Here's a perplexing question now facing lenders nationwide who are up to their ears in home mortgage applications: In a post-Sept. 11 economic environment, how do you evaluate borrowers' credit risks, particularly their likelihood of future delinquency or foreclosure?
Do you focus on credit scores, those ubiquitous three-digit electronic evaluations that have been the dominant mortgage risk prediction method for the past six years, or are there other factors that are as important or even more so?
The nation's largest mortgage insurer, MGIC Investment Corp., has just completed extensive research that should give lenders and home buyers pause. Based on a study of thousands of home loans MGIC insured during the last recession _ 1989 to '91 _ the corporation concluded that some borrowers with the highest "FICO" scores (FICO stands for Fair, Isaac & Co., the firm that came up with the idea of credit scoring) face much more serious risks of delinquency and foreclosure than borrowers with low scores.
The key to the surprising differences in risk is geographic location. If a high score, cream puff mortgage borrower owns a home in a "volatile" market _ hard hit by local economic woes _ that cream puff is far more likely to lose his or her home to foreclosure than a low score, credit-impaired borrower in a more stable local economy, according to MGIC.
FICO scores translate raw credit file data into easy-to-use three-digit numbers that rank a loan applicant's relative likelihood of a future delinquency on a loan. A high FICO score _ above 750, for example _ means an applicant offers relatively little statistical risk of nonpayment to the mortgage lender.
A lower score, say, in the 500s or 600s, indicates a much higher relative risk of delinquency or foreclosure.
Lenders often compensate for higher risks by charging borrowers with low FICO scores higher interest rates and fees. Even after loans are closed, lenders monitor low-scoring borrowers intensively, watching for signs of financial distress.
Online FICO scores have enabled lenders to make almost instantaneous decisions about mortgage applications. Virtually no one, including MGIC, disputes the predictive powers of the scores.
Major tests in the 1990s by giant investors Freddie Mac and Fannie Mae established that FICO scores are remarkably accurate in forecasting relative probabilities of nonpayments, foreclosures and even bankruptcies. MGIC says its new research confirms "that a borrower's (FICO) score is a fairly strong indicator" of whether the borrower's home will end up in delinquency or foreclosure.
During the last recession, for instance, homeowners with low FICO scores under 620 were six and a half times more likely to get into serious repayment problems than borrowers with FICOs above 660.
However, MGIC researchers found that, no matter how high your credit score, you're more likely to get behind on your payments and lose your house if you happen to live in an area with a weak local economy and declining property values.
In its study, the corporation divided its 1989-1991 vintage loans into two geographic categories: loans made in "volatile" markets, all in California and the Northeast, and loans made in relatively stable markets elsewhere around the country, where home values did not decline significantly during the recession.
MGIC found that people with FICO scores under 620 in stable economies were considerably less likely to default than high score borrowers in places like Southern California. A homeowner with a score above 660 in a volatile market in the Northeast had a 60 percent higher chance of losing his or her home than a borrower with a sub-prime FICO score in a flat real estate market in the Midwest.
Homeowners with high FICOs in volatile real estate markets were a stunning 10 times more likely to end up seriously delinquent than high score homeowners in more stable geographic markets. Joseph Birbaum, MGIC's senior vice president for credit policy, said the research is eye opening, since it suggests that credit scores forecast only part of a person's true risk of default in a recessionary economy, particularly when the home buyer made a small downpayment.
MGIC's findings have huge potential significance for lenders and borrowers alike: With the nation virtually certain to be declared officially in a recession by the end of December, homeowners' abilities to hang on to their houses will be an increasingly important subject. Where local markets face deeper and longer recessions _ some economists say as many as 10 states already meet the statistical test _ the likelihood of home mortgage troubles will be far higher.
If property values begin to slip in the face of rising unemployment, lenders will need to get the message out to homeowners, however high their credit scores: If you think you're going to have difficulty paying your mortgage on time, call us immediately. We just might be able to modify your loan schedule or adjust your payment amount to help you avoid foreclosure.
Ken Harney's e-mail address is kenharneyaol.com.
Washington Post Writers Group