Credit risk, credit scoring, and the performance of home mortgages - includes related information

Federal Reserve Bulletin, July, 1996 by Robert B. Avery, Raphael W. Bostic, Paul S. Calem, Glenn B. Canner

Secondary-market institutions also use application scores. Freddie Mac and Fannie Mae, for instance, have developed application scoring systems that indicate to the lender whether a prospective loan is clearly eligible for sale to these institutions or whether the lender will need to show that compensating factors exist that make the loan an acceptable credit risk.(20)

Private mortgage insurance companies use application scoring systems to quickly identify those prospective loans that clearly meet the underwriting standards of the insurer. Loan applications that fail the automated screen are reviewed by an underwriter to determine whether compensating factors are present that would make the loan insurable. Mortgage Guarantee Insurance Corporation (MGIC), for example, reports that about 30 percent of the applications they receive for mortgage insurance are approved through their automated application system; the remaining applications are referred to underwriters for closer review.(21)

Most credit history and application scoring systems are proprietary, and the specific factors used and the risk weights assigned to these factors in establishing scores are not generally available to the public. As a consequence, scoring systems have a "black box" aspect to them. Nonetheless, most scoring systems share a number of elements. For example, most credit history scoring systems consider records of bankruptcy, current and historic ninety-day delinquencies, and the number of credit lines. Most mortgage application scoring systems additionally consider factors such as the loan-to-value ratio, the ratio of debt payment to income, and measures of employment stability. However, the risk weights assigned to these factors vary from system to system.

Other Uses of Credit Scoring

Credit history scores and application scores have uses other than in the loan underwriting process. To monitor the quality of their portfolio and to determine the appropriate level of reserves to set aside for losses, lenders may periodically obtain credit scores for borrowers with outstanding loans. Similarly, institutions can use credit scores to evaluate the quality and value of mortgages they are considering for sale. For example, credit scores can help identify the credit risk of seasoned loans and help determine the appropriate grade (risk) pool into which individual loans should be placed for sale to the secondary market.

Lenders may use credit scores to differentiate risk categories of loans for pricing decisions. Rather than reject higher-risk loans for origination or purchase, the lender may decide to price the risk by requiring an interest rate premium on those loans with higher predicted probabilities of default. The use of credit scores can also help with the collection and loss mitigation process by, for example, allowing lenders to concentrate staff resources on borrowers whose credit scores indicate greater risk of delinquency.

Finally, lenders can use credit scores to facilitate strategic planning decisions. For instance, lenders concerned about possible attrition in their loan portfolio due to competition for refinancings may offer a new loan to those current borrowers whose credit scores indicate that they would be most attractive to potential competitors.