Over the last 70 years, the American housing finance system has provided unparalleled liquidity to the housing market. Trillions of dollars of home loans have been insured, guaranteed and placed in the secondary market, allowing lenders to reach ever more borrowers, many of whom were able to establish credit, build household wealth and achieve the American Dream.
We know that the housing finance system is not invulnerable. Likewise, we know that our nation and communities are stronger when we protect the mortgage market from lethal risks that sometimes lurk beyond the happy numbers. Achieving stability and sustainability requires careful balance.
In 2011, the Congressional Budget Office wrote that the true cost of guaranteeing the mortgage book of Fannie and Freddie in the aftermath of the Great Recession was an astounding $317 billion. This financial catastrophe was a result of poor basic risk management and, to some degree, the political class pushing the GSEs past responsible limits.
In mortgage finance, accurate credit scoring is at the heart of assessing risk. In the years preceding the crisis, lenders infamously ignored numerous risk indicators, including those provided by FICO Scores, and aggressively expanded the origination of sub-prime mortgages.
Ten years later, the political pressure to expand mortgage lending is growing again. To be clear, homeownership has traditionally been a primary driver of middle-class household wealth, and responsibly enabling it for more Americans, especially women and minority populations, should be a national priority. But upholding strong credit standards requires that same careful balance: nobody wins if borrowers are locked into mortgages they cannot afford and taxpayers have to bail out a system that took on too much risk.
The Federal Housing Finance Agency is considering proposed regulations concerning the credit scoring model used by the GSEs in originating conforming mortgages. A refrain has developed that new scoring models alone hold the potential to increase access to credit for millions of Americans.
Truly alternative forms of consumer data, those that exist outside of the traditional credit bureau file, have indeed shown promise, but the goal must always be improving the credit score’s predictiveness, not simply lowering standards. In 2017, the FHFA studied the use of alternative credit scores and found it would have a negligible impact on credit access.
Analysis by the National Taxpayers Union provided more troubling findings: Allowing mortgage originators, who hold no credit risk, to choose from multiple credit scoring models could encourage a “race to the bottom.” Originators could shop around for the score with the lowest standards that allows the origination of the most new loans, while passing the risk of those lower standards onto the parties who hold the risk in the mortgage market: investors, the GSEs and American taxpayers.
Investors, who live in the realm not of public opinion but of the uncompromising financial marketplace, rely on credit scoring to price mortgage loans and decide whether to supply the liquidity the entire system requires to operate optimally. And it’s not just their investment at stake; taxpayers are ultimately on the hook.
The $15 trillion U.S. mortgage market is so intensely critical to our national economy and to tens of thousands of American communities that changes must be undertaken with the highest degree of humility and care. Daily, investors make billion-dollar decisions based on the FICO Score, a model that has been validated as predictive of risk over decades.
In the mortgage market, having sufficient liquidity to function is not a given: a reliable universal metric for credit risk offers the homogeneity and consistency that investors crave. A careless change could lead to financial calamity, not just for the cogs in the mortgage finance wheel, but for the very same people that those arguing for rapid change purport to help.
Fortunately, Congress and the FHFA have taken great pains to avoid those unintended consequences. The regulator has provided, in its proposed rule, an avenue to pilot new models as a way to test new approaches and encourage responsible competition among scoring providers. Thus, the system can continue relying upon the score that has proven to be most predictive while responsibly incorporating new innovations in a way that does not pose systemic risk.
More can and should be done to introduce data which is not currently collected by credit reporting agencies and incorporate it into scoring models. But we should always begin with the goal of protecting taxpayers and avoiding a repeat of the past, rather than bending to politically attractive but ultimately misguided demands about how many more might be served by reducing credit standards.