Goldman’s FICO warning is a call to get smarter
In the world of fixed income, nothing catches the attention of investors as much as the idea of ”quality inflation.” After all, there are some widely accepted and easily understood scores from credit rating companies that still exert considerable influence in the global debt market, even though they are partly responsible for the financial crisis.
It’s no wonder, then, that this Bloomberg News article by Adam Tempkin drew many interested bond traders: “Inflated credit ratings leave investors in the dark about the real risks. In it, analysts from Goldman Sachs Group Inc. and Moody’s Analytics argue that the FICO credit ratings of Fair Isaac Corp. have been artificially inflated over the past decade and do not reflect the true ability of borrowers to pay what they owe in a downturn.
“Every credit model that relies solely on credit rating now – and there are a lot of them – maybe underestimates risk,” Goldman Sachs analyst Marty Young said in an interview. “There are a whole bunch of other variables, including the business cycle, that need to be taken into account.
The concern, according to Goldman and Moody’s, is that lenders have not adjusted their underwriting standards as average credit scores rose during one of the longest economic recoveries on record. So, as cracks begin to appear in the economy, a person whose credit rating has gone from 550 to 650 since the Great Recession may be paying their bills more like they did 10 years earlier.
“Borrowers’ scores may have gone up, but their individual risk, attitude towards credit, and ability to pay bills have remained the same. “
This states the obvious and does not suggest any sort of grim inflation. The US economic recovery that began 10 years ago has pushed the unemployment rate to its lowest level in half a century. Average hourly earnings are increasing at the fastest rate since the end of the recession. It follows that a number of Americans who were previously unemployed are now earning a stable income and have higher credit scores. This in turn gives them better access to credit.
So what is the problem? Cris deRitis, deputy chief economist at Moody’s, said he was concerned about “smaller, less sophisticated businesses lending to people with bad credit histories.” He added that “auto loans, retail credit cards and personal loans made online are the most vulnerable to inflated scores.” Tempkin notes that there is about $ 400 billion of this type of debt outstanding, a quarter of which is pooled in securities that investors now hold.
I realize that businesses that cater to the weakest borrowers can perform a vital function. Some subprime borrowers just need a lifeline to get their finances in order. JPMorgan Chase & Co. CEO Jamie Dimon even said in congressional testimony this week that when it comes to mortgages, easing the constraints on lending to people with low incomes or in default. alone could boost US economic growth by 0.2%.
Still, forgive me for not shedding a tear for companies that don’t look past FICO scores, or for investors who grabbed hold of high yield asset backed securities.
In February, I looked at subprime auto loans and concluded that they were far from a systemic risk, even though more than 7 million Americans were at least three months behind on their car payments. , most ever. Most at risk lenders include names like Global Lending Services, GO Financial, and Skopos Financial. As I said at the time, “If the worst-case scenario is that some private funds are supporting new entrants into the auto loan business and investors looking for a yield get burnt, that doesn’t sound so bad.
The hand twist on FICO scores is pretty much the same. Goldman attributes the growing number of delinquent auto loans to the general increase in credit scores. But again, it comes down to who makes the loan. Big banks certainly use more than FICO scores to determine who they choose to underwrite and on what terms. There’s a reason for this, and it probably has to do precisely with scores that look rosy during good economic times.
It’s not even as if FICO claims to be a perfect reflection of a borrower’s creditworthiness. Extract from Tempkin’s play:
“The relationship between the FICO score and delinquency levels can and does change over time,” said Ethan Dornhelm, vice president of scores and predictive analytics at FICO. “We recognize that there is a lot more context you can get beyond a consumer’s credit report. We don’t think score inflation is the problem, but the overlay of risk on underwriting factors outside of credit scores, such as DTI, loan terms, and even trends in macroeconomic cycles, for example. . “
It is not difficult to find ways to alleviate concerns about high FICO scores. Lenders may require a wider range of information before extending credit, or they may simply increase their FICO thresholds to account for the extended business cycle. The same goes for investors in asset-backed securities. They could easily be more selective in what they buy. But with the Federal Reserve no longer raising interest rates and yielding returns in style, that doesn’t seem likely. If the loan packages go awry, they will have no one to blame but themselves.
It’s tempting to look for signs of stress now that the US economy is on the brink of the longest expansion in history. And it is true that private label credit cards and online loans are seeing an increase in missed payments. But just as the inverted yield curve has served as a reminder that all business cycles must end (though not necessarily imminently), these overdue payments are simply a call to lenders and investors to get smarter.