One would think that credit scores would be a predictor of who would default on a subprime mortgage. But that doesn't seem to be the case.Subprime mortgage ; Credit scoring systems

Yuliya Demyanyk

English

Research Papers in Economics

REFERENCES
Demyanyk, Yuliya and Otto Van Hemert.  “Un-
derstanding the Subprime Mortgage Crisis.”  
Working paper (2008), available at the Social 
Science Research Network.  See ssrn.com/
abstract=1020396.
Fishelston-Holstein, Hollis.  “Credit Scoring Role 
in Increasing Homeownership for Under-
served Populations.”  Working paper, Harvard 
University, 2004.  See www.jchs.harvard.edu/
publications/finance/babc/babc_04-12.pdf.
500-600 600-620   620-675   675-700   >700  
25
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2007 2006 2005
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SOURCE: Author’s calculations based on First American CoreLogic 
LoanPerformance data
OnE YEAR AFtER ORiginAtiOn bY FivE CREdit SCORE gROUPS
Serious Delinquency Rate of Subprime Loans   
mortgages
A 
credit score measures the creditworthi-
ness of individuals or businesses.  Lenders 
increasingly use these scores to assess credit 
risk; they also use them to calculate how likely 
it is that borrowers eventually will be delin-
quent (late with payments) or in default.  By 
design, the higher the score, the less likely 
it is that a borrower will miss payments or 
go into default on a loan within one or two 
years after the score has been calculated.
Bill Fair and Earl Isaac developed the first 
commercial credit scoring system in 1958.  A  
credit score based on this system has developed 
into a FICO (Fair, Isaac and Co.) score,  and it 
became a standard measure of consumer credit 
risk in 1989.  Fannie Mae and Freddie Mac rec-
ommended the FICO score for use in mortgage 
lending in 1995.  The data for individual credit 
scores come from the three national credit 
bureaus and contain information—positive 
and negative—about how the potential 
borrower is using credit now and how he has 
used it in the past. 
Given the nature of FICO scores, one might 
expect to find a relationship between bor-
rowers’ scores and the incidence of default 
and foreclosure during the ongoing subprime 
mortgage crisis.  Analysis suggests, however, 
that FICO scores have not indicated that 
relationship:  Default rates have risen for all  
categories of FICO scores and, moreover, 
higher FICO scores have been associated with 
bigger increases in default rates over time.  
Delinquencies and Defaults in  
the Subprime Mortgage Crisis
The subprime mortgage market boomed 
during the first six years of the decade and 
collapsed in 2007.  Many borrowers with 
subprime mortgage loans could not make 
timely monthly payments and defaulted on 
their loan contracts only 
months after their loans 
were originated in 2006 
or 2007.  More precisely, 
18 percent of loans that were 
originated in 2006 and 14 percent 
of loans that were originated in 2007 
were either past due for more than two 
months or were already in foreclosure within 
one year after the loans were originated.  In 
comparison, only from 2 to 6 percent of loans 
originated in years from 2001 to 2005 were 
delinquent or in foreclosure during the first 
year after origination. 
Researchers, policymakers and the media 
have offered many explanations for this crisis.
Did Credit Scores Predict 
the Subprime Crisis?
By Yuliya Demyanyk
the term “subprime” describes a loan that in some way is worse than a prime loan.  Bor-
rowers may find these loans worse because of high interest rates or high fees that lenders 
charge.  Lenders also may charge exorbitant penalties for late payments or pre-payments.   
a subprime loan is worse in the eyes of a lender because it is considered riskier than a prime 
loan—riskier because there is a greater chance the loan will never be repaid—so lenders 
require those higher rates and fees to compensate for an extra risk, compared to prime loans.  
and, it can be worse for everybody and for the economy overall if the risk does materialize.  
a loan can be called subprime if: 
•	it	is	made	to	a	borrower	with	a	poor	credit	history	(such	as	a	FICO	score	below	620);
•	it	is	issued	by	a	lender	who	specializes	in	high-cost	loans;	
•	it	became	part	of	a	so-called	subprime	pool	of	loans,	to	be	traded	on	a	secondary	 
market;	or
•	it	is	made	to	a	borrower	with	“prime”	credit	characteristics	(e.g.,	a	high	FICO	score)	but	is	a	
subprime-only	contract	type,	such	as	a	2/28	hybrid,	a	product	not	generally	available	in	the	
prime	mortgage	market.		(A	2/28	hybrid	mortgage	carries	a	fixed	rate	for	the	first	two	years;	
after	that,	the	rate	resets	into	an	index	rate	[usually	a	six-month	LIBOR]	plus	a	margin.)
borrowers to refinance into larger loans and 
