On March 1, the Federal Housing Finance Agency held a public listening session on credit score models. I appreciated the opportunity to share my thoughts with over 25 other respected and knowledgeable stakeholders.
The importance – and the challenges – of credit scores are at the forefront in the current dialogue as we collectively strive to build a more efficient, effective, equitable and inclusive mortgage finance system.
Those posting loans can use whichever credit score model they prefer – or none if they wish. However, since the majority of loans exit through the secondary market, most lenders must use a lending approach that meets the requirements of secondary market participants, such as investors or guarantors, within the applicable mortgage channel. When a credit score is used, the associated score and model should match the participant’s pricing, risk and other applicable methodologies.
One of the practical challenges of marketplaces that use competing credit scoring models is the need to correlate the scores of different vendors on an apples-to-apples basis in pools or portfolios reflecting a combination of models. For example, it would be quite difficult for investors, rating agencies, lenders, risk managers, regulators and other participants in the mortgage finance ecosystem to assess whether a 700 under the “scoring model of credit A” is equal to a 700 or another – and potentially very different – score under “Credit Score Model B.” We can try to compare scores under competing models using analytical tools like scoreboards or score charts, but if the answer is different for different loans and different borrowers, it would reflect an inconsistent correlation and unreliable. This begs the question: what are the implications and risks of the resulting inadequate disclosures, data or analysis?
Mortgage finance stakeholders need to pay close attention to practical details which, if ignored or misunderstood, can become landmines when implementing even the best-intentioned new policies or practices.
The FHFA has wisely recognized this danger, as evidenced by its Final Rule on Validation and Approval of Credit Score Models. The Final Credit Score Rule provides for the assessment of the potential impact of new or different credit score models on the myriad of Fannie Mae and Freddie Mac businesses that involve credit scores. This includes, but is not limited to, private mortgage insurance eligibility requirements, unified mortgage-backed securities regulations, credit risk transfer transactions, and GSE capital requirements.
One of the options offered by the FHFA regarding credit score models was to give lenders the choice to choose between or among the models. In the comments to my listening session, after noting the need for an “apples to apples” dynamic, I said:
“Even if we could create valid, consistent, and reliable scorecards that correlate competing credit score models, we need to require a lender to identify in advance which model they will use to make a loan. Under no circumstances should we allow forum shopping when it comes to competing models. Nothing good comes from forum shopping – ever. If an appraisal is too low to warrant a loan, we do not allow additional appraisals until the loan is finally allowed to proceed. If we don’t follow the same careful practice for credit ratings, we risk encumbering the applicant with a mortgage they can’t maintain, and potentially violating consumer protections and harming the security and system strength. »
This is not to say that we are incapable of solving the various practical challenges posed by a credit score model or competing credit score models. It is also true that certain credit score models may be better suited to certain credit applicants. The same goes for other elements of consumer credit analysis such as underlying data sources and underwriting methodologies. For example, many stakeholders now recognize the potential credit impact of considering rent payment history for tenants and analyzing cash flow for gig workers. Innovations like these can help us improve the market’s ability to define and recognize creditworthiness.
This reflects one of the cornerstones of FHFA’s Final Credit Score Rule: the need to make real progress in expanding access to sustainable credit among the underserved. We know that many people – especially in communities of color, as well as low-to-moderate income and “credit-invisible” communities – may, in fact, be creditworthy, but fall outside the four corners of certain elements traditionally applied consumer credit analysis. Leveraging financial technology and new sources of data to improve our understanding of creditworthiness is essential to the ultimate goal of a fair, equitable, safe and inclusive consumer financial system.
But it takes time for markets and market players to evaluate new technologies and products and even longer to adopt and implement them. For this reason, FHFA requires in the Final Credit Score Rule a minimum review period, not to exceed seven years, for the evaluation and selection of authorized credit score models for a given term until the next exam period. This construct allows for stable and functioning markets, but it also risks stagnating technology and deterring competition. In response, and to encourage continued innovation and competition, FHFA should allow GSEs (and Federal Home Lending Banks) to establish pilot programs to evaluate new credit scoring models and technologies among official examination periods. Pilot programs also provide a safer space to test new products and initiatives while limiting the risk of consumer harm and negative market disruptions.
So what’s the crux of it all when it comes to new and competing credit score models?
We need a mortgage finance system where anyone who is able to maintain mortgage credit can obtain it on terms that are fair, equitable, secure and inclusive. Any credit score model we use must do what it is supposed to do in a statistically and methodologically sound way, passing rigorous back-testing and analysis, and resolving or explaining anomalies in a clear and transparent manner. . We must also leverage carefully evaluated innovations, including cutting-edge technology and improved sources of data and analytics, to achieve these goals, ensuring that we eliminate any built-in discriminatory elements.
At the same time, we must maintain the stability and smooth functioning of secondary mortgage markets as we assess, adopt and implement any credit scoring model. This means using a credit score model for a reasonable and defined duration, supported by pilot programs, unless an alternative model can be correlated and integrated in a safe, robust and consistent way. If there comes a time when two or more credit score models are used, we must not allow lenders to use an alternate second chance credit score simply because an applicant’s original credit score rendered ineligible for mortgage credit. Rather, we must implement protocols and procedural safeguards around credit score model selection to prevent irresponsible lending practices focused on “chasing volume” at the expense of credit sustainability and protection. consumers.
Responsible innovation and implementation of credit scoring models can improve our understanding of creditworthiness and help expand access to sustainable credit. But failure to adhere to the principles set out above could distort pricing, risk and other important methodologies, causing lasting damage to consumers and our mortgage finance system – despite the best of intentions.