Every year, my wife and I spend Labor Day with close friends. In our younger years, these visits were raucous. But as we’ve aged, the routine has mellowed. We relive the glory days. We play “who has the weirdest ailment.”
And we rewatch The Big Short.
In the film, one of my favorite scenes dramatizes a frustrated investor’s visit to S&P, the well-known ratings agency. At one point, the investor pushes: “Have you ever refused to rate any of these bonds’ upper tranches triple-A?”
S&P’s response? “If we don’t give them the ratings, they’ll go to Moody’s, right down the block.”
It’s understandable. And it’s dumb.
As an issuer, if I was paying for a rating, if I had at my disposal multiple agencies from which to choose, if I had insight as to the ratings I would receive – if those stars aligned, why on earth would I pay for the worst rating on the block? I’d shop for the best deal I could find.
Only a madman would think this the optimal arrangement for dispassionate, objective risk assessment.
Maybe the FHFA has gone mad.
Just last month, the GSE regulator expanded lenders’ ability to sell to Fannie and Freddie loans scored by a FICO alternative – VantageScore.
In and of itself, good. Great. Grand. Wonderful.
But a closer read reveals the absurdity: those same lenders get to “determine which credit score model … to use on each loan they deliver.”
Read that again. The lenders themselves select which model to use. A “choose your own adventure” of sorts.
Presumably FHFA Director Bill Pulte and his colleagues are hip to the obvious risks. In its public guidance, FHFA commits to “assess, develop, and implement risk mitigants, as appropriate, to ensure ongoing safety and soundness.”
They’ve certainly used all the right words. But FHFA must also walk the walk: it must address the perverse incentive lenders will have to shop for credit models. Otherwise, Fannie and Freddie won’t be buying loans with “a credit score of 700” – they’ll be buying loans with “a handpicked credit score of 700.”
Think this is purely theoretical? Think again. The Wall Street Journal reported just yesterday that United Wholesale Mortgage, one of the nation’s largest originators, “said it would pull both scores and use the higher one” in response to FHFA changes.
Competition and innovation in credit analytics aren’t bad. Those who build commercial risk models should continually polish their lenses. But when we allow originators to shop for scoring models loan by loan, those lenses become as objective and trustworthy as beer goggles.
Take it from me: I’ve been watching this movie for over a decade. And the ending has never changed.