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 10T 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 10T 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 10T 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 10T, 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 10T. The bottom line is that whether you use FICO Score 10T 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 10T Migration Guide by clicking here.
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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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