President Obama’s effort to reform the banking system doesn’t address the system’s biggest problem, which is how consumer credit is underwritten in the United States.
Without exception, no material consumer loan is made in America without the borrower’s credit bureau first being polled by prospective lenders and a credit score used to classify the borrower as good, bad or middle risk. Credit scores are supposed to accurately predict the probability of default by consumers, but in practice, credit scores don’t predict much of anything. Banks blindly rely upon the junk put out by consumer credit rating agencies and are getting burnt by ignoring the most basic rule of underwriting, which is to know their customer. While banks know borrowers' credit scores and information on the credit report, that isn’t the same thing as knowing their customer or things like their customer’s assets, liabilities and earning power.
Every bank, regulator, non-bank entity and institution such as Freddie Mac (FRE) and Fannie Mae (FNM) instantly thinks that they know their borrower simply by being told a three digit credit score. Credits scores under 650 are a problem, over 720 is to be good and around 670…well…maybe marginally OK.
If anyone wonders whether or not the system blindly relies on credit scores, just try to get a loan to buy a house or car or apply for a credit card without the bank pulling a credit report and a credit score. Without a credit score, the loan won’t happen, and if people want to live in the United States they don’t have a choice but to submit to the power and will of the consumer credit rating agencies. Imagine trying to get a loan at the “best interest rate” with a credit score of 600. It doesn’t make a difference if the credit score is wrong or based upon erroneous information, the loan just isn’t going to be made. Without exception, credit scores are the ticket to the dance of consumer credit in America.
It is amazing how everyone is ignoring the fact that the single common thread connecting every defaulted consumer and mortgage loan is that each borrower had their credit evaluated by the consumer credit rating agencies and a loan was made based upon the score.
Of course, in the case of sub-prime mortgages, lenders should have understood their risk. After all, the words “sub-prime” refer to the prospective borrower’s poor credit score, which is below average and therefore not “prime”. However, it’s hard to explain why there are more delinquencies and defaults in prime mortgage pools, i.e., pools of mortgages where the individuals had good credit scores, than in sub-prime mortgage pools.
Clearly, something is wrong and the system is broken.
The current system has two obvious big problems.
· Garbage in/garbage out credit scoring – Credit scores are only as good as the information that is used for calculation. If the information is wrong, then the credit score will be wrong. Very often the information used to calculate credit scores has one or more errors, and over time the cumulative effect of bad information destroys the usefulness of credit scores for many if not most Americans.
As an example, I have a close friend whose credit score recently went from the high 700s to the low 700s despite her credit improving. The reasons that the credit score went down are because she decided to save money and pay cash for a recent car purchase.
This particular individual is a saver, not a spender. About a year ago she had cash on deposit at a failing money center bank that was far in excess of the then applicable FDIC insurance limits. My friend decided that it was prudent to spread her cash around a bunch of banks so that all of her bank deposits would be insured by the FDIC.
She went to four other banks to open new savings accounts and each bank told her they needed to “run a credit inquiry” as a condition to accepting her money. They never really explained why depositing cash in a bank required the scoring of a depositor’s credit; after all, by depositing money in a bank, my friend was lending money to the bank and not the other way around. The inquiries were reported by every bank as if my friend had applied for revolving consumer credit rather than having deposited $100,000 at the bank. As a result, my friend’s credit bureau showed inquiries from a number of banks and each inquiry lowered her credit score.
Six months ago my friend decided to purchase a new car for her son. She paid for the car with a check, i.e., she didn’t apply for a loan and paid “cash”. The car dealer “ran a credit bureau” on my friend before accepting the check. This credit inquiry showed up on the credit report as an outstanding automobile loan for the amount of the car with no reported payment information. Again, my friend’s credit score went down.
The only other “new item” on my friend’s credit bureau was a disputed account for $128. This amount was reported by a medical laboratory that attempted to overcharge my friend for a medical test and then used the threat of reporting the $128 amount to the credit rating agency as a tool to extort the payment.
My friend’s family income is in excess of $1 million per year and she and her husband have no reported mortgage debt and revolving credit outstanding of less than $25,000. Obviously, since there are large savings on deposit at various banks my friend has lots of liquidity and large cash balances.
Her FICO score, as reported yesterday by Equifax (EFX), was 710 and is down from approximately 780 a year ago.
This week there was a real cost to my friend from the lower credit score. She bought another new car and was excluded from a promotional interest rate offered by the manufacturer because the cutoff for the lowest interest rate was 720.
Garbage in/garbage out credit scoring dropped what should have been in excess of an 800 credit score to 710. Bad information used to calculate credit scores isn’t an isolated phenomena and is causing consumers, in the aggregate, to pay billions more in interest to banks than is justified by their risk.
Of course, we only hear about credit scores that are too low because the credit rating agency messed up, never about scores being too high. So, when bank analysts wonder how consumers with prime credit scores can be defaulting on their mortgages as if they were sub-prime borrowers, keep in mind that for every mistake that incorrectly lowers a credit score there is an unreported mistake that raises a credit score. And when banks blindly approve consumer credit based upon credit scores, they are just kidding themselves when they think they have an underwriting process with integrity, or that they know their customer, which is the most basic rule of good underwriting.
· No one knows how the credit scores are calculated and the consumer credit rating agencies are shrouded in a veil of secrecy – The consumer credit rating agencies operate in a shadowy world of non-accountability and anonymity. They are as hard to penetrate as the Pentagon and more secretive than the CIA. The three for-profit companies determine the cost of credit for virtually all Americans, yet virtually no one knows who runs them or how they operate. And if the consumer credit rating agencies make a mistake, like when one of them gave out my information to a scamster last year, they are immune from both prosecution and accountability.
It seems like consumer credit rating bureaus act in concert, like a cartel oligopoly, with little of substance to distinguish their products and services. Consumers aren’t given a choice as to whether or not to participate in the consumer credit rating agency process. If someone decides not to participate they have effectively excluded themselves from the banking system, insurance companies and many jobs. People who want out of the consumer credit rating agency system need to move to another country or go to jail (there isn’t a lot of need for credit in prison). Consumer credit agencies determine the cost of our debt, where we can live and who we can work for, without our consent or approval and without any reasonable supervision.
The three consumer credit rating agencies protect their “formulas” for calculating credit scores like it is the secret to eternal life with the certainty that everyone will be instantly turned to stone if the secret gets out. When something is a secret it usually means that there is no accountability and no way to find out or correct errors. And, when financial products and services are protected under a Burka, history teaches that sooner or later major problems happen.
For example, what if my friend’s credit score was just calculated incorrectly, i.e., the inquiries and cash purchase of a car were reported correctly but just coded wrong by the credit rating agencies? How would anyone know and how would she be able to fix it? What is to prevent an entire class of people from being discriminated against (like immigrants, blacks or just people who live in a certain zip code)? And how would anyone know if there was a conspiracy to lower credit scores so that banks could justify higher interest and fees?
Consumer credit bureaus are used by businesses and banks as a semi- governmental and authoritative source of accurate information and authoritative analysis. Unfortunately, more often than not consumer credit rating agency information is wrong and misused.
If President Obama wants to enact serious reform, then fixing consumer credit rating agencies and overreliance on credit rating scores is the place to start. After all, the single most important common thread in the current credit and banking crisis is that every single defaulted mortgage file has in it a credit rating score that was assumed to have the authority of a biblical pronouncement.
The days of automated consumer underwriting based upon computer models that use bad information from credit bureaus and wrong credit scores need to end.