Credit score inflation throws a wrench into the calculation of credit risk.
By Wolf Richter for WOLF STREET.
A miracle of American consumerism has happened during the pandemic, the era of mortgage forbearance, student loan forbearance and rent moratoriums, and free money sent to consumers via stimulus checks and PPP loans: credit rating inflation.
Of the total number of auto loans and leases outstanding in the second quarter, the share of borrowers with “deep subprime” credit scores (credit scores of 300 to 500 on Experian’s credit rating scale) increased fell from 4.3% in 2017 to a share of just 1.9%, according to Experian’s report on the state of the auto finance market for the second quarter of 2022.
This means that the majority of high-risk borrowers with auto loans have improved their credit ratings and moved to higher categories. For example, a deep subprime borrower might have upgraded their credit score from 450 to 520, moving into subprime.
Of the total number of auto loans and leases outstanding, the share of borrowers with subprime credit ratings (credit scores of 501-600) fell from 18.5% in 2017 to a share of 14.5% in Q2 2022 (red line in the table below). This means that many subprime borrowers have improved their credit scores and moved on to higher categories.
As expected, the share of “near-subprime” (credit score of 601-660), which many subprime borrowers and some deep subprime borrowers settled into, increased from 17.5% in 2017 to an 18.4% share in the second quarter, according to Experian (green line in the chart below).
Of the total number of outstanding auto loans and leases, the share of borrowers with “prime” credit ratings (credit scores of 661 to 780) fell from 40.2% in 2017 to a share of 45.7 % in the second quarter of 2022, as many quasi-subprime and subprime borrowers have moved into this category.
But the share of “super prime” borrowers (credit scores of 781 to 850) remained roughly stable with 2017:
An incredible marvel. But how did this happen?
Student loan forbearance. Starting March 2020, all federal student loans were automatically enrolled in forbearance programs. Loans pending forbearance are no longer considered “delinquent”, regardless of their degree of delinquency. And the federal student loan delinquency rate plunged from around 10% in 2019 to 0%.
In other words, when it comes to credit scores, these delinquencies among federal student loans have been corrected and this has improved borrowers’ credit scores, although they have actually made no payments.
Private student loans did not participate in the forbearance, and the remaining delinquencies are concentrated among them.
Additionally, since these forborne student loans were frozen, earning no interest, and borrowers were not making payments, borrowers could use the money from unmade loan repayments to catch up with d other bills, 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 loans have been taken out under forbearance programs. Delinquent mortgages in forbearance did not count as delinquent, which cured the delinquency on credit reports.
Also, borrowers didn’t have to make any mortgage payments during the forbearance period and could spend the money on other things, like getting caught up on their other debts and fixing those defaults.
Most mortgages have now come out of forbearance and given the surge in house prices over the period, as a last resort borrowers could generally sell the home and pay off the mortgage.
Moratoriums on rents allowed tenants to divert funds from rent payments to other causes and catch up on bills and car payments.
Plus waves of government moneyfrom stimulus payments to PPP loans, have spread across the United States, allowing people to catch up on their debts.
As a result, crime rates have plunged to record highs during the pandemic for car loans, credit cards, mortgages, student loans and other consumer loans. Third-party collections and bankruptcies also plunged to historic lows. And credit scores began to rise.
Credit score inflation throws a wrench into the calculation of credit risk.
But credit scores haven’t improved because American borrowers have suddenly become far more responsible. They have improved due to the momentum that has cured delinquencies on credit reports.
But those dynamics were pandemic promotions that cleaned up the credit reports of millions of Americans who now appear to have made their payments on time and appear to have caught up on their payments, when in fact it was mass forbearance that produces this effect. , as well as stimulus payments that aren’t supposed to recur.
And that’s a problem for lenders. Lenders use credit reports and credit scores to assess a borrower’s credit risk, that is, their likelihood of defaulting on their debts in the future. The assumption is that past defaults are predictors of future defaults.
Lenders charge higher interest rates to compensate for higher credit risks. Subprime-rated customers borrow at higher rates than prime-rated customers because lenders face a higher risk of credit losses – similar to corporate junk bonds. But credit score inflation now throws a wrench into the equation and turns the already dodgy credit score system into an even less reliable predictor of credit risk.
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