17 June 2007

Is 740 the new 520?

Recently, sub-prime mortgage lending has made the news amid fears that there may be as many as 2.2 million new forclosures in the US in the coming year. In the Boston Globe a while back, Thomas Callahan summarize:

"NOW THAT everyone is paying attention, let's review how we got here: Subprime loans became the mortgage flavor of the day several years ago. The worst kind of lenders preyed on the universal yearning for the American Dream -- homeownership -- and too often targeted African-Americans and Latinos with alluring, affordable, and ultimately deceptive sales pitches.

. . .

These are not just run-of-the-mill high cost loans. Subprime lenders keep coming up with new products and new gimmicks. That is why there has been a proliferation of 'stated income' loans and interest-only loans. These products have been around awhile but they had a limited use until brokers and mortgage companies started selling them to average consumers who didn't have a realistic chance of paying the mortgage."

In a way, sub-prime lending in the mortgage market is a bit like...like what? Let's construct a shady example that unfortunately, I've been told happens more often than it should.

A mortgage broker woos potential borrowers with wonderful terms and immediately flips the loan after closing it. OK, perhaps the broker over-sold to an under-qualified borrower but that's not their problem any longer. Nor is it their problem really when they out and out misrepresent a potential borrower. The result is a lender that now has an at greater risk borrower that it would have accepted otherwise. What to do? Flip the loan. This cycle can continue, based on other criteria as well, until the loan is paid-off or the borrower defaults. Musical chairs or hot potato with a large loan.

Excluding the boring case where the borrower pays the loan off in-full, without incident, the end result is a loan in default because a borrower was misrepresented to a lender. Most people still need to borrow in order to finance large purchases, such as houses. Sub-prime mortgage lending will continue to persist in some manner because of this; people need houses. Less than ideal borrowers will need to, in some way, boost their all-important credit scores since, no matter what anyone says, you are just a score.

There are positive financial incentives to every party involved except the unfortunate lender holding the note when the risk-deflated borrower defaults. Not knowing when or if that event will occur is the risk. If there was no risk involved, there would be no sub-prime lending markets; all borrowers would be identical. Since this is not the case, borrowers need to be differentiated in some manner and this will continue to be the credit score, for better or for worse.

The potential problem at hand then is the renormalization of misrepresented credit scores and how that could affect better borrowers and risk-adverse lenders. Borrowers that previously would not qualify for certain lending options would have their scores inflated in order to qualify. Typical borrowers would remain the same or possibly be a bit inflated as well. In other words, the typical ranges of credit scores would begin to contract while the upper bound would remain the same.

520 would be scaled to 720.

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