Credit Score Red Herring

As the news of the subprime mortgage market meltdown continues an alarming angle of the story continues to be missed by the mainstream media.

The default situation in subprime mortgages (typically defined as borrowers with a FICO score below 620) has led to tremendous coverage and speculation as to whether the instability in subprime will spill over to the prime market. Famous people are weighing in on both sides trying to predict where this weakness is headed and if it is contained in subprime or not. The meida is loving this story.

The scary part of this all is that FICO score and prime v. subprime should not really be the story. The story should be on CAPACITY. Capacity is a borrower’s ability to make their mortgage payments and pay their debts on time. Why should capacity be the buzzword and not subprime v. prime? Because capacity plays a big role in mortgage defaults. Sure, intrinsically people with better FICO’s handle debt better and should be able to manage their finances better (that’s how they got the score in the first place) but your FICO score can’t pay your bills.

People with good FICOs already have a history of paying their bills you say. Yes, they do. And because of that the profit-hungry banks went ahead and said three key things; (1) "borrow as much as you like, you have good credit, we know you’re good for it" (2) "you tell us how much you make for a living and we’ll take your word for it," and (3) "here’s an exotic-type mortgage where you can pay only the interest, or even less, so you can afford a bigger house or maybe two or three."

(1) They increased the standard debt to income ratios (monthly mortgage payment/gross monthly income) when underwriting these loans so that people could borrow more, and then calculated the ratio off the lowest payment available under the loan program (interest only, etc.)

(2) They told borrowers just to put down a monthly income figure that "makes sense" for your position – we trust you. Your good credit obviously means you’re a good citizen and can handle borrowing as much money as you think you need and think you can afford. Just state your income.

(3) They made up all types of negatively amortizing loans and interest only loans to allow people with good credit to assume more long-term debt by minimzing their monthly cash out-flow.

The problem arises when it comes time for these exotic mortgages to recast or adjust to the long-term interest rate (or fully amortized payment) and these people get hit with major payment shock. Their debt to income ratio will go through the roof crushing their available cash flow. The outcome is easy to see – they will owe more money each month, their income may or may not support it, depending on how honestly they stated it, and their capacity to pay will vanish.

This capacity crush will lead to an increase in defaults on the "prime" side of the market. The media should be looking at percentage of prime loans that are high in loan-to-value, are stated income, non-traditional loans, and then run their analysis. I think the outlook will be more inline with what we are seeing on the subprime side.