The FHFA should nix its credit score plan, too

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Since the election of President Joe Biden in 2020, the direction of housing policy has taken a decidedly progressive turn, with many policy decisions being taken for political reasons and often without a firm basis in current law and regulation. Moreover, the apparent disconnect between the economic realities of the housing market and government policy is causing growing concern in the home finance industry. Following the Federal Housing Finance Agency's withdrawal of loan level pricing adjustment changes, it should revisit the plan underway to alter credit score use in underwriting.

LLPA alterations
After initially announcing changes to its pricing for conventional loans sold to Fannie Mae and Freddie Mac, some observers accused Federal Housing Finance Agency Director Sandra Thompson of subsidizing lower credit borrowers at the expense of stronger borrowers, a return to explicit cross-subsidy of lower income households.

The Chairman of the House Financial Services Committee, Patrick McHenry (NC-10), and the Chairman of the Subcommittee on Housing and Insurance, Warren Davidson (OH-08), sent a letter to Thompson, blasting the FHFA's recent changes to the loan level pricing adjustment structure as "a tax on creditworthy homebuyers to subsidize those with riskier loans."

"The changes in the LLPA matrix dropped the fees by as much as 175 bps for the lowest credit scores at the highest LTV," notes former MBA Chairman David Stevens. "And clearly the only increases were to higher credit score borrowers with the exception of some high credit scores borrowers with very low down payments. In all cases it was to the higher risk borrowers where the fees dropped."

Critics are right to question the technical logic behind the LLPA changes, yet the narrative from the critics of Thompson does not align very well with the data when it comes to market results. The obvious point is that there is not much benefit going to low-income borrowers because there are not that many loans below a 680 FICO credit score getting done in the conventional market. 

Sandra Thompson may have oversold the benefits of the LLPA change to the White House. Most low-income borrowers get far better execution in the government loan market, with FHA, VA or USDA as the insurer of the loan, as opposed to conventionals. Low income borrowers taking conventional loans are mostly enriching the private mortgage insurers at their own expense.  

The LLPA changes made by Thompson were mostly about election-year politics and leave in place decade-old injustices to lower credit borrowers in the LLPA matrix.  When a low income borrower navigates the new LLPA grid and the credit overlays that most lenders put on top of low-FICO, high loan-to-value loans, most applicants will select the FHA over the GSEs every time.

Credit scoring changes
Even more worrisome than the LLPA changes is the chaotic process begun by Thompson to require lenders to use two credit scores in the lending process, something that is arithmetically impossible and operationally problematic, yet is now government policy under the Biden Administration nonetheless. The considerable obstacles to implementation will ensure that the two-score regime is not adopted, if ever, until long after Director Thompson has left the building.

Initially, Director Thompson seemed inclined to allow lenders to make a choice as to which score to use. Since the mortgage industry is still using an older version of FICO score that is viewed by many progressives as racist in construction, allowing lenders to opt for the status quo was unacceptable to the White House. The three data repositories reportedly want to put FICO publisher Fair Issac out of business and substitute their own scores in the loan approval process.

As a result of such considerations, FHFA has thus now mandated a convoluted regime whereby the GSEs must use both scores in the loan review and purchase process. The timeline for implementing these changes is extremely aggressive, beginning in Q1 2024. 

In order to fit into this brave new world, lenders must somehow decide which score to use in the underwriting process. The most likely scenario is that prudent lenders will use the higher score, while more reckless lenders will opt for volume over quality and use the more progressive-friendly score. 

There are a number of troubling issues of consistency and method in the FHFA proposal mandating the use two credit scores. First and foremost, the proposal will require the FHFA to reassess the capital requirements for the GSEs. In the rule for Enterprise Capital Requirements, FHFA notes that:

"The Enterprises currently rely on Classic FICO for product eligibility, loan pricing, and financial disclosure purposes, and therefore the base grid for new originations was estimated using Classic FICO credit scores. Furthermore, throughout the proposed rule, the use of credit scores should be interpreted to mean Classic FICO credit scores. If the Enterprises were to begin using a different credit score for these purposes, or multiple scores, the grid for new originations, along with any other grid reliant on credit scores, would need to be recalibrated."

Not only would the capital rule for the GSEs need to be revised and re-proposed as a rule, but the entire ecosystem of investors, banks, central banks and rating agencies that operate in the world of mortgage backed securities would need to revise capital rules and ratings methodologies globally and seek approval for these changes from dozens of governments and regulators. Every part of the financial world that leverages credit scores will be affected by the FHFA proposal, yet there is little indication that FHFA has fully considered these real-world concerns.

In addition to the operational risks created by a two-score system, the rule also creates the potential for Fair Lending Act violations related to the loan approval process.  Lenders will need to satisfy the GSEs requirements not only about delivering both scores with the loan, but how the scores are used in the approval process. How the use of two scores impacts consumers and other organizations is a lengthening list that shows no signs of an end.  

The mortgage industry has made a Herculean effort to understand the new proposal from the FHFA, but the truth of the matter is that the proposal makes no sense. Technically, there is little actual "prior art" behind this latest example of progressive policy run amok in the world of finance. 

GSE officials tell industry that the new scores proposed are more "sustainable" than the old regime of FICO classic, but provide no data to back this up.  In fact there is no significant historical data behind either new credit score. The risk to lenders, investors and the GSEs themselves is considerable, yet there is no public indication that the FHFA or the GSEs have considered these risks.

In Washington today, considerations like the technical difference between credit scores or the prospect of degrading the value of conventional loans are unimportant. Likewise, the idea that federal bank regulators may increase the risk weight for conventional loans underwritten with two scores is likewise not considered important. What is important is the 2024 general election, now just 18 months away, and the desire of progressive politicians to issue press releases.

The opinions expressed in this column are solely the author's and do not represent views of the National Mortgage News.