Adjusting the credit score goalpost in an upside down market
Forbes.com's Maurna Desmond's May 8 article calls Alt-A loans "subprime in sheep's clothing". In short, crumbling housing prices will push more mortgages into default simply because even relatively affluent borrowers may not stick around once equity turns negative.
The "walkaway" factor has changed the reliability of credit scoring. The FICO score has been an accurate indicator for default risk. Now, the more important default indicator may be the personal debt-to-value ratio (that FICO scores do partially factor in), which requires a marked-to-market home valuation (and I don't think the credit bureaus use Zillow). Thus, the credit scoring system has loopholes... for example, a borrower with negative equity can accumulate credit card lines in order to continue to pay their bills on time and support their FICO scores, up until the day of reckoning when either their debt resources run out, or they just walkaway.
I don't think the major credit bureaus can change their existing formulas to reflect higher default risks based on debt-to-market value, and this undermines their credibility. Perhaps this is one reason why lenders have been ultra-cautious approving loans - the rules of the valuation and risk management game have changed too much for bureaucratic loan underwriters, who are used to following rigid loan guidelines that in a minority of cases may not applicable to today's topsy turvy market. So the baby goes out with the bathwater.
The Boston Fed did a study on subprime foreclosures and found that while credit history, FICO, income, rate resets, etc were contributing factors the primary driver of foreclosure was negative equity.
Hopefully the biggest takeaway for banks and regulators will be that it doesn't make sense to artificially inflate asset prices through the financial engineering of low payments (teaser rates, neg am, etc).
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Great point you make.
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