fannie Mae helped pave the way for this mess. John Venlet is right too; the individual high-risk loan is the problem. When lenders make (or acquire) lots of high-risk loans, they have lots of potential problems.

I don't think this is about lender greed. There may have been some greedy brokers putting shaky loans together then selling them to other lenders, but Fannie Mae didn't lower the credit criteria for subprime loans because of a greedy desire to reap profits from poor people. All the expansion in mortgage lending we've seen was about helping people. If the subprime market hadn't opened up to more borrowers, you can bet the same chicken littles gnashing their teeth over the subprime meltdown would have been screeching about lenders being racist and doing nothing to help the poor.

But lowering the threshold for entry into mortgage borrowing doesn't seem to work. Now that we know that, it's time for the industry to listen to Jon Venlet and tighten up their standards. And when lenders are accused in the future of not caring about lower income consumers, they can point to the subprime meltdown of 2007 to justify their appropriately strict standards.

But it isn't just the lenders who need to learn from this. Consumers should see this phenomenon as a validation of credit scoring. It isn't just an arbitrary number; it's carefully calculated to predict a risk of default. Too many borrowers see the credit score as a nuisance to be manipulated around. That kind of thinking leads to "meltdowns" like what we're seeing now.

I counsel people to make a 680 FICO score their goal. That's the borderline of acceptable credit. And it's not something to get to through trickery or fraud; if you use illegitimate means to improve your score, it's useless as a predictor of default. It doesn't just pull one over on the lender, it also stops protecting you from taking on loans you can't handle.