FICO is King no more; Long Live LTV
So, we all know about the FICO score right? It’s the ubiquitous yet very secretive formula used to determine and “score” your creditworthiness. This had been the benchmark of lending decisions from credit cards to mortgages since the beginning of time…almost.
My have times changes with the snafu’ed economy and credit crisis. FICO no longer holds the esteemed title for rating creditworthiness. Recently, there has been a trend that even those that are considered prime (FICO greater than 660) are defaulting at subprime rates. This is concerning for lenders particularly of mortgages and those that are involved in CDOs.
One reason of this phenomenon is that traditionally prime borrowers have over leveraged themselves in the boom days of house price increases and have took out too much equity on their homes either because they were seeing their property values soar or because they intended to flip the house for a quick and easy profit, either of which is now extremely difficult to do.
So, what do banks do now for lending decisions and for forecasting credit losses on mortgages and mortgage backed securities? Well, now we have LTV! Loan to value ratio is the ratio of debt to equity essentially to gauge how much of the property one actually owns. Essentially what this shows is that those that have more stake or equity in their homes are more likely to maintain payment and stay current on loans. 80% plus is bad. 90% plus is very bad.
To show the impact, last week Wells Fargo announced $1.4 billion in write downs connected with bad loans all of which were 90%+ LTVs. The problem is also getting worse as home prices drop which in essence lowers the denominator of the “equity” portion of the LTV equation. To demonstrate, since 2001 average equity in homes has dropped over 10% from 57.6% to 51.7% in June 2007.
LTV:1, FICO:0
Tags: credit bureau, credit crisis, credit score, credit rating, Banks, Credit, Uncategorized
Great insights. I wonder if this will effect credit card lending decisions soon. But LTV only is a measure for mortgages. Credit card lending can potentially use a debt to income ratio instead of FICO. But I do not believe that there is yet proof of this “phenomenon” in the personal credit industry yet.
Very insightful. Thanks. I have a fico of 680 which usually gets me most cards that I apply for but recently got rejected for an American Airlines card from Citi. This would hopefully explain why. Terrible that they punish the typical “better” cardholder.