Critical Ingredient to Identify Healthy Mortgage-Backed Securities
FICO® Scores: A critical element in cash flow analysis for proper valuation.
What you will learn:
- How liquidity is created in the secondary market
- How the FICO® Score can help investors better model cash flows
- Next steps for increasing value and liquidity
Though the origination of a mortgage may not be the most exciting event to some, to a renter buying a first house or a family finding their dream home, a new mortgage can be as thrilling as life comes. Origination is just the initial phase of the long and complex mortgage lifecycle, which begins with a lender qualifying a borrower and then providing the funds used to purchase a new property or refinance an existing property. The lender then holds the mortgage on its balance sheet or sells the mortgage on the secondary market to investors.
The secondary market plays a critical role in making capital available to lenders, so they have the funds to continue to offer borrowers competitively priced mortgages. In this blog, I will explore how the secondary market values mortgage loans, the importance of FICO®Scores in that valuation, and how essential it is to have consistent and universal credit standards to accurately compare loans across time and lenders.
Role of Secondary Market
After their origination by lenders, mortgages are bought on the vast secondary market by investors ranging from banks to insurance companies, to hedge funds. One key part of the secondary market involves the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac buy and guarantee mortgage loans that conform to their lending standards and advance their mission to make housing more affordable, creating a powerful market incentive for lenders to issue loans that meet these high standards.
Investors, such as Fannie Mae and Freddie Mac purchase mortgages in bulk and then bundle them together to create mortgage-backed securities (MBS) (a single lender can also issue its own MBS). Just as the quality of any item – a cup of coffee, a precision time piece, a grand piano - depends upon the quality of its materials or ingredients, the value of the MBS depends on attributes of its underlying mortgages. Some indicators of value are empirical in nature, such as loan-to-value ratio, debt-to-income ratio, and the unpaid principal balance, and each of these attributes has a unique charge-off and pre-payment curve associated with it that adjusts when these attributes are combined. But no MBS can be properly valued without an underlying FICO® Score, the key piece of information that informs investors whether they are making a sound investment or simply rolling the dice.
Importance of FICO Score
It should come as no surprise that investors in MBS first and foremost want to minimize the risk of losing some or all of their investment. Mortgages with higher FICO® Scores tend to be more valuable to investors since they represent lower risk and more predictable charge-offs, yielding more stable cash flows. Often lower FICO Scores mean lower pre-payment risk, yet higher risk of default, with a higher likelihood of leading to a charge-off. This is a stable cash flow model is so important in valuing mortgages on the secondary market.
Mortgage lenders adhere to credit guidelines and standards to ensure that the loans they originate meet the “buy-box” of potential investors of MBS in the secondary market. These credit guidelines and standards are used to evaluate a borrower’s risk level and ability to repay the loan. A uniform credit standard, which includes the FICO® Score, ensures that the loans lenders originate and ultimately securitize are universally comparable across time and with other lenders, helping drive market liquidity.
A universal standard credit evaluation process used across time and lenders allows investors to know they are comparing apples to apples, which is critical for the functioning of the secondary market. The FICO® Score allows investors to evaluate risk associated with loans they purchase as part of the MBS, and it provides a common framework for evaluating the quality of the underlying loans in the security. In short, the more predictive and reliable the credit score as a standard of creditworthiness is over time, the easier it is for investors to have faith that their investments will produce the anticipated cashflows. This, in turn, increases the overall value of the MBS as an investment instrument.
Remember, there are risks associated with the sale of mortgage loans in MBS on the secondary market. One is repurchase risk-- the risk a lender may be required to buy back a loan from an investor due to breaches in the loan's representations and warranties (Rep and Warrant). This can occur when the borrower defaults or when there are issues with the loan documentation or attributes used to document the loan.
Rep and Warrant exposure refers to the potential losses a lender may incur if they are required to repurchase loans due to breaches of these Rep and Warrants. All of this leads to the necessity of using the most predictive credit score possible to help project investor cash flows. That credit score continues to be the FICO® Score. With the latest score version, FICO® Score 10T being the most predictive FICO® Score on the market, projecting an incremental 5% approval rate over scores most commonly used in the market today.
Remember, a more predictive score could equate to a better valuation of MBS. For on-GSE loans in the marketplace, lenders, investors, rating agencies, and others should all start to consider how to upgrade the value chain to create more valuable securities with FICO® Score 10T.
To learn more about FICO Score 10T, visit the FICO mortgage migration center.
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FICO® Score High Achievers: Is Age the Only Factor?
