New Consumer "Payment Hierarchy"

Credit Card Bills Trump Mortgage Payments

I attended a private dinner this week where the featured speaker, a senior executive at FICO, offered a wide range of comments. Since the talk was off-the-record, I won't mention the individual's name, but the insights were fascinating.

In a nutshell, FICO is observing a sea change in how consumers prioritize their debts.

Twenty years ago, here's how it looked:

1. Mortgage
2. Car payment
3. Utilities
4. Credit Cards

Today, that hierarchy has literally been turned upside down:

1. Credit Cards
2. Car payment
3. Utilities
4. Mortgage

To say the least, this change has huge implications for housing, and the economy generally.

Two conclusions seem inescapable:

--The risk of continued mortgage defaults is quite high, especially in locations where homeowners are deeply underwater (i.e., their home is worth less than their mortgage). According to the executive, the % of underwater mortgages nationally is now 40%(!).

--The U.S. consumer is tapped out, and especially vulnerable to anything that makes installment debt (credit cards) less available and/or more expensive. Which is pretty much what's happening now.

When you're living off your credit cards, it's safe to say that any financial "cushion" you once had is already gone.

The executive was optimistic that the Federal Reserve was on top of things, and reacting appropriately to the economic crisis; less so that Congress would surmount politics, and spend and tax appropriately.

Silver Linings (Kind of)

Silver linings? The executive cited three (kind of):

--Per above, solving today's economic challenges isn't a question of knowing what to do -- there's actually a surprising consensus amongst policymakers about what's needed (I've noted this on previous posts). Rather, it's having the political resolve to do it (the ball's in Congress' court, not the Federal Reserve's).

--While the ranks of consumers with low FICO scores is swelling, so is the number of people with high FICO scores. The executive called this phenomenon a "flattening out of the bell curve"; the explanation is that many consumers are spending more conservatively, paring their debt, etc. as a result of the financial crisis.

--Everyone's mailbox is a lot emptier these days without all the junk mail, credit card solicitations (have you noticed?).

P.S.: It's too off-color for this blog, but Tom Wolfe has a hilarious, updated version of the "first base, second base" vernacular that every high school boy knows. FYI, "first base" is still kissing -- everything else is different. You'll have to read his novel, "I am Charlotte Simmons" to find out the rest.

FICO's Decline (& Fall?)

Credit Rating Agencies, Writ Small

As a long-time lender, I would always trade off fico for equity.

--email from Angelo Mozilo, Countrywide CEO (now charged with civil fraud), to a lieutenant

What exactly is Mozilo talking about?

Sub-prime lenders' growing concerns, circa 2006, that the size of a borrower's down payment was a much better predictor of their loan quality than their credit score as calculated by the Fair Isaac Corp. (now called "FICO").

As the housing boom wore on, such scores came to loom increasingly large in mortgage origination decisions -- much like the Triple-A ratings parceled out by Standard & Poor's and Moody's effectively became the "Good Housekeeping Seal of Approval" for trillions in mortgage-backed securities.

Unfortunately, the calculations made by both FICO and the credit rating agencies rested on the same, fatally flawed -- and for a time, very lucrative -- assumption: namely, just because something had never defaulted in mass numbers, it never would.

Un-unhh.

With respect to mortgage-backed securities, the prevailing mindset was that the risk of default to investors, always historically negligible, could be reduced even further by segregating the highest risk securities into discrete groupings or "tranches."

In FICO's case, the decision-making was at the level of the individual mortgagor (or borrower).

The fatal assumption? That consumers who had never defaulted on their debts, never would.

As now seems obvious, there's a big difference between paying your utility bills on time and owing, say, a couple grand on a few credit cards, and owing several hundred thousand (and perhaps much, much more) on a mortgage. On a house that's worth less than you owe. That you've got no equity in (and indeed, never did). When you've maybe lost your job, or are afraid you might. You get the idea . . .

Not surprisingly, the foregoing proved to be an especially combustible mix.

Lenders: 'Show me the money' (downpayment)

So now what?

At least at the moment, everyone's "back to basics":

--Only lend against good collateral, conservatively valued;
--Require borrowers to have some "skin in the game" (a sizable down payment);
--Carefully vet the borrowers' income and assets.

As Mozilo and other long-time bankers know -- and always knew, deep down -- it is those principles that are the foundation for high-quality mortgages -- not a third party's flawed, seal of approval such as FICO scores.

Mozilo's been called lots of things, but "dummy" isn't one of them (unless you count leaving behind incriminating emails).

Credit Score Pitfalls

Cash Buyers "Off the (Credit Score) Radar"

I can't say I've run into any as clients, but an article in today's Wall Street Journal makes the counter-intuitive point that simply not using credit -- as opposed to using it irresponsibly -- can lower your credit scores ("Credit Score Pitfalls of the Wealthy").

As the article notes, Fair Isaac, the company that devises the credit-scoring formula (hence the acronym, "FICO scores"), weights not just how responsibly people use credit, but how much credit they have. Basically, the more, the better (an exception: having lots of unexercised lines of credit is a demerit).

So, someone who's quite wealthy but credit-averse -- presumably, they pay cash for everything -- would likely have only a good, not great credit score.

I actually encountered a prospective client years ago who didn't have a credit score. That's not unusual for someone college-age, but this woman was in her late 40's.

It turns out that she had never had a credit card, borrowed to buy anything, or even paid a utility bill. As I quickly learned, she had lived in a rural area with immediate family most of her life, and never made any of the purchases "modern consumers" take for granted!

(And yes, it's tough to get a mortgage without a credit score: I put her in touch with several lenders, who all suggested she get a cheap cell phone or make some other nominal purchase to start the credit score process, then try again in six months. Pretty much, that was the last I heard from her!)