more than just soft information is lost when lenders rely on generic credit scores. Practical obstacles — and in some cases political considerations — exclude from the scores factors, such as income and education, that self-evidently affect creditworthiness. Moreover, score-based lenders, like Friedrich Hayek’s central planners, rely on “statistical information” that ignores “crucial circumstances of time and place.” From their far-away perch, they cannot recognize substance abusers, nor can they distinguish workers in plants scheduled to close from judges with lifetime tenure.
He argues that we need more traditional banking, involving credit judgment and originate-to-hold, and less securitization using credit scores. My thoughts.
1. Although in theory underwriting judgment could lead to wise decisions to over-ride credit scores, in practice I do not think this happens. Human underwriters are not geniuses. And they do not necessarily know when the information they have is really news to the scoring system. Maybe the scoring system does not explicitly know that someone is a substance abuser, but it may nonetheless observe behavior that reflects that substance abuse. I believe that judgmental over-rides tend to lead decisions that are worse, not better.
2. As Bhide points out, some of the shift toward originate-to-distribute was influenced by capital regulations.
3. In mortgages, the private securitization market remains pretty dormant. That is, without a guarantee from Freddie and Fannie, investors are reluctant to buy mortgage securities just based on loan-to-value ratios and credit scores.
4. I think that for bank regulation, stress testing is the least bad way to promote safety and soundness. Stress tests for mortgage portfolios should include scenarios of falling house prices. Stress tests for consumer portfolios should include rising unemployment.