As we start to examine the impact of the COVID-19 pandemic, the mortgage industry faces a new challenge: American consumers are experiencing significant economic stress.
Consumer prices are rising at their fastest rate in 40 years, with the inflation rate at 9.1% in June, 2022, the highest rate since President Ronald Reagan’s first year in office; the war in Ukraine has put pressure on energy and food prices and that pressure threatens to continue for the foreseeable future; COVID restrictions in China are having a negative impact on supply chains; and, in response to inflation, the Federal Reserve is raising interest rates, driving mortgage rates up and mortgage applications down to the lowest level in 22 years.
Many analysts and business leaders are predicting a recession, and some are predicting even worse: stagflation, or a combination of high inflation and unemployment at the same time.
What does this mean for consumers? They are cutting back on spending: 71% reducing their spending on restaurants and takeout meals; 49% buying less at the grocery store; and 38% delaying major purchases. In addition, homeowners are beginning to struggle to pay their mortgages, with foreclosure filings increasing by 153% in the first six months of 2022 compared to the same period last year.
In the face of economic stress, the mortgage industry needs, more than ever, tools that will help the industry reach borrowers before economic stress becomes a real problem.
FICO has developed one such tool: the FICO® Resilience Index, or FRI. FRI allows mortgage servicers to look over the horizon instead of waiting for a borrower to default or call for help. Before FRI, it was difficult for servicers to determine if or when borrowers were going to default and, based on limited information, to plan ahead. Unless a borrower called for help, a servicer would not know whether the borrower was at risk of imminent default. Servicers did not have the ability to plan ahead for staffing needs and to target their early intervention efforts on the most vulnerable borrowers. Once contact was made, it became complicated to assess a borrower’s options based on underlying conditions that may not be readily disclosed.
FRI is designed – as its name suggests – to estimate how well a borrower will respond to a financial “shock.” A borrower’s FICO® Score predicts a borrower’s likelihood of default based on the borrower’s past credit performance, e.g., how well the borrower did at paying bills in the past. FRI, on the other hand, identifies the incremental risk a consumer will default due to economic stress. The stress may be macroeconomic: inflation and recession. Or it may be caused by more localized or individual circumstances.
FRI is designed to be used with a borrower’s FICO Score. It reveals significant differences between borrowers with the same FICO Score as well as interesting similarities between borrowers with different FICO Scores. For example, a very resilient borrower with a 680 FICO Score may be significantly less likely to default in the event of a recession than another borrower with the same FICO Score but who is much less resilient. In addition, a borrower with a 640 FICO Score but very high resilience may be less likely to default if his or her financial situation changes than a borrower with a 680 FICO Score but very low resilience.
Borrower resilience tends to be associated with how a borrower uses credit. Highly resilient borrowers tend to have fewer active credit accounts, lower total loan balances, more experience managing credit and fewer recently opened trade lines.
With FRI, a mortgage servicer can take several pro-active steps to manage default risk. The most obvious one is early intervention. Within investor guidelines, servicers have a choice: call the day after a missed payment or wait until the borrower has had a reasonable chance to cure. For resilient borrowers, even if they have lower FICO Scores, waiting might make sense. It spares precious resources for borrowers who really need help. But for low resilience borrowers, regardless of their FICO Scores, there is a compelling business case for calling sooner rather than later. An early intervention may head off a delinquency or it may facilitate a modification in response to a risk of imminent default.
A servicer might also use FRI values (together with corresponding FICO Scores) to manage their staffing. A servicer with a large population of highly resilient borrowers will need less staff than a servicer with less resilient ones. Moreover, a servicer that anticipates a macroeconomic contraction can calibrate its staffing plans more precisely based on the resilience of its borrowers.
Finally, an FRI score can help a servicer determine how well a borrower is likely to perform with a loan modification. A resilient borrower will likely be able to afford modified payments since their resilience score indicates that their household debt, overall, is manageable for them; a less resilient borrower, on the other hand, is likely to have a harder time making mortgage payments, even after they have been modified, because their FRI score indicates that, even after a modification, they are bearing a bigger debt load.
The introduction of the FICO Resilience Index is timely. It can help the mortgage industry and American consumers weather the choppy seas that lie ahead.