Opinion: Easing GSE credit score requirements raises risk concerns

At a time when lack of affordability is a major issue for prospective homebuyers, eliminating minimum credit score requirements in GSE automated underwriting may sound like a great idea to expand credit access. However, there’s a reason the GSEs had such requirements in place for decades. They acted as an important override against errors in the analytical underwriting models that may not be able to distinguish between loans that are likely to default or not for certain types and thresholds of risk attributes. 

Loans with credit scores below 620 pose significantly higher default risk to credit investors, and consequently, the 620 credit score cutoff became a well-known benchmark for subprime lending used by the industry, including the CFPB. 

Both GSEs staggered into conservatorship in 2008, in part by their purchase of non-agency mortgage-backed securities for their retained investment portfolios that included many Alt-A and subprime mortgage loans. Notably, on the Single-Family side of the business, both GSEs never relaxed their minimum credit score requirements during the mortgage boom. No doubt the GSEs took heavy losses on their Single-Family loan purchases, but imagine the additional losses had they elected to drop their minimum credit score requirements in 2005. 

With the advent of automated underwriting in 1996, the GSEs revolutionized the mortgage lending process. It ushered in an age of quantitative modeling where a machine could effectively ingest a large number of borrower, loan, property and other risk attributes simultaneously and determine within a second the likelihood of default for a borrower. 

But these models had an “Achilles” heel; their ability to distinguish between good and bad loans was dependent on the historical data fed to it. Not having sufficient credit performance data for loans with credit scores below 620 subjected the models to errors in estimating credit risk for these borrowers and as a result posed higher losses for both GSEs. 

At the time these AUS models were deployed, the GSEs recognized the higher risk of borrowers with credit scores below 620 and so they implemented a set of overrides, essentially a safety net of sorts for the scorecard to limit the potential for bad loans to be deemed acceptable by the model. Consequently, the 620 minimum credit score became a mainstay among AUS overrides for decades.

Today, advancements in data and credit scoring have broadened credit access to a segment of borrowers that in the past have been turned away from the mortgage market.  Borrowers with limited or no credit history from which to develop a reliable credit score had few alternatives available to them. Both VantageScore and Fair Isaac have built new credit scores that leverage this information. 

Mining nontraditional credit sources such as rent and utility payments, among others, is a game-changer in terms of expanding credit access for so-called credit invisibles, however, great care must be taken by the GSEs to guard against potential blind spots in the models that aren’t used to assessing borrowers with subprime credit scores.

This concern is exacerbated by FHFA’s recent announcement allowing lenders to choose between VantageScore 4.0 and Classic FICO when submitting a loan to the GSEs. The GSEs integrate these scores and other credit information into their underwriting models and while Fannie and Freddie perform extensive diagnostic testing on these models before deploying them, eliminating the minimum credit score requirement at the same time new credit scores such as VantageScore 4.0 that incorporate nontraditional data sources are being used poses incremental credit risk to the GSEs. 

A more prudent approach would have been for the GSEs to maintain the minimum credit score requirements over some period where borrower credit performance could be observed and determined to be within the GSEs’ risk appetites. Ideally, credit scoring overrides are intended to stay in place until such time as sufficient performance exists to show that the underlying credit scorecard model can handle the risk currently screened out by the override. Only then could the minimum credit score requirement be relaxed. 

Expanding credit access to mortgage borrowers is absolutely an important objective for the GSEs, particularly at a time when many borrowers face enormous financial hurdles in buying a home. Still, FHFA and the GSEs must guard against the potential for significant credit losses from loans purchased with subprime-like credit. 

Both GSEs remain undercapitalized according to the Enterprise Regulatory Capital Framework by about a combined amount of $375 billion, signaling that should a major economic downturn in the mortgage market materialize at some point in the future, Freddie Mac and Fannie Mae could face significant headwinds against mounting credit losses in such a scenario. 

At a time when privatizing the GSEs in what might become the largest IPOs of all time are under consideration, the last thing investors need to worry about is the potential for a wave of unexpected credit losses from subprime-like borrowers.