FICO and the Sub-Prime Mortgage Mess

Forbes Magazine wrote about how, during the real estate market bubble, mortgage lenders got a little too confident in FICO scores, and failed to give more weight to how much the borrower put down, and how well the borrower's income is documented.

They quoted a Fair Isaac (the company behind FICO) vice-president: "FICO scores an individual's risk over time. It's not an assessment of the riskiness of the loan made."

Fair Issac and bond rating agency DBRS put out a study in January which found that a borrower with a high FICO score and no-money-down mortgage was just as likely to default as a lower scoring borrower who puts down 40%.

Then, the article contrasted two sub-prime loan portfolios from 2006:

In the first case, Lehman Brothers sold a $1.2 billion subprime loan portfolio in which borrowers had an average FICO of 631 (in the upper range of sub-prime). Fair Isaac predicts that a borrower with this score should default 5% of the time.

But, after 18 months, 15% of this portfolio's borrowers are in default (more than 90 days behind on payments).

In the second case, a portfolio called "Nationstar Home Equity Loan Trust 2006-E" had borrowers averaging a score of 600. The FICO estimate is that 6% of borrowers would default by now. But, only 4% defaulted.

The manager of Advantus Capital Management told Forbes that the difference between these two portfolios was documentation. The Nationstar portfolio had 30% better documentation than the Lehman package.