Did Inaccurate Credit Scores Cause Subprime Crisis?

Over on Linked In, Sailaja Sivalenka asks a good question:

Recently, I have come across a few articles that state the reason behind the subprime crisis in USA to be the result of inaccurate credit scoring which could not sufficiently predict subprime default risk.

But, Dr. Makr Greene, CEO of Fair Isaac, in his interview says it is wrong to blame the credit rating agencies.

What are your thoughts on this subject?

Inaccurate credit scores may be part of the problem, but you don't need that theory to explain subprime lending errors.

The biggest problem is out-of-sample estimation problems. If you look at the performance of subprime borrowers when 1) the housing market is strong, and 2) there is very little subprime lending going on, and then you extrapolate to an economy where these conditions are not met, you're taking on huge risk.

You could lend to a dog when the housing market is booming and not get burned; the dog wouldn't make any payments, but he could either flip the house for a profit. In worst case scenario (heart worms, distemper) the lender forecloses and sells the house for a price above the mortgage balance. No problems.

Condition 2: When few subprime loans are being made, they were probably to the best of the subprime lot. Two people with identical FICOs have different stories; one's low score is due to an accident or hospitalization, but the person is bouncing back. Another person with the same FICO is just irresponsible. In early days, I think that lenders found the first type of subprimes. As the housing market boomed, lenders widened their search for customers to the second kind.

Here's a simple way to think of it: think of an X-Y graph with some data points and a line fitted through the points:

You should be skeptical of your estimate of the slope of the line if you are looking at data points outside of the range of data over which the line was estimated. You may very well be looking at a very different shape when you look at a wider range of data:

Comments

[ValuationGuy]

credit scores were not the problem-scores like FICO & Vantage Score predict the likelihood that a consumer will repay their debt - not their ability to repay their debt. The single greatest cause of this mess from the lenders standpoint was the lax underwriting guidelines and the lack of income/asset verification.

[the gugg]

If you belive every rumor out there, then I would qustion motivation. Clearly the blame game is the blogers forum. I worked in this industry, it had nothing to do with scores. It had everything to do with greed. The investment banks found conduits for risky paper, and less then ethical people sold as gold.

[HumptyDumpty]

If this theory is to be used then the creditors i.e credit cards, collection companies, mortgages etc who report to the Bureau (repository) are to blame. The FICO is a snapshot at a particular point in time based on raw data reported by the creditors. This could be an interesting argument based on the fact that the secondary market had so much confidence in empirical data

[the finalhorseman]

hell....dont believe anyone about anything.

somebody out there made a freaking fortune when JPM came out with their lies about BSC and suddenly raised the stakes to $10. how many insiders were there on this?