Tuesday, April 28, 2009

Doing the Homework

Posted on Portfolio.com by Ryan Avent:

A lot of recent financial innovation has been defended on grounds that it improved the flow of credit or made credit easier to obtain. But increasingly it seems that it did this by allowing everyone to stop doing their homework. Magical de-risking processes made the need to do homework before investing unnecessary. Magical hedging formulas did the same thing, and saved lenders the trouble of caring when a borrower got in trouble. The financial system became like a fancy new car -- full of top-of-the-line safety features, traction control, ABS, and so on. And like drivers who seem so effortlessly in control and completely safe that they forget how deadly two tons of steel traveling at 80 miles per hour can be, market participants were lulled into forgetting how dangerous finance can be.

Posted on Rortybomb:

The homework [he] are talking about about is the soft-skills part of mortgage applications, the part of the mortgage application that isn’t just a function of your FICO score and a few quantifiable variables. The soft-skills part has almost entirely been replaced by quantification over the past decade. Part of the move in this direction is the (rightly at a certain point) fear that those soft-skills were cover for racism. Part of the move is that the costs of deploying soft-skills when handling loans at large firms is too high once banks get too big. And of course, another suggestion is that the quantification process, FICO and the like, had gotten so good that they could save the costs on this homework part.

How can we tell if the third part is true? One interesting test, using a regression discontinuity method, is to see how the behavior of defaults looked around the securitization checkoff line. A FICO score of 620 was the cutoff for most loans - if your loan was 619, you couldn’t be resold to an investment bank in a CDO. At 621 you could. This number was picked arbitrarily by the GSEs in the 1990s, and kept by the hedge funds and investment bankers in the 2000s who were trading the stuff. Since it is arbitrary, a FICO score at 621 is just marginally better than 619. There is no magical jump there in terms of how FICO is measured at that point.

So check out these two charts from the paper Did Securitization Lead to Lax Screening? Evidence From Subprime Loans (Benjamin J. Keys, Tanmoy Mukherjee, Amit Seru, Vikrant Vig), reproduced in their powerpoint presentation:

The only difference between the 619 and the 621, besides a marginal increase in credit quality, is that the 619 had more soft skills used in it and it was very likely that the loan would not be resold but instead would stay on the originating bank’s balance sheet. So in the first chart we should expect 621 to have a slightly lower delinquency rate than the 619. If your FICO is 621, you are 2 points more credit trustworthy than 619. Instead we see a much higher rate. It is even more dramatic with the 615-619 versus the 620-624; the 620-624 should have a lower rate of delinquency, since they have a higher FICO score and are less of a credit risk. Instead we see the exact opposite.

The powerpoint is very interesting, and worth a few minutes of your time. This should cast some doubts on how much large banks can provide social utility by replacing the soft skills, the comparable advantage of small and mid-sized banks, with number-crunching computers, Ivy-Leaguers and giant bonuses.

Quick Update: There are some concerns, in the comments and at Business Insider, that one can game one’s FICO scores. Three quick points. The bank lending can’t alter the FICO score - they just type in your SSN and it shows up.

Two, picture you are a borrower without any qualms who wants to game the loan procedure, and the broker says “We need you to state your income and occupation, but we won’t verify it. Also you need to make $100,000 a year to get this loan. What do you make?” You would respond “What a coincidence! I’m a football player/astronaut, and my salary is $101,000 a year.” Gamed!

If your FICO is 619, it isn’t really easy to do some quick things to make it 621, provided you don’t rob a liquor store to pay off your credit card balance. There’s a time lag, and as anyone who wants to improve their FICO can tell you, the movements can feel arbitrary in the short run. Now if you do pay off your credit cards and make consistent payments on your bills for 6 months, and your FICO goes up, you haven’t gamed the system - you are actually more credit reliable (according to the algorithm).

This Infosys paper on subprime and credit risk measurement has a good illustration (emphasis by Tracy Alloway in FT Alphaville):

In 2006, a large Wall Street firm solf a $1.2bn sub-prime loan portfolio in which the borrowers had an average FICO score of 631, within the upper range of subprime borrowers. Around the same time another portfolio was sold by another large mortgage company with borrowers scoring an average of 600, putting them in the depths of sub-prime. The investors were told that based on the credit cut off scores, the portfolio sold by [the] Wall Street firm was less risky. But 18 months into both pools lives, 15% of the borrowers defaulted in the first case while only 4% in the second case. The reason given was poor documentation for the former case — which obviously was not taken into consideration during the process of creating tranches. Clearly cut off scores are not sufficient. They rate an individual’s risk over time but do not necessarily provide the best assessment of credit risk of the loan, still that of a portfolio.

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