Tucked into the U.S. Senate’s recently passed financial regulatory reform bill is a provision that has nothing to do with regulatory relief for community banks, freeing up capital in financial institutions, or enhancing consumer protections. It concerns the way our nation manages risk in the mortgage market and has the potential to upend financial stability and soundness principles that have persisted for decades.
In 1995, Fannie Mae and Freddie Mac, the government sponsored enterprises that back much of the U.S. housing market, adopted the FICO Score for mortgages that conform to their guidelines. After its introduction in 1989, the FICO Score became the industry standard for predicting credit worthiness. With its increased use, the FICO Score helped to democratize access to credit by removing many of the barriers to fair lending that are inherent in judgmental underwriting decisions.
The GSEs’ regulator, the Federal Housing Finance Agency, is currently considering updating these guidelines, and has overseen a thoughtful, transparent process to confirm that its credit scoring policies are consistent with the FHFA’s mission to ensure that the GSEs operate in a safe and sound manner and serve as a reliable source of liquidity and funding for housing finance and community investment.
We have always supported a competitive review of credit scoring by the FHFA. Unfortunately, the provision in the Senate legislation circumvents the FHFA’s current review process, which is nearing completion, and instead significantly delays any decision to update the scoring model used for conforming mortgages.
Conversely, the legislation has been heralded as a win for the three main credit bureaus – Equifax, Experian and TransUnion – which jointly own and operate VantageScore, the primary competitor to FICO. Proponents of VantageScore promoted the GSEs’ potential adoption of this model as a step toward greater competition and increased access to credit, but it would be a step toward consolidated credit bureau power and an erosion of scoring standards.
In credit markets like credit cards, and personal or auto loans, FICO competes for the business of individual lenders. But unlike an auto loan, for example, where an originator is on the hook for the risk, in the conforming mortgage market, the originator passes on the risk to the GSEs, investors in mortgage-backed securities and ultimately, U.S. taxpayers. This transfer of risk creates the potential for moral hazard – but, it is exacerbated when risk management decisions are divorced from the entity holding and managing the risk. Allowing lenders to “shop around” for the best score – instead of allowing the FHFA to set the standard – would fall into that category.
Additionally, in the conforming mortgage market, an originator is required to get a single tri-merge credit report, a report that contains data from all three bureaus, meaning there is no competition among the three credit bureaus. This gives each credit bureau enormous pricing power. Since the credit bureaus are the single point of sale and distribution for credit reports and scores, their ownership of one of the scores raises serious questions about fair competition.
In this context, it easy to see how the credit bureaus could consolidate control over the one element of the mortgage credit reporting system that remains beyond their reach: credit scores. And it’s why FHFA Director Mel Watt asked:
“How do you ensure, in the long run, that one of the credit scoring companies, which is owned by the credit repositories, doesn’t have an advantage over the credit scoring company that is not owned by the credit repositories?”
Another refrain behind the push for alternative scoring is the promise of increased access to homeownership. But generating more scores doesn’t necessarily mean more mortgages. FICO and VantageScore use exactly the same consumer data, housed in the credit bureaus, to generate their scores. The difference is that VantageScore uses lower scoring standards that include thin or stale credit files. Director Watt has said there is no “significant difference in these credit scores from an access perspective.”
The real promise for expanding access to credit is not lowering standards, but responsibly drawing on reliable new sources of data outside of the credit bureaus.
When banks are on the hook, they choose to rely on the FICO Score because it’s independent and reliable. So when taxpayers are on the hook, why consider the adoption of a lower standard?
The FHFA’s current review process has allowed for the careful and transparent consideration of all of these concerns, including input from consumer advocates and industry participants. But as the Americans for Financial Reform recently noted, the Senate legislation “will delay and up-end that process by requiring them to start again from scratch.”
