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Did credit scores predict the subprime crisis?

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R E F E R E N C E S Demyanyk, Yuliya and Otto Van Hemert. “Un- derstanding the Subprime Mortgage Crisis.” Working paper (2008), available at the Social Science Research Network. See abstract=1020396. Fishelston-Holstein, Hollis. “Credit Scoring Role in Increasing Homeownership for Under- served Populations.” Working paper, Harvard University, 2004. See publications/finance/babc/babc_04-12.pdf. 500-600 600-620 620-675 675-700 >700 25 20 15 10 5 0 200720062005 SE RI OU S DE LI NQ UE NC Y RA TE ( % ) SOURCE: Author’s calculations based on First American CoreLogic LoanPerformance data OnE YEAR AFtER ORiginAtiOn bY FivE CREdit SCORE gROUPS Serious Delinquency Rate of Subprime Loans m o r t g a g e s A credit score measures the creditworthi-ness of individuals or businesses. Lenders increasingly use these scores to assess credit risk; they also use them to calculate how likely it is that borrowers eventually will be delin- quent (late with payments) or in default. By design, the higher the score, the less likely it is that a borrower will miss payments or go into default on a loan within one or two years after the score has been calculated. Bill Fair and Earl Isaac developed the first commercial credit scoring system in 1958. A credit score based on this system has developed into a FICO (Fair, Isaac and Co.) score, and it became a standard measure of consumer credit risk in 1989. Fannie Mae and Freddie Mac rec- ommended the FICO score for use in mortgage lending in 1995. The data for individual credit scores come from the three national credit bureaus and contain information—positive and negative—about how the potential borrower is using credit now and how he has used it in the past. Given the nature of FICO scores, one might expect to find a relationship between bor- rowers’ scores and the incidence of default and foreclosure during the ongoing subprime mortgage crisis.

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