When considering the credit quality of a mortgage pool, it behooves investors to beware of weighted average FICO scores, which can be misleading, warns Moody's Investors Service.
"Once FICO scores deviate substantially from the mean, which is usually the case in today's mortgage pools, relying on the weighted-average FICO score when making an investment may result in a poor decision," said Henry Engelken, a Moody's analyst.
To just know the "average," he said, is not enough, maintaining that the key is knowing the distribution of the scores. Engleken went on to explain that "mortgages with low FICO scores increase the risk much more than those with high FICO scores reduce the risk."
For example, a pool of six loans, all with a FICO score of 700, would of course have an average-weighted FICO of 700. Similarly, despite its differing constitution, a six-loan pool containing two loans with 600 FICO scores, two loans with 800 FICO scores and two loans with 700 FICO scores would have the same average weighting.
However, according to Moody's, the two pools do not present the same amount of risk. "The actual risk of this pool is much greater than the perceived risk based only on the pool's weighted-average FICO score," said Engelken, noting that the increased risk stems from the percentage of bad loans represented by the various FICO scores.
Moody's said a 700 FICO score represents one bad loan in 62 with odds of 1.59%. A 600 score represents one bad loan in 12 with odds of 7.69%. (A "bad" loan is defined as at least 90 days or more past due.)
As can be seen, as the FICO score drops, the percentage of bad loans climbs fast. For the aforementioned example of a six-loan pool where the distribution contains the two 600 FICO loans and the two 800 FICO scores, the percentage of bad loans is 3.14%, or "nearly two times the likelihood of getting a bad loan compared with the first, 700-FICO-only pool, according to Moody's findings.
Engelken calculated what he terms a distribution-adjusted FICO score. For the second pool, even though the weighted average FICO is 700, the distribution-adjusted FICO is 660, while for the first pool the distribution-adjusted score is the same as the weighted-average FICO score of 700.
According to Moody's, typical pools of jumbo mortgages, Alternative A loans and high loan-to-value loans carry weighted-average FICO scores between 675 and 725. Yet those same pools contain loans with FICO scores below 600.
Further, since subprime pools carry weighted-average FICOs between 575 and 600, they are more affected because credit risk escalates very rapidly below 600. For example, a FICO of 550 represents one bad loan in seven, or odds of 12.50%.
Engelken said FICO scores are like electric saws: They can improve efficiency but improper use can lead to dire consequences. - ES