<p>FICO’s latest research on <a href="http://www.fico.com/en/blogs/risk-compliance/us-credit-quality-rising-the-beat-goes-on/" target="_blank">national FICO® Score distribution</a> shows that US credit quality continues to trend upwards, with an increasing number of consumers scoring in the highest scores ranges. Given that, we decided it was time to refresh our study on “<a href="http://www.fico.com/en/blogs/risk-compliance/infographic-what-does-a-high-credit-scorer-look-like/" target="_blank">FICO® Score high achievers</a>,” where we examine the credit behavioural profiles of consumers with higher credit scores.</p> <p>As expected, our latest study showed that older people generally have higher scores, as has been the case in our <a href="http://www.fico.com/en/blogs/risk-compliance/age-before-beauty-credit-worthiness-before-youth/" target="_blank">past research</a>. This is largely because they have trade lines that have been open longer, which leads to higher scores (assuming the trade lines are in good standing and all other things equal). The most credit savvy among you will remember that length of credit history accounts for roughly 15% of the overall <a href="http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx" target="_blank">FICO® Score calculation</a>.</p> <p>But for younger consumers, it isn’t too helpful to say, “just wait until you are 50 years old, and that will fix things!” Thus, I decided to dive deeper with our analysis, including looking at the credit behavioural characteristics of younger consumers with high FICO® Scores.</p> <p>In this analysis, I looked at credit characteristics for the two highest score bands, 750-799 and 800-850, which have about 16% and 23% of the population, respectively. I further broke this down by looking at the characteristics of the youngest 15% in each group, which occurs at age 29 for the 750-799 group and 43 for the 800-850. We used FICO<strong>®</strong> Score 9 for our analysis, and examined typical variables of the categories that go into the make-up of the score.</p> <p><a href="http://www.fico.com/en/blogs/wp-content/uploads/2016/10/FICO-Score-High-Achiever-table.png"><img class="alignnone size-full wp-image-29367" src="http://www.fico.com/en/blogs/wp-content/uploads/2016/10/FICO-Score-High-Achiever-table.png" alt="fico-score-high-achiever-table" width="715" height="747" /></a></p> <p>Since there’s a lot to dissect in this chart, I’ll highlight a few findings that struck me: <ul> <li><strong>Credit history.</strong> Higher scores are undoubtedly associated with a longer time on file. What’s striking is the higher average time on file for the 800+ group, both overall and for revolving accounts (the most common trade line). Clearly, it helps to start credit use early in life – but that’s not the sole determining factor for high scoring. The younger cohorts in both the 800+ and 750-799 groups have time on file medians significantly less than their older counterparts.</li> <li><strong>New credit.</strong> High credit scorers do, in fact, pursue new credit. We see little variation in months since last trade line opening and last inquiry among all groups observed.</li> <li><strong>Pay on time.</strong> As you might expect, the further in the past the delinquency, the higher the score – and that’s <u>if</u> a delinquency ever happened. 95% of the 800+ people and 72% of the 750-799 group have never been delinquent, which is a striking contrast to the 57% for the total population. The percentages for the younger groups are even higher, especially so for the 750-799ers. Collection items are also scarce for these high scorers. While 23% of the national population have collection items greater than $99, the figures are only 0.5% for the 800+ group and 3% for the 750-799 group. It is clear that, in conjunction with starting a credit file early, paying on time is a key trait of the FICO® Score high achiever.</li> <li><strong>Balance and utilization.</strong> Finally, we look at how credit is being used, focusing on revolving product use. (Since most people only have one mortgage or one auto loan, variation in instalment product figures is minimal and driven by payment history, which is near perfect for high scorers, as we’ve seen.) FICO® Score high achievers tend to have more open revolving accounts. While the % active trades and utilization are generally lower, by no means do high scorers avoid the use of credit products. What drives the difference here is the amount of <u>available</u> revolving credit utilized. The 800+ group is roughly 1/4 of the national median, both in total and on their highest utilized card; they also have lower balances and more cards<em>. </em>The 750-799 group is more active and higher utilized, but still only at 2/3 of the national figures. The young 750-799 group compensate with lower revolving balances and, as a result, lower utilization, which is in line with what we see for the 800+ group.</li> <li><strong>Benchmarks.</strong> I’d like to point out that while this study provides good benchmarks of the typical credit traits of the FICO® Score high achiever, individual credit profiles will vary widely. And keep in mind that when we sort groups of consumers as a whole by different behaviours, some results may look superficially odd. For example, the 800+ band has a longer median average open account time (128 months) than average revolving months on file (140 months).</li> </ul> So, what do we conclude? A huge takeaway is that high scorers don’t have too much in the way of serious delinquencies and negative public record data.</p> <p>In most respects, the young 800+ people are like their peer group. They really only differ markedly in their shorter credit history and higher non-mortgage balance, both of which are a function of life stage. Our results show that you don’t have to be a credit product hermit; these high scorers have more credit cards. The takeaway is to start credit activity early and maintain well-managed and moderate usage.</p> <p>In many ways, the young 750-799 people are more interesting because their age profile is much younger. Their credit characteristics differ more from their peer group, particularly in terms of length of credit history. They compensate by having almost pristine credit records and lower balances.</p> <p>Ultimately, 39% of US consumers are FICO® Score high achievers, which they accomplish by following common-sense credit practices. It ain’t rocket science!</p>
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