Credit scores have been skyrocketing recently. Is this a good thing? Have 15 million consumer’s credit habits changed drastically in the last 10 years? What are the risks from “grade inflation” of credit scores? Why are scores rising so rapidly? How does this impact borrowers, lenders, and the general economy?
How much have scores changed?
According to Moody’s, there are around 15 million more consumers with credit scores above 740 today than there were in 2006, and about 15 million fewer consumers with scores below 660. I doubt 15 million consumers “credit habits” have changed. Consumer credit cores have been artificially inflated over the past decade since the last recession. This inflation is coming from general improvement in economic conditions along with fundamental changes in credit scoring.
Why did scores increase? There have been fundamental changes in the score calculation. The three major credit bureaus dropped certain items from the credit reports that have impacted a number of borrowers. According to Equifax, tax liens and judgments will likely be dropped since in order for them to show on your credit report after July they must contain four items (name, address, social, and date of birth). Most liens and judgments do not contain all this information so these “black marks” will be eliminated from most borrowers.
Why is this important? Many borrowers saw their credit scores increased substantially without this information. This should theoretically help millions of borrowers get better terms on various financing products (mortgages, credit cards, car loans, etc…)
Changes in Scores- Grade inflation: The objective of a credit score is to measure the “riskiness” of a borrower and their ability to repay a debt. As scores have trended up due to the economy improving and changes to the scoring model, underwriting has not kept up. For example ,to get a good auto loan you would need a 650 mid score, with all the “grade inflation” that score for some borrowers is more like a 550. “Borrowers’ scores may have migrated up, but inherently their individual risk, and their attitude towards credit and ability to pay their bills, has stayed the same.” Moody’s said. “You might have thought 700 was a good score, but now it’s just average.”
Economics is frequently a zero-sum game: the downside
The concern that’s come up, Goldman and Moody’s say, is that lenders haven’t adjusted their underwriting standards as average credit scores have risen during one of the longest economic recoveries on record. So as cracks start to appear in the economy, someone whose credit score rose to 650 from 550 since the Great Recession will likely pay their bills more like they did 10 years earlier.
Risk not priced in
“The relationship between FICO score and delinquency levels can and does shift over time,” said Ethan Dornhelm, vice president of scores and predictive analytics at FICO. Lenders have not factored in the shifts taking place. When pools of consumer debt are sold from credit cards to auto loans, these securities are rated for risk on the Fico or Vantage score. With the huge appetite for higher yielding assets, as the 10-year treasury yield has remained so low, investors have continued gobbling up consumer credit. This demand for higher yielding debt has allowed pricing for various portfolios to remain high even as the risk has increased exponentially.
A pool bought today with an average credit score of 625, is like a pool 10 years ago that had an average score of 525. The pool today is not being priced as a “deep subprime” pool, it is being priced as a relatively safe pool. When the economy turns, this pool that investors through was relatively safe as the average score was 625 will behave like a deep subprime pool with much higher default rates and losses to the portfolio owner.
Who is most at risk?
The highest risk loans rely heavily (or exclusively) on credit score for their underwriting. This includes auto loans, consumer loans, retail credit cards, etc… As the hunt for yield has intensified, many lenders have lowered standards to increase volumes. With scores today inflated, the performance of bonds backed by this debt will be at risk. This kind of debt totals around $400 billion, with nearly $100 billion bundled into securities that’s been sold to investors, data compiled by Bloomberg show.
Implication to the economy
The “grade inflation” will eventually filter through the economy. Like the mortgage crisis in the last recession, buyers of consumer debt do not fully grasp the riskiness of the assets they are buying as credit scores are underestimating the true downside. When economic conditions change the various pools that have been bought and sold will not perform as anticipated and the holders of the notes will face substantially higher losses than anticipated. As losses pile up, two major changes will occur almost simultaneously. First, credit issuers will pull back on lending by adjusting their models to compensate for the newly discovered risk. Second, pricing for consumer debt will decrease substantially as models are updated for the new default rates. These two changes will further decrease economic activity as access to auto loans, credit cards, etc.. is drastically curtailed.
At the end of the day, when the economy turns someone will be “holding the bag”. Unfortunately, it will not be a bag of money, but one holding something considerably less pleasant. Losses will begin piling up due to “grade inflation”. The only mystery will be is who will be holding the bag with all the losses when the music stops.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).