Fitch: Do FICO Scores Matter?

While rising mortgage defaults are to be expected during a housing market downturn, the sharp rise in U.S. subprime mortgage defaults — combined with a collapse in available subprime credit — is an event that is gaining strong attention from regulators and rating agencies alike. In a new report, Fitch Ratings tackles the collateral attributes that contribute to early default activity in subprime mortgages underlying RMBS issuances.

Generally, Fitch noted that there is typically a lag between the slowdown in home price growth and a rise in mortgage defaults. However, the rating agency’s analysis found that the severe response of the 2006 subprime vintage to the cooling housing market is attributable to high borrower leverage, as well as the widespread use of stated income loan programs.

After studying the collateral attributes of early payment default (EPD) loans and comparing them to loans that did not default in the first 12 months after issuance, Fitch found that Fair Isaac Corp. (FICO) scores have become less significant as an early default indicator when other high risk loan attributes, such as piggyback second liens or loans with no-income verification, are present.

“While FICO scores continue to be highly predictive measures of relative credit risk for loans with similar characteristics, FICO scores play a lesser role when additional risk layers are added,” said Glenn Costello, Managing Director, RMBS, Fitch Ratings.

“In the case of the 2006 vintage delinquencies, additional risk layers that are factoring into the sharply higher delinquencies include high combined loan to value ratios (CLTVs) and stated income loan programs as borrowers with higher FICO scores tend to be highly levered.”

In addition, loans made for home purchases have become a much larger percentage of subprime originations as opposed to refinances, which historically made up a majority of subprime pools. “The added risk from the higher leverage and stated income feature is driving up default rates for purchase loans,” said Suzanne Mistretta, senior director or the credit policy group at Fitch Ratings.

The report marks the first in a series of regular commentaries by Fitch on the challenges in the subprime market. Subprime Collateral Trends and Early Payment Defaults can be found on the Fitch Ratings web site at http://www.fitchratings.com.