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Obama Pressure on FICO Scores Revives Subprime Lending Risks

A few years after crisis, regulators switch to ‘more credit’ bias


Known as the gatekeeper of consumer credit, Fair Isaac may be losing that role to federal regulators and activists eager to reopen the floodgates on lending to borrowers with shaky finances.

 Bowing to pressure from Washington, the San Jose, Calif.-based Fair Isaac FICO   has agreed to tweak its widely used credit-risk scoring model to give a break to consumers with debts that have gone into collections.

The unprecedented move follows months of talks with Obama administration regulators, who have charged that the firm’s FICO credit score inaccurately portrays many low-income and minority consumers as credit risks and denies them access to loans and credit cards.

The lower weight that FICO will now give unpaid medical debt, for instance, could boost some affected borrowers’ score by 25 points or higher, potentially making them eligible for loans previously denied.

A subprime borrower has a FICO score of 660 or lower.  Easy Credit, Easy Default?

While inflating credit scores will make it easier for tens of millions of Americans with subprime credit today to get mortgages and other loans, it also threatens to inject major risk into the financial system just six years after the devastating credit crisis.

The change comes as mortgage lenders see another housing bubble forming. Recent industry data show the average FICO score on approved loans plunging.

Last month, 56% of lenders surveyed by FICO expressed concern that an “unsustainable real estate bubble is inflating.”

More than 6 million U.S. homeowners are still underwater on their mortgages. Meanwhile, total homeowner equity is at its highest mark since the eve of the crisis in late 2007 as home prices surge in many cities.

In addition, General Motors GM   , Ford F   and other automakers increasingly rely on subprime loans with lengthy repayment terms to fuel vehicle sales.

Credit Gold Standard

First introduced in 1989, the FICO credit-risk score evaluates a borrower’s creditworthiness based on bill-paying history and several other objective factors. It is viewed as the most trusted credit-bureau risk score, factoring into some 10 billion lending decisions a year. A large body of research has found FICO scores to be the most accurate predictors of default.

That’s why 90 of the largest 100 U.S. financial institutions rely on it. FICO scores, moreover, are the required credit risk underwriting standard for all FHA-insured loans, as well as all mortgages sold to Fannie Mae and Freddie Mac. In the run-up to the crisis, however, Washington regulators pressured institutions to overlook credit scores as part of a crusade to expand homeownership.

After months of meetings with the powerful new Consumer Financial Protection Bureau, FICO agreed that it would no longer count as points against credit scores delinquent medical debt or any debts that go to collection agencies and get repaid.

Federal regulators argue that it’s important to insulate consumer credit scores from medical debt, for one, because such bills are “unexpected.”

Critics call that distinction a slippery slope, arguing that under such reasoning, delinquent debt from losing a job or crashing a car might also be excluded from credit scores.

In a May report that was covered uncritically by the Washington Post and other major media, the CFPB said its internal research found that FICO’s model “overly penalizes” consumers because of medical debt.

But the 20-page study suffers from several flaws, including a narrow sample of consumers and data limitations so severe that the authors included a caveat that their findings “may be misleading.”

 Activists Apply Pressure

 The CFPB’s Consumer Advisory Board, which is made up largely of civil-rights lawyers, voiced “issues with the FICO scoring model” for “low-end” borrowers, according to September 2013 meeting minutes.

FICO gives heavier weight in its formula to payment history and amounts owed than its closest rival, VantageScore, which holds about 6% of the market.

A joint venture of Experian, EquiFax EFX   and TransUnion, VantageScore also loosened its standards. Last year, it began excluding medical debt in calculating consumer scores, as well as all paid collections.

In 2012, CFPB Director Richard Cordray announced from Detroit that the government would, for the first time, start policing the $4 billion credit reporting industry in response to activists’ complaints of rampant errors and racial bias.

The bureau opened up a complaint line and portal for consumers with damaged credit, followed by on-site examinations at Experian, Equifax and TransUnion. Examiners ordered the agencies to turn over data about their methods and practices.

Then the CFPB released a study claiming that less than 80% of credit reports are accurate, which in turn triggered an avalanche of stories in the press casting doubt on the veracity of credit scores.

In fact, a major 2011 study by the Policy and Economic Research Council found that 98% of reports contain no material errors. Also, a 2007 Federal Reserve study found no racial bias in credit scoring in a national sample of more than 300,000 credit bureau records. It found, if anything, that scores typically underestimate the risk posed by African-American borrowers, who “show consistently higher incidences of bad (loan) performance than would be predicted” by their FICO scores.

At a 2012 House hearing, the CFPB’s Cordray vowed to focus on medical collections’ impact on scoring. “We will be overseeing all of their approach to this, including medical debt,” he said.

A December 2012 CFPB report warned that “credit scores have the potential to reinforce the effects of discrimination.”"

 Critics fear that politicizing the scores could compromise their integrity and make them less reliable in such lending decisions, exposing borrowers and lenders to greater risk. Investors could also be impacted by subjective analytics. If they lower the quality of loans in mortgage and auto securitizations, they could create a dangerous systemic risk.