Credit Scores: Not-So-Magic Numbers

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Over the years, Fitch Ratings upped the score's weighting in its model, reflecting the lending industry's growing reliance on the measure. "Fair Isaac worked with us to develop the [securities] ratings model with FICO," says Glenn Costello, co-head of Fitch Ratings' U.S. residential mortgage-backed securities group.

NO WARNINGS

Now Fair Isaac's Greene takes issue with the way Wall Street applied credit scores to troublesome mortgage-related securities such as collateralized debt obligations. FICO scores, he says, were intended to measure the likelihood that a single borrower, not an entire pool of home loans, would default. And the score, he says, was never geared to exotic loans whose variable rates could soar. "It didn't anticipate a product that would effectively double the interest rate six months down the line," he says. "That's not the way the score is constructed." But his argument rings hollow to Fitch's Costello. "I never heard them warning anyone away from FICO," he says. "I can't say we were ever told it was a bad idea." (Fair Isaac says that over the years it has warned Fitch and the other rating agencies that there are appropriate and inappropriate ways to use FICO scores.)

While Fair Isaac was singing FICO's praises to bankers and ratings agencies, the model was breaking down. According to a Fitch study, the average FICO score of borrowers who stopped making home-loan payments was 589 in 2001, compared with 620 for those who were paying on time—a 31-point difference that pointed to FICO's predictive ability. By 2006, as subprime loan volume was surging, the gap had closed to just 10. Costello says the data suggest "there's something wrong with FICO." Adds Jeffrey E. Gundlach, a mortgage-backed securities expert who runs the TCW Total Return Bond Fund (TGMLX): "There's nothing in the FICO score that worked in terms of predicting the default and delinquency trends." Fair Isaac's own analysis shows only a "tiny bit" of erosion in the formula's predictive value for subprime mortgages over the past few years, an amount that's "not alarming," says Tom Quinn, vice-president for scoring solutions.

Golden West Financial (WB), a longtime FICO skeptic, is one of the few mortgage lenders to minimize its use in recent years—and it credits that decision for its below-average mortgage losses. Now a subsidiary of Wachovia (WB), Golden West's delinquency rate on traditional mortgages is running at 0.75%, vs. 1.04% for the industry. Richard Atkinson, who oversees part of Golden West's mortgage unit from San Antonio, says the bank calls to verify employment, examines a borrower's stock holdings and other assets, and employs a team of appraisers who are judged not by the volume of loans but by the accuracy of the appraisal over the life of the loan. "The way we do business is a lot more costly, and cost was a big reason many competitors embraced credit scoring," he says. "But some of our best borrowers had low FICO scores and our worst had FICO scores of 750."

James C. Blaine, CEO of the $12 billion North Carolina State Employees' Credit Union, the nation's second-largest, has long eschewed credit scores in favor of a more egalitarian process. He charges those of his 1.2 million members who meet his underwriting standards the same flat rate—now 6.25% —regardless of their credit history. "You shouldn't abuse a good person just because they don't understand the financial system," says Blaine. The former construction worker argues that subprime borrowers default because of high interest rates, not FICO scores. He says there's barely a difference in defaults among his borrowers with the lowest scores and those with the highest. And of his members who would be traditionally classified as subprime, just 1.25% defaulted on their home loans, well below the 7% that analysts expect at lenders like WAMU this year.

A FINE-TUNED UPGRADE

Most lenders, despite their vocal protests, are sticking with the FICO score for now. Many have responded to the subprime debacle simply by raising the score for new subprime loans. Consider Accredited Home Lenders, a San Diego firm that specializes in subprime mortgages. Back in 2004, AHL could arrange 100% financing to any applicant with a 640 score—including people who'd never owned a home. Today, borrowers with a 640 score may be asked to make a down payment of 15% or more just to get the loan.

FICO 08 could well help matters. The new system still spits out scores in the 300-to-850 range, but its analysis goes deeper. Whereas the current score penalizes consumers equally for any type of delinquency, FICO 08 is fine-tuned to reflect how many times a borrower is delinquent and the types of debt involved. Overall, Fair Isaac estimates, FICO 08 will improve the accuracy of lending decisions by as much as 15%, cutting default rates.

But only two of the three major credit bureaus have agreed to use FICO 08 with their consumer data. (Equifax (EFX), based in Atlanta, says it won't implement the new score. Fair Isaac sued it in 2006 over a rival credit-scoring product.) Even after the credit bureaus get on board, lenders may need 6 to 12 months to revamp their systems. Meanwhile, credit doctors and other characters will start lining up to take their whacks at the new system. Says Hendricks: "I don't expect any of this to go away."

With Brian Grow in Atlanta and Robert Berner in Chicago