Thursday, December 1, 2011

Why more bad mortgages? Too much reliance on credit scores

The current financial crisis is at least partially blamed on lax lending practices in the US mortgage industry. More mortgages were provided to less credit-worthy individuals with smaller down-payments than ever before, until this house of cards fell apart. Of course, this is not the whole story, but at least there is some partial truth to it, right? Now I am not so sure.

Indeed, Geetesh Bhardwaj and Rajdeep Sengupta look at a large fraction of the sub-prime mortgages originated from 2000 to 2006. And they find that the credit-worthiness of their holders, as measured by the FICO score, actually increased (and more so than the general population). How could this be possible? One hypothesis is that mortgage issuers have gradually relied more and more on simple metrics they could enter into some software instead on analyzing other details on an application file. And if you end up relying on a single criterion, the selected applicant will look much better according to this criterion. But if this criterion is not well correlated with actual credit-worthiness and relevant information is neglected, your loan pool becomes more risky.

1 comment:

Anonymous said...

Seems like a variation of Goodhart's Law applied to the private sector.