Credit score inflation throws a monkey wrench into the calculus of credit risk.
By Wolf Richter for WOLF STREET.
A miracle in American consumerism occurred during the pandemic, the era of mortgage forbearance, student loan forbearance and rental moratoriums, and free money sent to consumers through stimulus measures and PPP loans: credit score inflation.
Of the total number of outstanding auto loans and leases in the second quarter, the share of borrowers with a “deep subprime” rating (credit scores of 300-500 on the Experian credit score scale) fell from 4.3% in 2017 to a share of just 1. 9%, according to Experian’s State of the Automotive Finance Market report for Q2 2022.
This means that the majority of deep-subprime auto loan borrowers improved their credit scores and moved into higher tiers. For example, a deep subprime borrower could have improved his credit score from 450 to 520, moving him to subprime.
Of the total number of outstanding car loans and leases, the share of borrowers with a “subprime” credit rating (credit scores of 501-600) decreased from 18.5% in 2017 to a share of 14.5% in the second quarter of 2022 ( red line in the table below). This means that many subprime borrowers improved their credit scores and moved into higher categories.
As you might expect, the share of “near subprime” (credit score of 601-660), which many subprime borrowers and some deep subprime borrowers went to, rose from 17.5% in 2017 to a share of 18. 4% in the second quarter. according to Experian (green line in the chart below).
Of the total number of outstanding auto loans and leases, the proportion of borrowers with prime credit ratings (credit scores of 661-780) increased from 40.2% in 2017 to a share of 45.7% in the second quarter of 2022, as many near-subprime and subprime borrowers have fallen into this category.
But the proportion of “super prime” borrowers (credit scores of 781-850) was roughly the same as 2017:
A miraculous miracle. But how did it happen?
Student loan tolerance. Beginning in March 2020, all federal student loans were automatically enrolled in forbearance programs. Understanding loans no longer count as “past due,” no matter how past due they were. And the federal student loan default rate dropped from about 10% in 2019 to 0%.
In other words, in terms of credit, those federal student loan arrears were cleared, and borrowers’ credit scores improved, even though they weren’t actually making payments.
Private student loans did not join the forbearance, and the delinquencies that still exist are concentrated among them.
In addition, since these forbearance student loans were shelved, accrued no interest, and borrowers who failed to make payments, borrowers could use the money from the unpaid loan payments to be made up in other accounts, which would further improve their credit scores.
The federal student loan forbearance program has been extended through December 31, 2022.
Mortgage Forbearance. Same principle here. Millions of home mortgages were taken out for tolerance programs. Delinquent mortgages in forbearance didn’t count as delinquent, which cured the credit report delinquency.
In addition, during the deferral period, borrowers didn’t have to make any mortgage payments and could spend the money on other things, such as catching up on their other debts and recovering those arrears.
Most mortgages have now come out of permissiveness, and given the rise in house prices over the period, borrowers were usually able to sell the house and pay off the mortgage as a last resort.
Rent moratoria enabled renters to divert money from rent payments to other targets and catch up on their bills and car payments.
In addition, waves of public moneyfrom stimulus payments to PPP loans, flooded the US, leaving people in debt.
As a result, defaults decreased pandemic lows in auto loans, credit cards, mortgages, student loans and other consumer loans. Collections from third parties and bankruptcies also fell to record highs. And credit scores started to climb.
Credit score inflation throws a monkey wrench into the credit risk calculation.
But credit scores didn’t improve as US borrowers suddenly became much more responsible. They improved because of the dynamics that healed delinquencies on credit reports.
But those dynamics were pandemic specials that cleared the credit reports of millions of Americans who now appear to have made their payments on time, and seem to have caught up with their payments, when in fact it was mass forbearance that caused that effect, along with incentive payments that haven’t. planned to come back.
And that is a problem for lenders. Lenders use credit reports and credit scores to evaluate a borrower’s credit risk – how likely they are to default on their debts in the future. The assumption is that past delinquencies are predictors of future delinquencies.
Lenders charge higher interest rates to offset higher credit risks. Subprime-rated customers borrow at higher rates than prime-rated customers because lenders have a higher risk of credit losses — similar to corporate junk bonds. But credit score inflation is now throwing a monkey wrench into the equation, turning the already questionable credit scoring system into an even less reliable predictor of credit risk.
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