One particular type of credit score, the FICO score, has grown to outsized importance in recent years. Initially, FICO scores were used by consumer lenders and not by mortgage lenders because the score was designed to predict borrower credit behavior over a fairly short period of time (about two to three years). Until several years ago, only a few mortgage issuers used this information to screen borrowers.
When investors began demanding more credit information, however, issuers started using FICO scores. Thus, even though FICO was not designed for mortgage credits, it is still a readily available credit score, is widely understood and recognized, and is consistent from issuer to issuer. Additionally, FICO scores are tabulated by an independent credit agency using a model created by Fair, Isaac and Company and not by the issuers themselves. Today, if a FICO score is unavailable on a nonagency deal, many investors will not consider it.
The agency cutoff for FICO several years ago was 620, but that limit was moved up to 660. However, more recently, the agencies have revised their underwriting standards to accept the higher end of the subprime market, and these loans carry lower FICOs. The agencies require a higher loan rate for subprime collateral to offset the higher default risk of those loans. In the jumbo and alt-A sectors, the lower cutoff is between 600 and 620, depending on the issuer. In subprime, most issuers use 500 as a cutoff. Average FICOs in the jumbo, alt-A, and subprime sectors in 2004 were around 735, 710, and 620, respectively.
FICO score plays a key role in determining credit performance in various parts of the nonagency market. Default rates are directly related to the distribution of FICO scores in a loan pool. However, FICO score also plays an important role in prepayment speeds. Lower-credit subprime borrowers often refinance when they improve their credit. For example, a C credit borrower who kept current for a year or so on consumer and mortgage loans may be eligible for a B credit loan carrying a much lower interest rate. This "credit curing" refinancing represents a major part of the base-case prepayment speed in subprime lending. This is also why average base-case speeds in subprime at 25% to 30% CPR are much faster than the 6% to 8% in the agency market.
Additionally, because lower-credit borrowers face higher closing costs and points to refinance and fewer companies offer theses loans, subprime loans are much less sensitive to changes in interest rates than are agency loans. Hence, credit—that is, FICO score—is an important determinant of prepayments, as well as of delinquency and loss rates.
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