Credit score panacea failed to stop us mortgage crisis
LOS ANGELES, May 10 (Reuters) – The crisis that has swept the U.S. subprime mortgage industry may come down to a simple, three-digit number, multiplied by millions.
Three homes display "For Sale’ signs in a row on Palma Bonita Lane in Perris, California May 2, 2007. In the latter stages of the housing boom, armies of independent mortgage brokers like Musick, and a new breed of subprime lenders like Argent, helped bring a whole new class of borrowers to the housing market, a boom that led to bust for thousands. REUTERS/Mark Avery
Lenders in the midst of an unprecedented U.S. housing boom pared borrowing requirements to a minimum — a single number, known as a “FICO score,” that was supposed to reflect the borrower’s ability to repay a mortgage.
Traditional down-payment demands were dropped. Borrowers were taken at their word because checking a salary took too long. Proof of savings, housing history, a job — sometimes these, too, fell by the wayside.
Critics of the system argue scores are full of errors and dangerous to use alone. They also are easy to manipulate. A cottage industry has thrived helping prospective borrowers raise their scores without changing their underlying ability to repay a mortgage.
“There are fundamental flaws in the system because people can manipulate characteristics to get the FICO score they would like to see,” said Kevin Jackson, a strategist who follows mortgages at RBC Capital Markets in New York. The system can be played “to come up with the kind of mortgage for people who really couldn’t afford a house.”
A credit score and a written, unchecked statement of income have often been enough to get a loan. That provided the fuel that kept the housing boom going as huge demand for homes met a seemingly endless and unchecked supply of money.
“The combination killed the goose,” said Bill Dallas, chief executive of Ownit Mortgage Solutions, a failed subprime lender headquartered in Agoura Hills, California. Subprimes are higher interest rate loans for lower-credit-quality individuals.
Mortgage failures hit record highs at the end of last year and the housing industry is in crisis. Now, loans worth hundreds of billions of dollars could be in jeopardy.
TRICKS OF THE TRADE
The FICO scoring system takes its name from Minneapolis-based Fair Isaac Corp., the company that developed it in 1989. FICO scores have been used by credit-card companies, auto loan providers and mortgage lenders as part of a process to grant credit for billions in purchases. FICOs incorporate five types of information to calculate a score on a scale of 300 to 850.
A score above 700 is strong, mid-600s is good for many, and 620 is clearly considered second-tier, or subprime.
FICO has been embraced by the $10 trillion U.S. mortgage industry as an objective, easy-to-use way to make the market more efficient and fair, and even after the demise of some two dozen lenders, it is the main lending criterion for many companies.
“Now the banks don’t want to hear letters of explanation. They just want to learn FICO scores,” said broker Bob Moulton, president of Americana Mortgage Co. in Manhasset, New York.
Lenders who focused too narrowly on FICO numbers often failed to see how the figure was being misused.
“You can do a lot more than you should be able to do to a FICO score, a lot quicker,” said Ownit Mortgage’s Dallas, a real estate industry veteran. He said a FICO score can predict default but his company used scores as just one element in a complex set of factors used to approve loans.
One problem with relying exclusively on credit scores is they are easily changed. Consultants are available to fix errors in credit reports and also offer tips to raise scores, undermining the system.
For example, borrowing money to temporarily pay down debt can boost the score. Ironically, opening more credit card accounts can also increase their amount of available credit — and sometimes can boost the score.
Another common way to boost scores is to piggyback on a relative’s good standing by getting added as an authorized user of their credit cards. That way, it appears the person has the same access to credit as the relative.
Entrepreneurs are taking that idea a step further, making a business of buying and selling credit card accounts, or “tradelines.” For $1,500, addatradeline.com offers to connect a customer to another person’s credit card with a $15,000 limit and 10 years of payment history, creating the appearance of a solid borrower.
“As long as there are banks out there that will score with tradelines, there will be a market for this,” said Adam Wheeler, owner of the Orange County, Calif.-based addatradeline.com.
Lenders bragged that credit scores were rising among borrowers in the midst of the housing boom. However, a rising level of delinquencies last year revealed growing problems with the system. The total of loan payments more than 60 days late by January had surged to record highs above 14 percent, up from near 6 percent in mid-2005, according to UBS Securities data.