Something unexpected happened after the financial crisis: Americans have become far more responsible when it comes to their finances. At least that is the conclusion one would derive by looking at the average US credit score, which has increased by nearly 20 points, from 686 in 2009 to 704 in 2018.
Additionally, according to Moody's, there are around 15 million more consumers with credit scores above 740 today than there were in 2006, and about 15 million fewer consumers with scores below 660.
As we discussed recently, on the surface, this "disappearance" of subprime borrowers is good news. But is there more than meets the eye to the American consumer's FICO score renaissance? And, separately, are FICO scores subject to "grade inflation", as the Federal Reserve recently claimed?
To answer these questions, Goldman recently conducted an analysis into the causes behind this welcome development in US credit scores. The bank founds that, as expected, some of this increase reflects legitimate improvements in the credit behavior of US consumers. For example, household debt has declined as a percentage of GDP:
Since measures of indebtedness/over-extension represent roughly 30% of the FICO credit score calculation, this de-leveraging will, appropriately, lead to higher credit scores.
Some of the increase in average FICO scores is also a reflection of the relatively benign macro-economy to which consumers have been exposed in recent years, according to Goldman. Past payment history is the largest driver of most credit score formulas, and low current delinquency rates help drive credit scores higher even if these low rates of delinquency are partly explained by the strong economy.
With these two considerations in mind, Goldman cautions that in light of the strong economy and lack of a (recent) stressful economic scenario, with unemployment rates now below 4%, high credit scores for 2019 vintage borrowers might overstate credit quality.
Echoing this point, Cris deRitis, Moody's deputy chief economist said that "borrowers with low credit scores in 2019 pose a much higher relative risk. Because loss rates today are low and competition for high-score borrowers is fierce, lenders may be tempted to lower their credit standards without appreciating that the 660 credit-score borrower today may be relatively worse than a 660-score borrower in 2009.”
"Borrowers’ scores may have migrated up, but inherently their individual risk, and their attitude towards credit and ability to pay their bills, has stayed the same. You might have thought 700 was a good score, but now it’s just average," deRitis continued.
Indeed, despite the record high average FICO score, cracks are already starting to show on the surface: there has been a rising number of missed payments by borrowers with the highest risk, despite the past decade of "growth". And now that the economy is starting to show weakness, these delinquencies could accelerate and lead to larger than expected losses.
Ethan Dornhelm, vice president of scores and predictive analytics at FICO doesn't seem to notice score inflation and blames the issue on underwriters: “The relationship between FICO score and delinquency levels can and does shift over time. We recognize there’s a lot more context you can obtain beyond a consumer’s credit file. We do not think that score inflation is the issue, but the risk layering on underwriting factors outside of credit scores, such as DTI, loan terms, and even trends in macroeconomic cycles, for example.”
Marketplace and peer to peer lending has also been showing signs of stress. Missed payments and writedowns increased last year, according to NY data and analytic firm PeerIQ. "We don’t see the purported improvement in underwriting just yet," PeerIQ wrote in a recent report.
And the pressure isn't just showing up in auto loans and marketplace lending. Private label credit cards, those issued by stores, instead of big banks, saw the highest number of missed payments in seven years last year. “As an investor it’s incumbent on you to do that deep credit work, which means you have to know as much as possible about how things should pay off or default", said Michelle Russell-Dowe, who invests in consumer asset-backed securities at Schroder Investment Management. "If you don’t think you’re being paid for the risk, you have no business investing in it."
Of course, with FICO scores rising to new all time highs, it is only logical to expect that virtually no underwriter will actually bother to understand the underlying credit risk(s), which is also why consumers will likely be saddled with even more debt just as the broader economy is set to turn. The only question is whether such inflation FICO scores will be the catalyst behind the next debt-driven meltdown.