FICO scores and mortgage loans

FICO comes from Fair Isaac Corporation, a company who created a system for measuring someone’s credit worthiness.

FICO is always an important factor banks (in the US) take into account for making the decision to lend or not. Scores tend to range from 300 to 850.

FICO is a bit simplistic and has some shortcomings. For example, anyone can request a credit card and promptly pay it off each month to raise their FICO score. FICO also doesn’t take into account the person’s income.

When the rating agencies (Moody’s and S&P) rated the safety of mortgage loans they asked for average FICO scores of all the parties the loans were made to, the average only needed to be around 615 to get an AAA rating. The big problem with the system is that there was a mix of very reliable lendees and very unreliable lendees. Taking an overall average was quite useless as there could be many people included in the bonds created with these mortgages that were not creditworthy, creating  great risk of defaults.

Nevertheless, the bonds were given high ‘safety’ scores as investments by the ratings agencies, which appears to have also made a big contribution to the whole subprime meltdown. After all, would financial institutions buy so many bonds if they were deemed risky?

I love this book, ‘the big short’, it’s giving me a much clearer vision of what happened in the housing market that sparked the financial crisis. It’s not too technical. It’s easy for someone like me to understand.