Hidden Culprit in Financial Crisis

A Mortgage Cash HomeThe Financial Crisis Inquiry Commission, created by the Fraud Enforcement and Recovery Act (May 20, 2009), held its first public meeting today, launching its mandate to examine causes of the financial crisis. The statute enumerates 22 possible culprits, all now usual suspects, like executive compensation, bad regulatory oversight, financial derivatives, complex securitization schemes and the like. Also on the list is the general notion of bad lending practices at banks, which two Commissioners today likewise noted in general terms.

Not on the list, and not mentioned today, or much discussed in the cacophonous litany, are the credit scoring systems lenders use to make first and sometimes final cuts on loan decisions. The credit scores lenders used before the crisis are still used today. But they do not measure credit-worthiness, or probability of loan repayment, as much as they measure whether applicants are good customers of banks, compared to those less reliant on banks. They value debt, and over-leverage is a recurring culprit in all financial crises.

To illustrate, take a pop quiz. Suppose the following two people apply for a mortgage loan on a home in suburban Maryland (say for $500,000). (1) Which is more credit worthy? (2) Which is more likely to be approved? (3) Would the answers differ if the decision were made today, after the financial crisis, or two years ago, before that?

Applicant A is a tenured Professor of Medicine at Johns Hopkins University, with a mid-6 figure base salary, doubled by significant practice income, revenue on patents she shares with the University, and rental income from resort properties she inherited from an aunt years ago that are owned free and clear of any liens or loans. The Doctor has no outstanding debt, a net worth in the low seven figures and has bought and sold two previous homes, paying off related mortgages before their maturity date.

Applicant B is a local real estate developer, with a low-6 figure income, ¼ of which is in contingent bonus compensation, and no other source of income. His net worth consists mainly of a modest retirement account, stock options and grants from his employer, and some cash in the bank, about enough to make the down-payment contemplated by the mortgage loan application. He has several lines of credit outstanding, all with meaningful balances, that he has increased regularly for years, though always paying monthly minimum balances when due.

(1) A, the Doctor, is by far the more creditworthy of the two.

(2) B, the real estate developer, will have a much higher credit score.

(3) No, under the so-called Desktop Underwriting software that lenders use, before crisis and now (hawked as enabling these decisions to be “made in less than 15 minutes”), B gets a far higher credit score than A. B passes lender underwriting cut-offs; A does not.

Why? Credit scores increase when people have large amounts of debt and decrease when they do not have large amounts of debt. Credit scores are unaffected by factors like employment security, equity net worth, or income. True, after credit score screening, banks may apply an additional test to borrowers with good credit scores, to assure requisite ratios of income to debt payment obligations. But the credit scores bias even that evaluation and still overlook significant factors. They essentially foreclose the possibility of making loans highly likely to be repaid.

In short, credit scores do not reflect people’s probability of repaying loans (whether they are creditworthy) but whether someone is a good customer of the banking system. Contributing to the crisis, banks made mortgage loans to millions of people with wonderful credit scores who lacked creditworthiness. They avoided lending to people with bad credit scores and strong credit quality. The practice continues. The Commission should put credit scoring on its list of possible causes of the financial crisis.

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6 Responses

  1. Deven says:

    Thank you. As always, the post is clear, educational, and delivers a knock-out conclusion.

  2. Bruce Boyden says:

    This strikes me as odd, since there seems to be a missing incentive to have reliable credit scores. Someone’s bearing more risk than they wanted to somewhere. Is it because of the way the secondary market works (again)?

  3. Lawrence Cunningham says:

    Bruce,

    My theory is more general: credit scores emphasizing debt reinforce a culture of debt that strengthens the importance and profitability of banks in the economy. Banks make money when corporations, consumers and governments finance activities using debt, not when those groups use current income, accumulated savings, retained earnings, net worth/equity, and annual tax receipts to do so. Banks pay credit reporting companies so the latter report what banks value and want to hear, and that is debt, and its repayment, not income, and especially not accumulated savings and other assets.

    America is excessively leveraged, and that factored in the crisis: the federal government’s budget deficit is massive; the individual savings rate was negative for many recent years and anemic before that and since the crisis; and corporate debt-to-equity ratios are large and activities funded far more by debt than by retained earnings (American Airlines yesterday borrowed billions of dollars to enable it repay billions of dollars in outstanding debt).

    Excessive leverage may be a problem for many corporations, people and governments in ordinary times, but in aggregate benefits banks then, and only becomes a problem for banks amid spectacular, rare crises like the present one.

    True, as you suggest, secondary market operations may partially explain, if banks transfer loan risk to pools rated highly by conflicted rating agencies insufficiently attuned to examining actual credit quality. But then why not lend to high-quality credits too or design a screening mechanism allowing them to the next step?

    Besides my bank-centrism theory, high-quality borrowers are not only more likely to repay debt, but also prepay it, sometimes costing banks profitability (say, if rates fall, and the bank must relend at lower rates). Banks certainly want to avoid absolute dead-beats, but their best target market are people who use debt a lot and are reasonably good at repaying it roughly on schedule, perhaps even a little late, but never early.

  4. I’m with Deven (and probably everyone else): important and very informative post and insights. Thanks so much, Danielle

  5. “The Commission should put credit scoring on its list of possible causes of the financial crisis.”

    Should it be listed before or after Barney Frank?

    Credit scoring is just a tool – it doesn’t “cause” anything. If banks et al use it incorrectly or over rely on it, then that is on them, not the product provider. Perhaps some innovative law professors, seeing a market need for a better credit-granting tool, can develop one.

    Of course, if the market doesn’t know it got burnt by its over-reliance on the credit score (maybe because the government bailed them out?), then perhaps the Commission should look at what parties are distorting messages to the market.

  6. C.L. says:

    I agree that the system discourages loans to people most likely to pay them off. Even now, banks still don’t want customers who pay off their loans.
    My husband and I in February tried to get a mortgage to buy our first house together. He has a middle-range salary and no debt, and I am in law school with no debt. We were planning to put %30 down on a mid-priced house that 25% of his salary per year would pay off in 7-8 years. We were unable to secure a loan for that amount; the highest we could get would allow 25% of his salary per year to pay off the home in about 5 years. The problem is that both of us have always paid credit cards down each month and he has always paid off loans and mortgages early.
    We are really a terrible investment for a bank, so no wonder we couldn’t get a good mortgage.