take out cash, basically taking out the equity 
from their homes and spending it.  Nega-
tive equity could lead to default.  A third 
popular explanation involved loosening the 
underwriting standards.  If borrowers did 
not pay any down payments, they had noth-
ing to lose in case of adverse personal or 
economic circumstances, which could make 
defaults almost costless.
A paper written in 2008 by Yuliya 
Demyanyk and Otto Van Hemert shows 
that contrary to popular beliefs described 
earlier in this article, the subprime crisis 
did not confine itself to a particular market 
segment, such as no-documentation loans, 
hybrid loans, cash-out refinance loans, etc.  
It was a (subprime) market-wide phenome-
non.  For example, borrowers with mort-
gages that carried a fixed-interest rate—the 
rate that will not reset through the entire 
term of a loan—had very similar problems 
to borrowers with hybrid mortgages.  Bor-
rowers who obtained a subprime mortgage 
when they bought a home had the same 
problems in 2006 and 2007 as those who 
refinanced their existing mortgages to 
extract cash.  Borrowers who provided full 
documentation and no documentation fol-
lowed the same pattern.
Demyanyk and Van Hemert also show 
that throughout the boom and subsequent 
collapse of the subprime mortgage market, 
borrowers with low FICO credit scores were 
more likely to miss their mortgage payments 
or default on their loans.  However, as the 
data show, borrowers who took out sub-
prime loans in 2006 and 2007 had higher  
or similar FICO scores, not lower, than  
borrowers who took out their mortgages  
in earlier years.  
The figure shows how the serious delin-
quency rate has changed for five groups of 
borrowers who had different FICO credit 
scores when their loans were made.  Their 
mortgage loans were originated in 2005, 
2006 and 2007.  A mortgage loan is seriously 
delinquent if a borrower has missed more 
than two monthly payments, has defaulted 
on a loan or if the property has gone into 
foreclosure.  Each bar on the graph repre-
sents an origination year.  The height of 
each bar shows the percentage of loans that 
were seriously delinquent within the first 
year after the loans were originated.
The first 
explanation 
is the resetting 
of mortgage rates from low “teaser” rates 
into much larger adjustable rates for the 
hybrid mortgages.  With higher interest 
rates, monthly mortgage payments became 
larger; borrowers could not afford the new 
payments and defaulted on their loans.  The 
second suggested reason was a tendency for 
For each group of borrowers, with low 
and high FICO scores, loans that originated 
in later years had larger serious delinquency  
rates one year after origination.  Moreover, 
the higher the credit score, the larger 
the increase in serious delinquency rates 
between 2005, 2006 and 2007.  For example, 
for borrowers with the lowest credit scores 
(FICO scores between 500 and 600), the 
serious delinquency rate in 2007 was twice 
as large as in 2005—an increase of nearly 
100 percent over the two years.  For bor-
rowers with the highest credit scores (FICO 
scores above 700), the serious delinquency 
rate in 2007 was almost four times as large 
as in 2005—an increase of nearly 300 per-
cent.  In addition, the serious delinquency 
rate in 2007 for the best-FICO group was 
almost the same as the rate in 2005 for the 
worst-FICO group.
The evidence presented above seems to 
suggest that the credit score has not acted as 
a predictor of either true risk of default of 
subprime mortgage loans or of the subprime 
mortgage crisis.  The subprime mortgage 
crisis is still a black box, and it requires more 
analysis to fully understand how the develop-
ments in the subprime mortgage market 
and a subsequent crisis have “subprimed” 
so many issues that used to be considered 
fundamental, like credit scoring. 
Yuliya Demyanyk is an economist at the Federal 
Reserve Bank of St. Louis.  For more on  
Demyanyk’s work, see http://www.stlouisfed.org/
banking/PDFs/CVs/Demyanyk_vitae.pdf.
Mortgage Loans Can Be Labeled  
Subprime for Many Reasons
12   The Regional Economist  |  October 2008 The Regional Economist  |  www.stlouisfed.org   13

Credit Scoring Role in Increasing Homeownership for Underserved Populations.” Working paper,

Mortgage Loans Can Be Labeled Subprime for Many Reasons 12 The Regional Economist |

Understanding the Subprime Mortgage Crisis.” Working paper (2008), available at the Social Science Research Network. See ssrn.com/ abstract=1020396.

Did credit scores predict the subprime crisis?

http://stlouisfed.org/publications/re/2008/d/pdf/mortgage.pdf

Did credit scores predict the subprime crisis?

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