Why Credit Scores are Crucial to Healthy Securities

The value of asset-backed security is determined by the cash flows generated by the underlying assets and understanding the predictability of those cash flows

What you will learn:

  • What can increase the value and liquidity of securities
  • How FICO Score 10 T can help you better model cash flows and analyze securities

Today there is approximately $8.5 trillion in U.S. mortgage-backed securities (MBS) being held or traded by institutions and investors, a staggering sum that dwarfs the GDP of every other nation except the U.S. and China. Given the hefty financial footprint of these and other securitized assets, a quick review of securitization in general is worth a review before we delve into more details.

Securitization generally refers to the process of converting a pool or group of assets into tradable securities, thus offering increased liquidity. Securitization is initiated when a financial institution pools together a group of assets. These assets can include loans, leases, and receivables—from aircraft leases to solar projects, but most frequently are commercial or residential mortgages (e.g., mortgage-backed securities), auto loans, and credit card balances. Asset-backed securities are initiated when a financial institution creates securities collateralized or backed by the cash flows generated from the underlying group of assets in the securitized pool. These asset-backed securities are then sold to investors.

The value of the security is largely dependent on these cash flows. The more predictable and stable a cash flow from a given security is, the higher price it will likely attract from investors. Valuation is a critical part of securitization. Determining cash flow that one can expect from a given security involves analyses of several factors that can prove tricky, and complicated. This generally involves evaluation of the “face value” of a security.

The face value of a security generating cash flow can be impacted by a charge-off, which is when a borrower defaults, or by a pre-pay when a borrower pays off debt. In both these cases, cash flow to the holder of the security ends. To navigate this sticky wicket and properly value securitized assets with more certainty and greater predictability, lenders and investors often look to the underlying FICO® Scores, which are utilized in more than 90 percent of public asset-backed securities issued in the U.S. Cash flows are derived from the interest and the principal payments made by the borrowers on the loans. The cash flows are passed through to the investors.

The borrower’s credit score is one of the most critical factors in the valuation of securitizations. As the credit score used by more than 90% of top lenders in the U.S., lenders trust the FICO® Score to help assess the credit health of borrowers and predict the portfolio-level likelihood of default, which directly dovetails with the charge-off curves used to do cash flow modeling. A higher FICO Score indicates a lower likelihood of default and a more predictable balance sheet for lenders.

The FICO® Score is therefore widely used to determine the risk associated with the underlying asset and the potential losses that could occur due to default with asset-backed securities. Without the underlying assurance of a highly predictive FICO Score, investing in securitized assets would be akin to valuing a diamond with the naked eye alone without the benefit of a jeweler’s loupe; securitized assets would prove a much more risky investment, and also much more expensive.

In securitizations, the FICO® Score is also widely used to determine credit enhancements that may be required to make the securities attractive to investors. Credit enhancements provide additional collateral or guarantees to reduce the risk of default and therefore increase the credit rating of the securities. Required credit enhancement depends on the credit scores of the borrowers and the level of risks associated with the underlying assets.

FICO® Score 10 T is the most predictive FICO® Score in the industry. This new FICO Score version is the same FICO® Score version that Federal Housing Finance Agency previously announced was validated and approved for use by Fannie Mae and Freddie Mac (Enterprises), and will be required to be used when available, as FICO is today, for each conforming mortgage delivered to the Enterprises.  A more predictive score means more predictable cash flows which are, in turn, more attractive to investors for all types securitized assets (e.g., mortgages, auto loans, credit cards, etc.). FICO Score 10 T delivers increased predictive power while preserving the trusted and proven FICO Score minimum scoring criteria, while utilizing a consistent odds-to-score relationship as the prior FICO Score version used by the Enterprises, offering continuity and stability for lenders, investors, and consumers.  Every lender and investor should optimize smooth and reliable cash flows to increase the value of their securitizations.

To recap, the valuation of securitizations involves a number of factors including cash flows, charge-offs, pre-pays, and credit scores. The FICO® Score is a critical part of the valuation process and is used to assess the risk associated with the underlying assets. Understanding these factors remain critically important for investors who are considering securitized products, as they can have a significant impact on the returns generated and the risks involved.  

The key thing to keep in mind with securitizations is that a more predictive score can lead to a better valuation of MBS or other securities. That is why it is important to upgrade to FICO® Score 10 T, the latest and most powerful FICO® Score available. If you are an investor in securities that include mortgage loans provided to the Enterprises, or simply desire a more predictive score to drive value to your portfolio, you can benefit from the new FICO Score 10 T. The bottom line is that whether you use FICO Score 10 T or another FICO Score version to evaluate ABS, MBS, or other securities, you should be confident that you are using the credit score trusted by lenders and investors across the industry as the reliable, predictive and independent credit scoring standard. As an investor, there is no substitute, you should continue to rely on the FICO® Score as your standard for evaluating consumer risk in the secondary market.

To learn more, download the FICO Score 10 T Migration Guide by clicking here.  

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