Community Investments
Volume 10; No. 3; Summer 1998
Credit Scoring and The Secondary Market: Perceptions, Policies, Practices
By Henry Cassidy, Senior Vice President, Single-Family Risk Management,
Freddie Mac, and Robert J. Englestad, Senior Vice President for Credit
Policy, Fannie Mae
When you think of the secondary mortgage market, it is likely Freddie
Mac and Fannie Mae come to mind. As two of the largest sources of home
mortgage funds in the nation, Freddie Mac and Fannie Mae purchase mortgages
from lenders, package them into securities, and sell them to investors.
In doing so, they replenish the pool of funds available for new mortgages.
Chartered by Congress to increase the supply of capital for housing, Freddie
Mac and Fannie Mae provide continuous, low-cost funds for our nation’s
homebuyers and renters.
With credit scoring here to stay, many wonder how it will affect the
flow of capital for our nation’s housing. This article addresses how the
secondary mortgage market is handling credit scoring. In a series of questions
posed by Community Investments, experts Henry Cassidy from Freddie Mac
and Robert Engelstad from Fannie Mae discuss how credit scored loans are
treated, highlighting policies and practices for loan buy-backs and loan
pricing. They also address common perceptions and misperceptions about
the processing and purchasing of credit scored loans. Sharing the lessons
they have learned about credit scoring, Mr. Cassidy and Mr. Engelstad
offer suggestions on how new underwriting services and credit scoring
instruments can help lenders find good loans and increase the flow of
low-cost capital for our nation’s housing needs.
Loan Purchases and Buy-Back Policies
To what extent does a credit score affect the purchase of a loan and
the possibility of a buy-back?
Fannie Mae - Fannie Mae’s quality control underwriting
reviews include an assessment of the borrower’s credit history and
score in the very same manner that we advise lenders--as just one part
of a comprehensive analysis of the mortgage application. The evaluation
of a borrower’s management of credit--whether this evaluation includes
a credit score or not--is only one factor in a mortgage underwriting decision.
Fannie Mae’s underwriting review also considers the loan terms, the
borrower’s ability to repay the loan, the value of the property and
other factors to determine whether or not the loan meets Fannie Mae guidelines.
Loan repurchases are rare; last year we had approximately one repurchase
for every one thousand mortgages that Fannie Mae purchased. Also, we do
not require repurchases of mortgages for underwriting reasons as long
as the mortgage is not delinquent.
Freddie Mac - Freddie Mac maintains standards for our
mortgage purchases through our published underwriting guidelines and Seller/Servicer
contracts. These standards typically are the same whether or not credit
scores are used in underwriting.
We require our lenders to represent that every loan sold to Freddie Mac
using traditional, “manual” under-writing techniques meets the standards
set forth in the underwriting guidelines we agree to in our purchase contracts.
To ensure the accuracy of these representations, Freddie Mac conducts
a post-purchase quality control review of a sample of the loans sold to
us. The sample is drawn from a number of mortgage purchase categories,
including loans randomly drawn from total purchases, loans with high-risk
attributes, and loans sold by lenders whose recent performance is poor.
Among the many tools we use to define “high-risk” are credit bureau scores
indicating extremely poor credit histories.
We’re taking steps that hold the promise of largely eliminating the risk
of repurchase requests for the vast majority of loans. When lenders sell
us mortgages using Loan Prospector
What quality control mechanisms should lenders use to avoid repurchases
of credit-scored loans?
Fannie Mae - The quality control efforts that work best
do so regardless of the use of credit scores. They include: the commitment
of senior management, accountability of all employees, clear and measurable
standards of quality, ongoing assessment against the standards, and constant
feedback to eliminate the causes of errors to improve the performance.
Credit scoring can help an underwriter perform a more consistent, objective
and accurate evaluation of credit report information but it should never
be used in isolation for making underwriting decisions. Credit scores
should be used as part of a comprehensive analysis of
the unique characteristics of each individual mortgage application and
should complement an underwriter’s judgement, not replace it. Fannie Mae
sees credit scoring as another tool that helps the industry make more
mortgages, not as an excuse to do less.
If credit report errors or discrepancies surface when re-scoring
loans, how will these errors affect the purchase price of the loan and
the possibility of a buy-back?
