A major debate underway in our nation’s capitol hinges on how federal regulators choose to define a “Qualified Residential Mortgage” (QRM). Opposing sides agree on one thing: this decision could fundamentally change America’s real estate industry. After researching a key component of the debate, FICO has found a significant flaw in the draft regulation.
If you haven’t been following this topic, here’s a quick recap. The Dodd-Frank Act calls for mortgage issuers to retain a small percentage of the risk in the home loans they securitize and sell to investors. This risk retention is likely to raise costs for banks, and consequently, for borrowers—because banks must hold more capital in reserve. Analysts at J.P. Morgan Securities have reportedly estimated that mortgage rates could rise by as much as three percentage points for loans that are subject to risk-retention.
However, the Act allows an exemption for high-quality loans that meet QRM standards. In other words, banks that securitize loans won’t need to retain any part of the risk of QRM-compliant loans. Congress left to regulators the work of defining what constitutes a QRM-compliant loan. So regulators from six Federal agencies recently proposed QRM standards as part of a larger risk retention rule and invited public comment by August 1.
We were surprised by the way the proposed QRM standards would determine repayment risk. Instead of using proven, reliable credit scores, the standards would require a manual review of derogatory factors in the borrower’s credit report. Lenders used that approach for decades, but it was so imprecise they were unable to offer risk-based pricing. Lenders quickly abandoned that approach in the ‘90s when the FICO® Score became available because the score assesses risk far more precisely and reliably.
Research by FICO has revealed that, under the regulators’ proposed QRM standards, any pool of QRM loans would contain a far greater level of credit risk than was intended by both the regulators and Congress. The proposed approach would:
- Lead to the inclusion of more high-risk borrowers in QRM loan portfolios. We found that the minimum FICO® Score of consumers who would meet the QRM delinquency standards was as low as 472. The FICO Score range is 300 to 850, with lower scores indicating higher risk. The median FICO score of US consumers is about 713.
- Lead to the exclusion of excellent credit risks. The maximum FICO® Score that would fail to meet the QRM delinquency standards was as high as 845.
In such an environment, some lenders could shift away from using objective credit scores as they invest risk management resources to meet the regulatory guidelines. They would return to the days and ways marked by personal bias in loan decisions, restoring an environment that once permitted discrimination.
Clearly, if the QRM is going to include credit history standards then credit scores need to be part of the final rule issued by regulators. A large body of research demonstrates that empirically derived credit scores are reliable, objective predictors of credit risk.
In order to get our economy back on track and ensure a properly functioning securitization market, credit risk must be determined by transparent, reliable and objective criteria. That’s why I believe that sound underwriting standards–including the government’s QRM standards–must include credit scores that are analytically derived and statistically sound, such as the FICO® Score. No debate should be necessary on that point.