New Scores ID Likely Defaults

TowerGroup recently analyzed VantageScore, the credit scoring tool launched last March by Experian, Equifax and TransUnion, to determine whether the model should be used and its potential growth amongst lenders and consumers in its 15-page report What’s the Score? New Risks, Credit Scores, and Revenue Opportunities in U.S. Consumer Credit Markets.

“The credit scoring market is mature in product acceptance, loan processing efficiency, and decisioning speed,” TowerGroup said in the study. “However, lenders still need better stratification of credit risk by consumer segment than current scores provide. VantageScore has raised awareness of these issues” at a time when lenders are increasingly targeting emerging markets segments and “grapple with skyrocketing defaults and increased losses in the subprime lending sector.”

TowerGroup previously found that, more than any other score, mortgage lenders use the Classic FICO score, which is also the most used credit score in the country.

“TowerGroup encourages lenders to evaluate new custom credit score options,” the research group said in an announcement. “Lenders need better scoring that serves low and moderate income loan applicants, including those that have little or no traditional credit history tracked by the credit bureaus. Lenders also need scoring solutions that better determine whether consumers are of subprime or prime credit quality.”

The VantageScore shares a single methodology created by the “Big 3” credit reporting bureaus to formulate credit scores. These scores for a consumer will be more similar than the three Classic FICO scores for the same consumer because each bureau has a different score algorithm from Fair Isaac Corp. for the Classic FICO score, TowerGroup explained.

As of February 2007, numerous lenders were testing VantageScore, but few were using it to prescreen consumers or to underwrite loans, according to the TowerGroup study, authored by research area director Craig Focardi.

“Lenders are evaluating VantageScore to determine if it provides better predictability of loan performance,” TowerGroup said in an announcement. VantageScore will have “moderate” success in the credit card lending segment and amongst consumers who purchase their own credit reports and scores, but “will have difficulty gaining ground among the mortgage and home equity lenders.”

TowerGroup cited “challenges for lenders related to testing and implementation costs; significant policy, operational, and training changes; and general institutional resistance to change.”

The research group explained that lenders’ process of credit score data collection, modeling, and testing can easily take two years or more, while preparation and implementation can also take a year or more.

“Resistance to change is rational because numerous parties involved in loan account opening processes, loan purchase, loan servicing, and portfolio monitoring must all change for the new score to have acceptance,” TowerGroup added. The cost is huge and the coordination of these activities is difficult. For example, FICO score acceptance in the mortgage lending industry took almost half a decade because of the extensive evaluation and testing by lenders, rating agencies, and secondary market loan investors.”

“Lenders must weigh the potential long-term benefits of implementing a new score against high upfront costs and time commitment,” the research group added. “The long-term benefits of the new score must clearly outweigh those costs.”

Barret Burns, chief executive of VantageScore LLC, told Mortgage Daily.com in an e-mail statement that VantageScore was created in response to lenders’ desire for a model that could enable scoring for a greater number of thin file consumers.

The primary reason VantageScore is able to score more of the thin file population is due to the difference in score exclusion criteria versus other models, Burns said. For example, VantageScore is able to provide scores for people who may have been “out of the credit market” for up to two years, rather than for up to six months.

TowerGroup noted that VantageScore “distributes credit score distributions more broadly across its credit score range and thus provides better predictability of loan performance than the Classic FICO score” because the broader score distribution “enables lenders to better refine loan underwriting guidelines and loan pricing for consumers with prime or subprime credit quality.”

Also, VantageScore may better reflect current payment and product trends than other scores that have not been updated in recent years, TowerGroup wrote.

But VantageScore faces the same challenge as NextGen FICO in competing against the Classic FICO for lenders, the research group said. NextGen, a 2000 version of the Classic FICO, contained enhancements that made it more predictive for subprime credit quality, thin credit file, and young credit file consumers, according to the study.

Fair Isaac has proven that NextGen is more predictive than the Classic FICO score in accurately scoring subprime and emerging markets’ customer segments, but most lenders decided against conversion after weighing the costs of converting or using both scores against the potential benefits of improved predictive power and usability for a wider variety of consumer segments, TowerGroup said.

Fair Isaac recently said a major lending-industry study, which included participants such as Freddie Mac, HSBC, First Franklin and Option One, proved that its FICO Expansion Score was the “first strong and reliable” credit score for assessing the risk of millions of loans prospects who have minimal or no credit information on file at the Big 3. The study confirmed that Expansion consistently assigned lower scores to consumers who later had more delinquencies and charge-offs, while it gave higher scores to those who later had fewer delinquencies and charge-offs.

“These validation results clearly impressed participating lenders, particularly in the score’s proven ability to objectively and consistently rank-order consumers by their likelihood to repay a debt,” a Fair Isaac executive said in an announcement. “Equally as important, the confirmation that FICO Expansion score aligns with Classic FICO score means that lenders can quickly and confidently incorporate FICO Expansion score into their current credit decisioning strategies.”

TowerGroup noted that, although new mortgages and home equity loan accounts have been the biggest driver of credit reporting and scoring product revenue in recent years — with mortgage lenders’ originations representing 30 percent of total new loan accounts in 2005, there will be larger opportunity growth — 39 percent between 2001 and 2010 — through the segment consisting of consumers purchasing their own reports.

To date, no lenders have publicly announced that they are switching to VantageScore. The model will have lower adoption rates with mortgage lenders and slightly more potential with home equity lenders because they keep more of these loans in their portfolios. Due to the growth in second lien securitizations, investors may resist using a new credit score, except perhaps in the subprime loan segment. Nonetheless, VantageScore is likely to be “more attractive for portfolio credit risk management than for loan origination because it is less disruptive in lending operations to implement a new score,” TowerGroup wrote.

“In general, TowerGroup does not believe that VantageScore will replace the Classic FICO score as the most-used score in any customer segment or loan product segment,” the study read. “Other scores that serve new customer segments and address markets where no credit score currently exists, such as the Anthem Score and FICO Expansion score, have more potential for adoption in those segments.”

Nonetheless, VantageScore’s Burns said that “because of the complexity of the underlying algorithm and its consistency” across the Big 3, “credit granters that use VantageScore will be better able to delineate risk in a predictive manner, helping to reduce overall portfolio risk, operational costs (via more insightful automatic decisioning), and credit losses.

“We encourage mortgage lenders to perform their own due diligence, as we are confident that the mathematical and economical advantages will be compelling.”