A Brief History of FICO: How Traditional Credit Metrics Fail Prime Borrowers

Most lenders today rely almost exclusively on consumer credit scores, predominately FICO, to determine a borrower's credit risk.  The reason for this is not because FICO scores are a particularly good predictor of credit risk, but rather because the mortgage market irrationally subscribes to FICO.  This irrational behavior has its roots with the usual suspects: Fannie Mae and Freddie Mac.  Through Fannie and Freddie, the US Treasury will only guarantee "conforming loans".  The definition of "conforming" is where the over-reliance on FICO originates: only mortgages originated to borrowers with FICO scores of at least 620, and usually 640, qualify as conforming loans.  This bright line delineates the traditional "prime" and "sub-prime" segments of the consumer loan market.  This artificial credit delineation can cause massive disruptions in the mortgage market (as it did in 2008).  However, Fannie and Freddie's religious adherence to FICO make it impossible to overcome: 50% of the mortgage market or 45% of the entire consumer loan market are conforming loans.   


Over-reliance on FICO scores disproportionately affects Prime student loan borrowers.  The exact formula for calculating FICO scores is secret, but the credit bureaus publish rough guidelines:

• 35% Payment history: positive for successful payment history, negative for delinquencies
• 30% Credit utilization: ratio of revolving debt to available credit
• 15% Length of credit history: longer credit history is unconditionally positive
• 10% Types of credit used (student loans, credit cards, mortgages, auto loans, etc.): more types of credit are unconditionally positive 
• 10% Recent searches for credit

It should be readily apparent that a Prime borrower - a recent college graduate who is gainfully employed - would be universally hurt by 90% of these scoring criteria (bolded).  A recent graduate has no payment history outside of minor credit card debt - a negative value for 50% of the scoring rubric.  A recent graduate will likely have a low credit limit because, incestuously, credit limits are determined by FICO score! So, a recent college graduate making $250,000 a year will likely have a lower credit card limit than a 60 year old on social security.  Additionally, post-Financial Crisis credit limits have contracted substantially, so the average Prime borrower today has a much lower credit limit than what has been the historical average.  As a result, today's Prime borrower has a much higher "credit utilization" ratio than the historical average, a negative for 30% of the FICO score.  Notably, this metric doesn't take into account more traditional ratios, such as total income to revolving debt, but focuses exclusively on liquidity.  So our Prime borrower with $250,000 in annual income and $1,000 in credit card debt with a limit of $2,000 (the average) would be heavily penalized for a high utilization rate despite an income to debt ratio of 250:1.  Finally, a Prime borrower likely only has two types of loans: student loans and credit cards.  Very few students have mortgages (why would they?) and very few have auto loans.  As a result, Prime borrowers are penalized for lack of diversity in their credit portfolio - 10% of FICO.  

These negatives are beginning to stack up, but what's the overall affect?  Let's look at the numbers: below is a chart showing FICO score as a function of age (source: Credit Karma).

 

This figure should be very alarming to any unsecured lender heavily relying on FICO scores: the correlation between FICO and age is extremely strong.  Prime borrowers, who would fall in the 25-34 bucket, have an average score of 649.  The average for a borrower of 55+ is 691.  This differential is completely unjustifiable and flies in the face of income data.  Below is a chart of the average household income by age.  We note that the average for the 25-34 group is $51,000 while the average for the 55-64 group is $56,000.  That is a small income differential for a very large FICO differential. Additionally, we draw attention to the fact that the "spread" between age groups has tightened considerably since the Financial Crisis - a trend that has not been extrapolated to the FICO distribution.  All of this should give us serious doubts about the viability of FICO in determining a recent graduate's credit risk, yet student lenders continue to limit a borrower's access to credit unless they have a FICO of at least 700. 

Byline:
Derek Kaknes

The Best of Times, The Worst of Times: How Student Loans Changed After the Financial Crisis

Charles Dickens famously began his 19th century novel A Tale of Two Cities: "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity."  Dickens was, of course, referring to the contrasting developments in London and Paris at the turn of the 19th century - a time of both exuberant optimism and explosive turmoil.  One could very easily extend this description to the world of student loans at the onset of the Financial Crisis in late 2008.  The Financial Crisis affected broad swaths of our economy, but it had a particularly acute effect on financial services.  Industries from mortgages to credit cards to student loans changed overnight, and though many have recovered, it would be a mistake to extrapolate pre-crisis assumptions into the post-crisis world.  In this post, we examine one such assumption that is being inappropriately relied upon in the student loan market.

The student loan market, and the broader consumer credit markets in general, changed historically on September 15, 2008 - the day Lehman Brothers filed for bankruptcy.  Investors across the globe awoke to the realization that their investments held tremendously more risk than they had ever previously anticipated.  As a result, lenders began to restrict credit and increase interest rates in order to more accurately capture the default risk in their portfolios.  In the private student loan market, this had a particularly dramatic effect: the average interest rate on a student loan jumped from 5.5% in June 2008 to 12.5% by December 2008.  For a student, that meant that the spread on their second semester loan had widened by 700bps from the loan they used to fund their first semester.  As the chart below demonstrates, interest rates have receded mildly from their 2009 highs, but they have stabilized to a still elevated rate of 9.5%.  Increasing interest rates is an effective way to offset increasing default risk, however it does not address prepayment risk, and, in fact, greatly exacerbates prepayment risk.

The significant increase in interest rates has a profound effect on the prepayment risk in student loans: increasing interest rates increases the pressure in the adverse selection cycle.  Today, "Prime" borrowers are able to access private student loan refinancing opportunities for rates of ~5.0% through companies such as Prime Student Loan.  So, if a Prime borrower took out a loan before September 2008, then their interest rate was probably near 5.5% and there would be very little incentive to refinance.  However, if a Prime borrower took out a loan after September 2008, then their interest rate is probably near 9.5% and there is a significant incentive to refinance to the lower rate.  Thus, there is a much greater likelihood that borrowers will refinance these post-crisis loans; and, as a result, we are just entering into the heart of a new prepayment epoch in student loans.

Thus far, we have laid out several reasons why the voluntary prepayment rate in private student loans is set to increase dramatically.  We showed that the evolution of a student's credit quality mitigates the two greatest default risks within six months of graduation, producing a large amount of Prime borrowers.  In this post we outlined how post-crisis interest rates have created the demand for Prime borrowers to voluntarily refinance their loans - a demand that did not exist pre-crisis.  In the next posts, we will discuss some of the remaining hurdles to the onset of this prepayment avalanche and begin to quantify the effects of this prepayment trend for the existing student loan portfolio.

Byline:
Derek Kaknes