Tuesday, November 16, 2010

Credit Reporting Companies Seek To Fight Back Against Strategic Defaults With Lower Scores!!

Credit reporting agencies are taking serious notice of strategic defaults. The main credit reporting agencies, Equifax, Experian, and Trans Union, have seen a sharp and significant increase in default rates among prime borrowers. The main credit scoring companies, Fair Isaac creator of FICO and VantageScore Solutions creator of the Vantage Score are seeking to account for the change in consumers payment behavior during this current economic crises.

Below is an excerpt from an article published by The Real Deal as it relates to this new attitude by credit reporting company's:

"[i]n late October, both Fair Isaac, the developer of the FICO score that dominates the mortgage field, and VantageScore Solutions, a joint venture by the three national credit bureaus and marketer of the competing VantageScore, outlined modifications they are making to handle the vast credit disruptions caused by the housing bust, the recession, high unemployment and behavioral changes by consumers. Not only are borrowers who previously were rated outstanding credit risks far more likely to default today...but many homeowners are defying long-standing credit industry assumptions by going delinquent on their first mortgage payments while simultaneously continuing to pay their credit card balances and second mortgages on time. Strategic defaults -- walkaways -- by high-score borrowers also have been an unexpected and shocking development."

"To adjust its statistical models to these new realities...VantageScore 2.0...expected to be rolled out nationwide to lenders in January, focuses in on the subtle warning signs of credit stress that might have been missed earlier -- and penalizes or rewards consumers with higher or lower risk scores than they would have received before. New FICO 8 Mortgage Score is based on similarly exhaustive research into consumer credit behavior changes...[w]hen used by a lender to rate the risk of new applicants or existing mortgage customers. The Mortgage Score is likely to be anywhere from 15 percent to 25 percent more accurate in detecting signs of future default compared with the standard FICO model."

So what does this all mean?
It means that if a credit reporting agency determines that you strategically defaulted or you are "at risk" of strategically defaulting then it may cause an even larger reduction in your credit score.

Let's face it. We can all understand why credit reporting companies want to track strategic default behavior. The credit models are based on certain underlying assumptions. One assumption being that people normally pay their debt if they have the money to do so. There is a lot of financial and emotional "weight" placed on one's credit score. It is used for loans, jobs, and housing. It directly affects one's attitude and confidence. It creates fear. It is a status symbol. Credit reporting companies are aware of consumer behavior and consumer's underlying sensitivities to credit scoring. However, the companies did not anticipate consumer's current reactions to the economic crisis. The credit reporting companies do not have a measure for "strategic default" behavior and attitudes. They did not anticipate the growing number of people who do not care about their credit score. They did not anticipate that consumers do not want to be slaves to never ending, perpetual debt while throwing away cash and savings. In any event, the main mission of the credit reporting company is to stay relevant with their main customers: lenders, employers, governments, and property owners. Credit reporting agencies do not have the consumer's best interest at heart.

Now how can a credit reporting company truly determine strategic default behavior? Even if the credit reporting company can accurately determine strategic default behavior why should it negatively affect a credit score? A strategic default can be considered a rational financial decision to protect cash, savings, and investments. 

How will this work? What are the various factors considered? What if a borrower stops making payments on a mortgage but continues to make payments on other types of debts, such as credit cards or lines of credit - does this mean the borrower has strategically defaulted or intends to strategically default? How many months of payments must be missed to be a strategic default?

How will a credit reporting company determine a strategic default without information on a borrower's current income, savings, investments or assets? What if a strategic default is based upon a lender's unreasonable refusal to enter into a good faith loan modification? What if an individual stops payments on all of his debt? What if he or she stops payments on one credit card and one mortgage? What if...What if...

Does it matter why a person stops making payments? If you miss a payment your credit score goes down. Period. What if a person is unable to make payments due to loss of income or other personal or financial crises - will the credit reporting companies take that into account? [The answer is a resounding NO!. That's why credit reporting companies have the ridiculous - "You Can Provide A Written Explanation For Your Default/Non-Payment" fill in the box section on credit reports. So what if you can write in a reason for why you missed a payment...it still does not change the actual score].

The credit reporting companies should take into account the reasons for a strategic default. If we compared someone who is 90 days late due to financial distress with someone who is 90 days late because of a strategic default - who is the greater credit risk?

Let's face it. The only purpose for credit score changes in the face of strategic defaults is to create a model that penalizes borrower's strategic default behavior in order to "incentivize" borrowers not to strategically default. It is an attempt to discourage rational financial behavior on the part of consumers. It is an attempt to maintain the relevancy of a credit scoring model that may in fact be losing some of it's relevancy. Remember, credit reporting agencies make money from lenders, governments, property owners, and other agencies or businesses that pay for the information.

There is no way to determine future behavior based on a present decision to strategically default. A strategic default is based on the decision to protect cash, savings, and investments from a money draining worthless asset. Especially when there is little chance of getting the money back. It is a risk analysis solution employed by borrowers who have determined that the cost to strategically default is less than the cost to continue paying on a debt. It is a form of personal financial control in a world where lenders, big businesses and governments strategically default all of the time and get rewarded for doing so through bailouts, debt forgiveness, debt restructuring, low interest loans, and unlimited credit facilities. In this case it seems that "what's good for the goose is not good for the gander."

The proposed predictive model is not that complex. All a credit reporting company has to do is to determine if a borrower's property is worth less than the outstanding mortgage balance. In such a case there may be a strong chance that the upside down borrower will strategically default. Still got to ask: why should strategic default behavior be scored differently than any other non payment behavior?

This is the blatant message from the credit reporting agencies: "If we determine that your late payment or non payment is based on a strategic default instead of a true financial crises then your credit score will be even lower. In fact we will 'punish' you in the long term if we determine you strategically defaulted. We will also consider you a risk if you have an upside down property. We will create disincentives to strategic defaults based on your fear of a lower credit score.WE WANT YOU TO STOP STRATEGICALLY DEFAULTING. PLEASE."

All this hoopla about new payment behavior patterns forming due to this economic crises is like a broken record. This is not the first financial downturn or the last. Instead credit reporting agencies should seek to rehabilitate consumers credit scores who are having a difficult time making payments or have made the decision to protect their cash and savings for the future. Credit scores should go up for rational financial behavior that serves the best interest of the debtor. Of course none of this will happen. It just to say that how will this "new behavior" be properly measured and/or quantified?  

In my opinion credit reporting companies have a steep hill to climb. The proposed process appears to be arbitrary. It seems almost impossible to apply equally to all borrowers.

WHAT SHOULD YOU DO. It makes sense to start obtaining a free credit report each year and make sure to file it with your records. All of the main credit reporting agencies provide a yearly free credit report as required by federal law. Also it makes sense to get a written credit score each year. There is a cost to get a credit score. However it may be worth the cost to track changes in your score. If your score makes an unusual change then you have the right to ask the credit reporting agency why. Make sure to put your request in writing. Also request a written explanation of the new credit scoring methods. Your goal is to make sure there is no arbitrary reduction in your credit score due to a credit reporting agencies "perceived" change in your payment behavior or your "potential" risk of strategic default. 

You can go to this link to learn more about VantageScore 2.0 and go to these links to learn about FICO 8 here and FICO 8 here.  

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