Fannie Mae - For some cases, we obtain a new credit
report and independent verifications of income and assets during our underwriting
review. If the new credit report contains information that is different
from the report obtained by the lender--which would not be unusual--we consider
whether or not the additional information would warrant a different underwriting
decision. We also consider whether or not the information would have been
available to the lender at the time the underwriting decision was made.
Standard “score migration” would have no effect on the purchase price
of a mortgage or its eligibility for sale to Fannie Mae. Fannie Mae understands
that it is not unusual for a borrower’s credit score to change from the
time when the lender underwrites the application to the time when the
mortgage is sold to Fannie Mae. This is one reason we offer lenders the
option of providing us with the credit score they used as part of their
underwriting decision.
Freddie Mac - If a lender concludes that a credit score
is based on significantly inaccurate information, the lender is free to
ignore the credit score and sell us the mortgage based on the lender’s
documentation of the borrower’s overall credit history. This policy ensures
that borrowers obtain an “A” rate when there is inaccurate information
in their credit reports. In terms of re-scored loans being subject to
the possibility of a buy-back, there is no difference in the way Freddie
Mac treats these loans from any other loans we purchase.
What types of credit errors are significant to warrant a possible
score override?
Fannie Mae - Whenever an underwriter has reason to believe
that the credit score may be compromised by inaccurate information, the
underwriter should disregard the credit score associated with the repository
file that had the inaccurate information. This is particularly important
when significant items of credit information are involved --such as any
reported accounts that do not belong to the applicant and any derogatory
information that is reported in error.
Freddie Mac - Freddie Mac’s experience indicates that
minor discrepancies in the balances owed or payment amounts on open accounts
belonging to the borrower are typically not significant to the predictiveness
of the credit score. The following inaccurate information, however, may
significantly undermine the usefulness of a credit score:
- Public records information on a bankruptcy, foreclosure, judgment
or collection that does not belong to the borrower;
- Delinquencies that are reported in error; and,
- One or more tradelines that do not belong to the borrower.
How do you respond to the notion that score thresholds (e.g., 620)
exist in practice, and that the threat of buy-backs dissuades some lenders
from conducting more time-consuming, manual reviews of marginal or low-scoring
loan applications?
Fannie Mae - Fannie Mae constantly and consistently
communicates to our lenders that we will purchase mortgages with credit
scores below 620. We make this clear through our underwriting policies,
our underwriting training, our meetings with lenders, and most important--through
the way we conduct business. We do purchase loans with lower credit scores.
We do not prevent lenders from delivering these loans to us, nor do we
ask for repurchases simply based on lower scores.
Freddie Mac - Freddie Mac has repeatedly advised lenders
that a credit score of 620 should not be viewed as an absolute threshold.
Second, the fact that a loan has a score below 620 or, for that matter,
any other number does not make a loan subject to repurchase. Our advice
on using credit scores is that they can be used to quickly process the
vast majority of borrowers, freeing up resources and time for lenders
to focus on the more difficult loan files.
What products and services do you offer that encourage lending to
borrowers with all levels of credit scores?
Fannie Mae - Fannie Mae’s Desktop Underwriter underwrites
and approves loans with credit scores below 620. In our letters to lenders
about credit scoring, we provide specific examples of situations in which
it would be acceptable to sell us loans with lower credit scores. We are
currently piloting and developing new products for Desktop Underwriter
designed to provide even more approval options for lower-scoring, higher
risk loans.
Freddie Mac - Traditionally, mortgages purchased by
Freddie Mac have been characterized as “A” quality loans. Loans deemed
to be higher risk often were originated in the subprime market--a higher-cost
source of mortgage financing. Most subprime borrowers have a variety of
past credit problems--some minor and others serious. Borrowers who need
to consolidate debt or refinance often turn to the subprime market when
they cannot qualify for conventional financing.
Freddie Mac currently has a series of pilot initiatives that will bring
former subprime borrowers into the lower-cost prime market. Most notably,
Freddie Mac has expanded the loans it will purchase to include “A-minus”
loans. “A-minus” loans have risk attributes that place them close to “A”
quality standards. Borrowers usually fall into this category rather than
“A” category because of a few additional blemishes on their credit records.
Additionally, by more accurately measuring risk, Freddie Mac’s Loan Prospector1
Access to developing and current products, through the use of better
statistical tools promises to benefit minority and low-income families.
