LO 33.5: Discuss the key variables in a mortgage credit assessment and describe the use o f cutoff scores, default rates, and loss rates in a credit scoring model.
In assessing an application for mortgage credit, the key variables include:
FICO score: a numerical score serving as a measure of default risk tied to the borrowers credit history. Loan-to-value (LTV) ratio: the amount of the mortgage divided by the associated propertys total appraised value.
Debt-to-income (DTI) ratio: the ratio of monthly debt payments (mortgage, auto, etc.)
to the monthly gross income of the borrower. Payment (pmt) type: dictates the type of mortgage (adjustable rate, fixed, etc.)
Documentation (doc) types, which include:
(cid:31) Full doc. a loan which requires evidence of assets and income. (cid:31) (cid:31) No ratio: similar to stated income, employment is documented but income is not.
Stated income, employment is verified but borrower income is not.
The debt-to-income ratio is not calculated.
(cid:31) No income/no asset. Income and assets are provided on the loan application but are
not lender verified (other than the source of income).
(cid:31) No doc. no documentation of income or assets is provided.
C u t o f f S c o r e s
Cutoff scores represent thresholds where lenders determine whether they will or will not lend money (and the terms of the loan) to a particular borrower. As noted earlier, the higher the score, the lower the risk to the lending institution. Setting the cutoff score too low presents a higher risk of default to the lender. Setting the cutoff score too high may limit potential profitable opportunities by unintentionally eliminating low risk borrowers.
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Topic 33 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 9
Once the cutoff score is established, historical experience can be used to establish the estimated profitability for a specific product line and the associated loss rate. As estimates are made from longer time horizons (which hopefully capture a full economic cycle), a bank may adjust its cutoff score to maximize the appropriate balance between risk and profitability.
Banks are required by the Basel Accord to group their portfolios into subgroups that share similar loss attributes, with score bands used to differentiate the groups by risk levels. For each of these subgroups, banks are required to estimate the PD and the LGD. The implied PD is a by-product of the historical loss rate and the LGD such that if a portfolio has a loss rate of 3% with a 73% LGD, then the PD is 4% (i.e., 3%/75% = 4%).
S c o r e c a r d P e r f o r m a n c e