The credit scoring blind spot – Macroeconomics

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In February 2016, about six months after rating a securitization, Moody’s found “faster buildup of delinquencies and charge-offs than expected” in the pool of Prosper loans backing the ABS. Experts had noticed deterioration months earlier…pundits discerned a signalinsights followed—macro trend…credit cycle…borrower stress. But then in July, Moody’s decided there was “absence of substantial deterioration”.  So, what about that borrower stress?  Well, it’s back.  In its October 8-K filing, Lending Club observes “Higher delinquencies are more evident in 2015 and early 2016 vintages, which coincides with an uptick in consumer indebtedness in the U.S.”.  And the pundits are considering the evidence.

WAIN Street’s analysis of over a million loans originated by a leading marketplace lender between January 2012 and June 2016 shows that median credit scores have been flat and even increased slightly since Q1 2014.

creditscoringblindspot-fico-20120131-20160630
Median origination credit score by quarter.

How does one reconcile increasing delinquencies and stable credit scores?

First, don’t blame the credit scores.  They are not designed to provide an absolute statement of risk but rather a relative assessment within a population of borrowers.  The actual level of defaults is influenced by economic conditions.  Not convinced.  Just look at default rates for various credit score bands before, during, and after the Great Recession.  For the same credit scores, defaults nearly doubled during the Great Recession.

Second, look at economic conditions.  WAIN Street’s Very Small Business Default Index has been validated as a leading gauge of consumer confidence, spending, and defaults.  The data are clear—things started to deteriorate in Q4 2014.

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Quarterly default rate of very small businesses. Universe includes sole proprietors and businesses with fewer than 20 employees.

Third, link individual  borrowers to economic conditions.  We assigned each loan to a Local Economic Vitality band based on data current as of the origination date and examined the loan mix for the eighteen quarters. The proportion of loans originated to borrowers from economically stronger locations peaked mid-2014 and has been declining since then.

Log ratio of loans assigned to “Better” versus “Worse” Local Economic Vitality bands based on borrower’s location. A value of 0 corresponds to an equal number of loans to borrowers in Better and Worse locations. Positive (negative) values correspond to greater (fewer) loans to borrowers in Better locations.

And that is the blind spot.  From a credit scoring perspective, things were stable.  But credit scores do not fully reflect the impact of economic conditions on portfolio performance.  Thus, increasing delinquencies during stable credit scores.  To avoid being blindsided, we can use WAIN Street’s Local Economic Vitality data to monitor origination mix and benchmark portfolio composition.

The complete article is available here: The credit scoring blind spot – Macroeconomics.