Looming risk for mortgage credit and MBS investors from Lender Choice

"Since 1996 when Freddie Mac introduced the industry to the first automated underwriting system (AUS) for GSE-eligible mortgages, a borrower's credit score has served as one of the most important predictors of mortgage delinquency. For many years thereafter, FICO score was the sole provider of scores to both GSEs' AUS scorecards. The arrival of VantageScore as a competitor to FICO has turned up the heat on the use of credit scores in mortgage underwriting with FHFA's decision to allow lenders to choose between FICO and VantageScore in delivering loans to the GSEs."

"This lender choice policy poses risk to both credit and MBS investors. Lenders clearly have an economic incentive to deliver loans that have the best chance of being purchased by the GSEs. Loans that pose higher risk may be subject to additional fees (LLPAs) or may not be an acceptable risk to the GSE. Ever since the rollout of GSE automated underwriting, lenders have always been on the hunt for ways to find weaknesses in these scoring systems."

Since 1996 a borrower's credit score has been one of the most important predictors of mortgage delinquency, and FICO long supplied scores to GSEs' automated underwriting systems. The arrival of VantageScore and FHFA's decision to allow lender choice between FICO and VantageScore creates economic incentives for lenders to deliver loans most likely to be purchased by the GSEs. Loans with higher risk may face additional fees (LLPAs) or be unacceptable to the GSEs. Allowing lenders to select scores invites adverse selection, where lenders exploit scoring differences to deliver relatively higher-risk loans, increasing credit risk to GSEs and MBS investors. Statistical approaches mirroring sophisticated lender behavior can detect potential adverse selection.

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