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1.3.4.3 Do Creditors Know How to Price Risk?

The evidence that the industry was ever good at sorting borrowers into “risky” and “not-so-risky” categories is slim at best.264 Particularly in the subprime market, price and risk do not correlate closely. A California study found that 60% of subprime borrowers believed they had good or excellent credit.265 In 2005 borrowers with FICO scores of 700 or higher who found themselves in the subprime market paid 0.29 percentage points more than borrowers in the prime market with FICO scores below 600.266 Lenders’ reliance on credit scores to determine risk may also be misplaced. Evidence suggests that credit scores have become less predictive of default risk.267

Footnotes

  • 264 {190} See, e.g., Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15 Hous. Pol’y Debate 533 (2004) (one percentage point of the risk premium paid by subprime borrowers could not be explained by the borrowers’ credit risk attributes). See Susan Wharton Gates, Vanessa Gail Perry & Peter M. Zorn, Automated Underwriting in Mortgage Lending: Good News for the Underserved, 13 Hous. Pol’y Debate 369, 380 (2002) (automated underwriting predicts performance better than manual or discretionary underwriting); A.C. Sullivan, Competition in the Market for Consumer Loans, 36 J. Econ. & Bus. 141, 148 (1984) (“The extent of risk segmentation of the consumer loan market appears to be dictated by the structure of rate ceilings.”). See also Eisenbeis & Murphy, Interest Rate Ceilings and Consumer Credit Rationing, a Multivariate Analysis of a Survey of Borrowers, 41 S. Econ. J. 115, 122 (1974) (“[T]here is little evidence to support hypothesis of market risk segmentation.”); Goudsward, Consumer Credit Charges and Credit Availability, S. Econ. J. 214, 217 (Jan. 1969) (“A systematic comparison of borrowers at low and high rate lenders shows little difference between them based on their risk characteristics.”); Boczar, Purdue Univ., Credit Research Ctr., Working Paper No. 9, Competition Between Banks and Finance Companies (1970) (“[T]he evidence on borrower characteristics does not support the risk segmentation hypothesis.”).

  • 265 {191} Kevin Stein & Margaret Libby, Cal. Reinvestment Comm., Stolen Wealth: Inequities in California’s Subprime Mortgage Market 21–22 (Dec. 2001).

  • 266 {192} Marsha J. Courchane, The Pricing of Home Mortgage Loans to Minority Borrowers: How Much of the APR Differential Can We Explain?, 29 J. Real Est. Res. 399, 415, 417 (2007).

  • 267 {193} Kurt Eggert, The Great Collapse: How Securitization Caused the Subprime Meltdown, 41 Conn. L. Rev. 1257, 1289–1291 (2009).