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.

Comments

[Alex]

Jeff,

I have to go back and wonder if this is a real problem or just a perceived problem. Yes, lenders are going to take a hit. But will it be any worse than the economic freefall (tongue securely planted in cheek) of the burst of the NASDAQ bubble and the 20 percent subprime foreclosure rate of 2000 to 2003? What we don't seem to be looking at here is that, with housing, we still have a tangible asset that rarely loses all value.

I've said it before and I'll say it again. From a purely economic standpoint (with no moral value added for the impact of people losing their homes that, from these reports, they shouldn't have had in the first place) this may turn out to be a real boon to redevelopment companies and those on the cusp of credit worthiness as house prices go down to match the "real" value of the asset.

Alex

[Jeff Michael]

I agree that the housing market needed a correction, and I suspect you're right that the upside to all this could be positive.

And while this is a real problem, it's been way overhyped by the media--they predicted economic meltdown in the housing sector for years, and when they finally got some evidence of it, (in the form of the current correction) they couldn't contain their glee.

As for lenders, inasmuch as they were too indiscriminate in their lending, the mortgage companies deserve to take a hit on this. (Too bad Fannie Mae & Freddie Mac likely won't get their share of the punishment, though).

I only hope potential homeowners learn the right lessons from all of this:
1. Improving one's credit to qualify for a loan isn't just a formality or a hoop to jump through. Credit scoring is a consistently accurate indicator of the likelihood of success. Taking shortcuts to "beat the bureaus" leaves you vulnerable, in a long-term loan that you probably can't afford.
2. Adjustable rate mortgages adjust--upward. One shouldn't get into a loan without fully understanding how it works.
3. Homeownership is still a very good thing; it's the essential first building block to real wealth accumulation.

The bottom line is, people should become homeowners, but not until they're really ready. And if they're not sure whether or not they're ready, an accurate credit record is a good indicator. Despite what mortgage brokers might tell you, if you have a credit score of 600 and no money to put down, you aren't ready to buy a house.

[Boris Yeltsin]

Here's a article on illegal credit repair scams, emails that promise instant relief and what you can do to protect yourself from these scammers:

http://bestbraindrain.com/2007/08/07/credit-repair-scams--what-they-are-and-how-to-avoid-them.aspx

Don't get taken by credit repair scams.

B. Yeltsin