The subprime portion of the mortgage market finances a significantly higher
percentage of minority borrowers, particularly African-American households.
It also finances a significantly higher percentage of low-higher percentage
of low-income borrowers and a higher share of borrowers living in underserved
areas.2
Pricing and Fees
Do you base the price of loan purchases on credit scores? If so,
how?
Fannie Mae - We have always based the prices we charge
for credit risk on the mortgage characteristics most strongly correlated
to default risk, such as product type, mortgage term, and loan-to-value
(LTV) ratio. Credit scoring represents a more efficient and accurate way
to reflect borrower credit risk in our pricing and provides additional
insight about relationships between risk factors such as a credit score
and LTV on defaults. We have incorporated this credit scoring information
into our pricing system. Although credit scores are now used in our loan
pricing, they are not used alone or as the sole factor in the pricing
of any mortgage.
We work with our lenders on a variety of pricing structures. The variations
reflect an individual customer’s preferences related to operational capability,
changing market conditions, and changing profiles or risk characteristics.
We typically base our credit risk pricing on the expected risk profiles
of future loan sales to Fannie Mae. Some lenders prefer to have their
pricing reflect the risk profile of actual deliveries.
Freddie Mac - Credit scores are only one of several
factors we use to assess credit quality and are one element in pricing
for all customers.
In the past, conforming mortgages in the market were priced based on
the average price of a group of loans, such as 30-year mortgages. While
this type of pricing was useful, it limited the number of high-risk mortgages
that the conforming market could bear or it would increase the pricing
on the mortgage pool with higher percentages of riskier loans, represented
in part by low credit scores.
With the advent of new technology and increased credit expertise, the
mortgage market is moving to risk-based pricing, which prices each loan
according to its specific risk attributes. In response to these developments
in the mortgage market, we have begun to provide lenders with the option
to price mortgages on a loan-level basis using risk-based pricing. In
a number of these limited pricing initiatives, we use credit bureau scores
as one of the elements used to establish a loan-level price. Our effort
to set loan-level prices for mortgages or packages of mortgages up-front
is in a pilot stage, but we expect it to become the predominant method
for almost all lenders to establish their mortgage rates. Risk-based pricing
is a tool that Freddie Mac will use to provide the lowest-cost mortgage
financing available today to as many borrowers as possible.
The Bottom Line
In terms of loan performance, have the predictive factors of the
credit scores proven to be accurate?
Fannie Mae - Yes. The research we have done indicates
that, holding all other risk factors constant including the amount of
the downpayment, a borrower with a lower credit score, below 620, is 2
1/2 times more likely to default than someone with a credit score between
660 and 699. The actual default rate for loans in the score range between
660 and 699 is similar to the average default rate for all Fannie Mae
loans.
Our credit scoring research has also taught us an important lesson about
the predictive factors of a borrower’s income. It is just as likely for
a low-income homebuyer to have a high credit score as a high-income homebuyer.
A borrower’s management of credit, as measured by credit score, has little
correlation with the borrower’s income.
Our analysis has also provided us with a more dynamic view of the relationship
between credit risk, as measured by credit scores, and downpayment. For
example, a borrower who makes only a 5% down-payment but has a high credit
score (e.g., over 740) would be less likely to default than a borrower
who put 30% down but had a weak credit profile (e.g., a credit score under
620). If we only looked at downpayment as the primary risk factor for
default, we would overstate the real risk of many homebuyers.
These lessons learned from our research on credit scoring should help
lenders use credit scoring to find more good loans. They should also improve
access to credit for low-income borrowers. For example, a low-income homebuyer
who might not have been able to save a downpayment could still get a mortgage,
with a strong credit profile compensating for the lack of a downpayment
from the borrower’s own funds.
Freddie Mac - In 1996, we became the first (and, we
believe, to date, the only) industry participant to publish evidence that
the custom mortgage scoring model we use in Loan Prospector
Additionally, the U.S. Department of Housing and Urban Development (HUD)
recently approved Freddie Mac’s Loan Prospector as the first automated
underwriting system for FHA loans. HUD adopted Loan Prospector after
a 18 month pilot (with 15,000 loans) which validated our long-standing
findings that Loan Prospector is a fair and objective tool for evaluating
borrowers and expands homeownership opportunities for America’s families,
including minorities.
