Sunday, May 20, 2007

Overhaul of FICO is coming

Overhaul of FICO is coming

Kathleen Pender

Sunday, May 20, 2007

Fair Isaac said last week that it will introduce a more powerful credit-scoring system in September, but said it's not a response to criticism that the company's widely used FICO scores did a less-than-stellar job predicting defaults as the mortgage market grew more exotic.

The Minneapolis company said the new version will increase "predictive strength by 5 to 15 percent," especially for new accounts, subprime borrowers and borrowers with thin credit bureau files.

While it's promising big improvements for lenders, the company says the new system will have little impact on consumers.

"Some consumers' scores will go up slightly, some will go down slightly," says Fair Isaac spokesman Craig Watts.

The company would not explain what would cause a score to change, which is a shame considering the growing impact credit scores have on our lives. Lenders use credit scores to make or deny loans and set terms and rates. They are also being used, where allowed, by insurance companies, landlords, employers and utilities.

Credit scoring applies a formula to the information in your credit file and comes up with a number that predicts how likely you are to default on a loan.

Credit scores have performed so well that lenders have placed growing faith in them, perhaps too much. As long as borrowers had decent credit scores, many lenders were willing to lend them up to 100 percent of a home's value and let them make no principal and partial interest payments for a number of years. Many let customers state their income without documenting it.
Some critics say FICO scores did not perform as well as expected in this Wild West environment.

In a December conference call, HSBC finance chief Douglas Flint said that in 2005 and 2006, a "considerable amount of activity ... moved away from more-traditional products to affordability products" such as adjustable-rate mortgages, stated income loans and option ARMs. These products let people afford bigger mortgages with smaller monthly payments.

"What is now clear is that FICO scores are less effective or ineffective in circumstances where the ability to meet payments is beneficially enhanced by virtue of the fact that the payment obligations have been reduced because of very low interest rates. In other words, the FICO scores' predictive ability, because people weren't missing payments, were recording higher creditworthiness than might have been the case if they had had to make payments at more normalized interest rates, or without the benefit of affordability elements," he said.

Fitch Ratings, which rates mortgage-backed securities, says that as lenders added more layers of risk to a loan, the borrower's FICO score became less predictive.

For mortgages issued in 2003, before lenders abandoned common sense, borrowers who defaulted had significantly lower scores than those who didn't, says Glenn Costello, a Fitch managing director.

Borrowers who became 90 or more days delinquent had an average FICO score of 589 compared with an average score of 620 for those who never paid that late -- a difference of 31 points.

For loans made in 2006, that margin had shrunk to only 10 points. Borrowers who became seriously delinquent had an average FICO score of 615 compared with 625 for those who didn't.
"The loans that are defaulting now have higher FICO scores" than in the past, Costello says.

He adds that FICO scores still do a good job predicting risk, all else being equal. "If you have two loans with the exact same attributes, the person with the lower FICO score has a higher probability of default. If I take person with the higher FICO, give them a piggy-back second or a stated-income loan" and the default risk increases, he says.

Costello says FICO scores can still be useful as "part of a healthy balanced diet."

PMI Group, which insures mortgages with low down payments, uses FICO scores "as one of many different data elements in assessing risk," says Mark Milner, the firm's chief risk officer.

PMI looks at borrower-related data, including FICO scores; loan-related data, such as the interest rate and payment structure; and property-related data, such as whether the home is owner-occupied, a rental, single-family or condominium.

"For what it is, a FICO score is a very strong variable. But it's hardly the only one," says Milner.
Ron Totaro, Fair Isaac's vice president of global scoring solutions, says the FICO revamp has been in the works for 14 to 18 months and is not a reaction to recent criticism.

"We've talked to lenders, regulators and individuals who use FICO scores to drive their decisions. There has been no feedback that says these scores are working any differently than they have over the last 18 years," Totaro says.

The new version could be a reaction to VantageScore, a credit-scoring system developed jointly by the nation's three major credit-reporting agencies: Experian, Equifax and TransUnion.
Fair Isaac has sued the three agencies, alleging that VantageScore violates antitrust laws and confuses customers.

One of VantageScore's touted benefits was that it would do a better job with thin-file customers, meaning those without much credit history such as young people and recent immigrants.
The FICO upgrade also expands assessments of thin-file borrowers.

Fair Isaac now divides the population into 10 segments based on credit histories and applies a slightly different formula to each. Eight segments include people with no serious credit blotches and two are for people with serious problems.

The new system will divide the population into 12 segments: eight for people with good credit and four for people with bad credit. This will deliver better results for people in the lower end of the credit spectrum, Watts says. The system also incorporates changes in consumer behavior since its last upgrade.

Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at

This article appeared on page E - 1 of the San Francisco Chronicle

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