FICO® Scores are designed to rank-order the expected future payment performance of consumers’ credit obligations based on their
credit bureau characteristics, irrespective of the economic environment. Investors may calibrate FICO Scores based on their own loan portfolios’ recent performance to predict the odds of satisfactory payment performance.
However, disruptions to the economic environment put stress on consumers that can change these repayment odds in a way that
differs from an investor’s calibrated estimates, leading to discrepancies between predicted and actual future default odds, and
ultimately to sub-optimal investment decisions. Such disruptions reveal “latent risks” within portfolios that only manifest during periods
of economic stress.
A formidable challenge for credit risk management is that disruptions can be extremely difficult if not impossible to anticipate, as the
COVID-19 pandemic again demonstrates.
Two practical questions about latent risk measurement and management then naturally arise:
- How can I identify economically resilient consumers from readily available credit bureau data?
- How should I factor knowledge of consumers’ economic resilience into my portfolio management decisions?
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