The use of credit bureau scores must be kept in perspective. Technological
advances such as credit scores, automated underwriting and risk-based
pricing are merely tools, not ends in themselves. Freddie Mac believes
that these tools will enable us to finance homes for borrowers who were
clearly on the fringe of the conventional conforming market in the past.
Freddie Mac’s vision is to make the lowest cost of mortgage financing
available to as many Americans as possible. We are working diligently
to achieve that vision and to keep concerns about fairness foremost in
our thinking. We welcome the opportunity to engage in dialogue about ways
to improve the world’s best housing finance system.
For more information about the products and services of Freddie Mac
and Fannie Mae, please visit their Web sites at: www.fanniemae.com
or www.freddiemac.com.
Credit Scoring: Tool for Secondary Market Small Business Loans
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| Selling mortgage loans in the secondary market is now common practice
and credit scoring is one of the tools that has helped sales to top
$1.7 trillion. Although less common, there is growth in the securitization
of business loans, which in the last two years reached $34 billion.
This growth has occurred as financial institutions are seeking to
increase non-interest income while retaining relationships with their
small business borrowers. The Riegle Community Development and Regulatory
Act (1994) paved the way by reducing capital requirements to apply
only to the unsold portion of a securitized small business loan. As
with selling mortgage loans, securitization can help to reduce exposure
to interest rate fluctuations and concentration risk. Securitizing
a loan portfolio requires standardized underwriting, loan documentation
and monitoring. To ensure consistent underwriting, when pooling small
business loans with similar risk profiles, some banks are looking
to credit scoring. Fair, Isaac and Company, Inc. pioneered the use
of credit scoring to assess the risk of small business credit applicants.
By using their Small Business Scoring ServiceSM (SBSS) banks can standardize
their small business loan application process to both increase efficiency
and facilitate potential future sales. |
| For more information contact Fair, Isaac at 1-800-999-2955. |
1 The benefits of our tools are described in more
detail in Freddie Mac’s report, Automated Under-writing: Making Mortgage
Lending Simpler and Fairer for America’s Families (available at Freddie
Mac’s Web site: http://www.freddiemac.com).
2 Based on an analysis of home-purchase borrowers
in the primary market versus the subprime market done by researchers in
the U.S. Department of Housing and Urban Development’s (HUD) Office of
Policy Development and Research, 5.3 percent of primary market borrowers
were African-American borrowers, compared to 13.5 percent in the subprime
market, and 6.2 percent of primary market borrowers were Hispanic borrowers
compared to 9.2 percent in the subprime market; 10 percent of borrowers
in the primary market had incomes at or below 60 percent of area median
income, compared to 14 percent in the subprime market; 23 percent of borrowers
in the primary market had incomes at or below 80 percent area median income
compared to 29.5 percent in the subprime market; and 24 percent of borrowers
in the primary market were living in “Underserved Areas” (as defined by
HUD) compared to 36 percent of borrowers in the subprime market. See HUD’s
Office of Policy Development and Research, Working Paper No. HF-001, Table
B-1 (12/96).
About the Authors
Henry Cassidy is the senior vice
president of single-family risk management for Freddie Mac. Having
served in this role since January 1996, he is responsible for
promulgating mortgage underwriting policies, the quantitative
development of automated underwriting and collateral evaluation
systems and their associated policies, and for quality control.
He acts as secretary to the Credit Policy Committee.
Previously, Mr. Cassidy served as vice president
of mortgage credit policy from February 1990 to 1996. Prior to
joining Freddie Mac, he was director of the General Research Division
at Federal Home Loan Bank Board from 1971-1984. Mr. Cassidy holds
a Ph.D. in Economics and a M.A. in Mathematical Statistics from
the University of Illinois, and a B.S. from Carroll College in
economics and mathematics.
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Robert J. Engelstad is the senior
vice president for credit policy at Fannie Mae. In this position,
he is responsible for the policies relating to loan underwriting,
performing loan servicing, and counter-party risk. Since joining
Fannie Mae in 1984, Mr. Engelstad has also served as manager of
appraisal standards and assistant director of real estate sales.
Prior to coming to Fannie Mae, he worked in the Office of Single-Family
Housing at HUD/FHA and with the Ginnie Mae Mortgage Backed Security
Program. Mr. Engelstad is a graduate of the School of Public and
International Affairs at George Washington University in Washington,
D.C.
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