Point of View: FICO Test a Flaw in Plan

The viewpoint is an excerpt from Congressman Frank's opening remarks at a recent committee hearing on the subprime lending crisis. During the hearing, Congressman Frank commented on the administration's plan to aid troubled nonprime borrowers who are facing upward adjustments to their mortgage payment. The remarks came on the heels of the release of the Bush Administration's proposal.

I do then want to make two points today. One is a general point and what's been striking about the subprime crisis is not just simply the subprime crisis but the extent to which it has spread to be the most significant financial problem in the world since it seems since the Asian financial crisis. And as I think about it, it does seem to me there is a problem intellectually and then ultimately politically that we in the executive branch, in the legislative branch, and in the private sector all working together have to solve and that is we need to find a substitute, and it is the substitute for - and the bank regulators are here and I have always been told by bankers that the prime rule of banking was 'know your borrower.'

And what has happened is that we have created through a whole group of new methods a situation in which you not only don't know your borrower, you have no idea who your borrower's borrowers' were or are. The nexus between the borrower and the lender, I believe turns out to have been a more important safeguard than we thought and we have been trying very hard, the private sector has, and some of us in the regulatory field have been trying to find a substitute for the borrower-lender relationship and we have as it turns out have been less successful than we thought.

That is what risk management is. It is a substitute it seems to me for trying to know whether the person you lent the money to can pay you back. And what we need to do is to figure out in not just subprime but in general how to deal with that, and that will be the subject of further hearings.

How do you keep the benefits of this increased liquidity and find some way to preserve again what has been the great safeguard of not lending money to people who you didn't think can pay you back. When you don't have to worry about whether they pay you back, and when the people who now own the loans don't know whom in effect they lent it to ultimately, we have problems.

With regard to the proposal that the Administration has put forward, I welcome it, it is a recognition that the increase in the rates would cause serious problems and that some public sector concern with that is appropriate, that the market cannot be left entirely on its own, although there is no violations by these legal rights. But I did tell Secretary Paulson in a conversation this morning in fact that there are a couple of problems that I have with this. First of all, I think it is a grave error to say as I understand the proposal does, that there is a cutoff at a 660 FICO score.

Apparently people have thought that a FICO score credit rating was a good proxy for income. I don't think it is and I think we would be making a great mistake frankly, morally and also politically if we tell two people who are otherwise similarly situated that the one who has been more careful about his or her credit is not going to get the benefit that people who have been more/less careful will. I think the 660 FICO score is a great mistake.

I understand that there needs to be some kind of screen but I think all of us, literally all of us - conservative, liberal, Democrat, Republican, etc, we have all been telling people, "Please don't get into debt beyond what you can handle.

Try and keep your credit score up." We have all be telling people to keep their credit scores up, now we have a situation where people listened to us who got their credit scores up are now going to be worse off vis-a-vis than other people who didn't keep their credit scores up is a great mistake.

The other flaw I think from the standpoint of someone supportive of the general idea, and I welcome it and I appreciate the initiative and I appreciate what Chairwoman Bair and others have done to urge its adoption, is the failure to do anything about a pre-payment penalty.

It seems to me that if you delay this for five years that is a good thing because the hope is that during that period people can find some way to refinance and avoid the reset, but if they still face the prepayment penalty as I understand from Secretary Paulson, nothing in this proposal does anything about the pre-pay penalty except in effect to "toll it" as lawyer would say, just push it down the road, but not having the prepayment penalty addressed, I think is a flaw.

I believe it is a mistake to use that FICO score screen. I hope they will recognize that you need to do something about prepayment penalties.

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