Can A New Scoring Paradigm Correct The Credit Catch-22?

Establishing a credit history can be an unexpectedly tricky thing – to get a loan consumers need to demonstrate a past history of managing with debt well. To manage debt well, entities need to extend loans to consumers. Since the inception of credit, the above catch-22 has been an issue, but under normal circumstances, it has been a solvable one.

Unfortunately, the last seven or eight years have not been regular circumstances.

While the roots of the 2008 financial crisis are myriad and complex – at its center was a lending crisis brought on by financial institutions and consumers enthusiastically working together to create a bubble in the housing market that literally flattened the global economy when it burst.

Unsurprisingly, the immediate result of the meltdown was a crackdown – both institutional and regulatory.

Lending standards became so stringent that only two types of borrowers could be guaranteed an extension of credit by a mainstream lender: prime and super duper.

Further exacerbating matters, the credit crunch didn’t just change how regulators and institutions thought about debt.

In the five years following the crisis, consumers fell rapidly and precipitously out of love with borrowing money. According to a report by the Fed, Americans not only took out fewer mortgages and credit cards – an expected result of lenders tightening up standards –  they also applied for far fewer of each. And while a large segment of that decline can be explained by consumers who a) saw their income stream interrupted as a result of the recession or b) had their creditworthiness damaged as a direct or indirect result of the recession – the report indicated that a large number of consumers were scared off borrowing.

“Since the onset of the financial crisis, households have reduced their outstanding debt by about $1.3 trillion. While part of this reduction stemmed from a historic increase in consumer defaults and lender charge-offs, particularly on mortgage debt, other factors were also at play,” the report began. “Household choices, along with banks’ stricter lending standards, helped drive this deleveraging process.”

And while a moment might have been spared four or five years ago to congratulate the American public on their newfound thrift – since profligate borrowing had tanked the entire financial system briefly- by 2012 it was fairly obvious that a credit shy economy was recovering much more slowly than expected. PYMNTS has extensively covered the SMB side of this – and how alternative lending vehicles of various descriptions are working to fill that gap – but the consumer side of the lending scene has seen a less sharp, but still noticeable decline. And those declines are particularly notable in some segments of the economy more than others.

“It seems likely at this point that the pendulum has swung too far the other way, and that overly tight lending standards may now be preventing creditworthy borrowers from buying homes, thereby slowing the revival in housing and impeding the economic recovery,” then Chairman of the Federal Reserve Ben Bernanke said in a 2012 speech. “Lower-income and minority communities are often disproportionately affected by problems in the national economy, and the effects of the housing bust have followed that unfortunate pattern. Indeed, as a result of the crisis, most or all of the hard-won gains in homeownership made by low-income and minority communities in the past 15 years or so have been reversed.”

Re-integrating borrowers into the system, however, has turned out to be a little easier said than done. While “bad credit” has been on the decline in the last five or six years, thin credit – people with no active FICO score because they are not carrying “traditional debt” like mortgages, car loans or credit cards – has been on the increase. Young people, immigrants, or people who have spent the last several years recovering from a credit busting event are now a group that the system cannot evaluate easily and score within the standard framework – and financial institutions are starting to see that as a missed opportunity.

Is there a way to recover that opportunity?

The Fair Isaac Corporation (FICO) thinks so. Last week it announced that it will be launching a new credit score aimed at capturing those FICO-less consumers out there a new type of credit score. A score that looks at other measures of stability like rent payments, and staying up-to-date on recurring bills. According to reports, FICO estimates that it can make a dent in the over 50 million new potential borrowers who are currently locked out because they are judged too risky by standard measures.

FICO, as the creator of the most widely used consumer-credit scores in the country, has gotten a lot of attention for this move – though they are far from the first to the space. VantageScore has slowly but surely been gaining traction with a credit evaluation tool similar to what FICO is currently developing – and that tool is currently being used by 10 major banks – all of which are looking to boost the lending portfolio.

So how does the new creditworthiness function, who likes it and who doesn’t? PYMNTS has your guide here.

The New FICO Score

The new FICO score looks at payment histories instead of debt management when evaluating creditworthiness. In particular, the system looks to capture recurring monthly expenses that consumers can pay on time, including cellphone bills, utility bills and cable bills. The data will come from a database of telecommunications and utilities providers maintained by Equifax.

More than looking at how well consumers pay their bills, however, the new measurement metric FICO is developing is also hoping to capture how potential lendees live. Using data from LexisNexis Risk Solutions, the new scoring mechanism will factor in how long a borrower has lived at a particular address since conventional wisdom indicates that long-term tenancy indicates stability and timely rent payments.

All in all, the purpose of the new system is to collect  “positive” data that a traditional credit report might miss.

Fair Isaac says the data it uses would make it possible to evaluate 15 million consumers of the 53 million who lack credit scores. Of that batch, about a third would see a score of 620 or above, says Jim Wehmann, an executive vice president with Fair Isaac. The new model would have the same range as the traditional FICO score of 300 to 850.

About 200 million adults in the U.S. have FICO scores, which are used in 90 percent of consumer lending decisions. The new move comes as lenders have been stepping up pressure for a score that will allow them to lend to more borrowers, including those who haven’t been using credit but are responsible with monthly payments, said Dave Shellenberger, senior director of scoring and predictive analytics at FICO.

“There are more lenders who are very interested in addressing [this]—I don’t think you saw that six or seven years ago,” he said in an interview with The Wall Street Journal.

The New Stability

And FICO is not alone in answering this call.

VantageScore has been in the alternate creditworthiness game since 2006. It comes as a partnership between the three major credit rating bureaus – Experian, TransUnion and Equifax – and exists currently as a FICO competitor product. More than 2,000 lenders, including six of the 10 largest U.S. banks, and other industry participants, such as landlords, use it. It currently does what the FICO product under development seems to be seeking to do – look for other “positive information” on potential borrowers to draw a fuller profile that is not as dependent on formal credit history.

“Nearly 80 percent of lenders significantly underestimate the number of people in this country who belong to a group we call ‘credit invisibles. Our data tells us that consumers who are not often “scoreable” by conventional credit scoring models,” Vantage Score noted in a statement. “Some 30 million to 35 million consumers cannot be quantified by a credit score because their credit behaviors don’t meet the criteria of traditional models. In fact, about 7.6 million of these consumers earn scores of 620 or higher, placing each consumer well within the desirable range for many mortgage lenders.”

Mike Trapanese, SVP of VantageScore Solutions has further noted that as far as he can see, the time is now, while the economy is recovering, when people have more money in their pocket and are feeling like making investments is the time that credit needs to be more available, not less.

“The business case for allowing lenders to use updated and more inclusive credit scoring models is perhaps only matched by the impact on the many creditworthy households that are currently all but invisible to mortgage lenders,” Trapanese said. “As the demographic make-up of homebuyers evolves it’s critical that the current system effectively provides access to sustainable homeownership for all creditworthy borrowers. The economy actually can’t just stay in pause forever here.”

And the VantageScore method is getting attention.

Last month, mortgage firms Fannie Mae and Freddie Mac, which currently are dependent wholly on FICO scores for underwriting, began reviewing alternative credit-scoring models: VantageScore’s in particular.

Remaining Concerns

While the idea of evaluating credit in a new way has gotten some interest, the practice has also drawn some criticism.

Some have noted that banks could easily justify charging alternatively qualified applicants a higher interest rate – since they are a less proven commodity than a borrower who qualified through traditional measures. Others have noted that while this may be the case, the borrower – who presumably wants to buy a home, car or get a credit card – would prefer that outcome than to not being able to secure any loan at all.

Others have noted some concerns that this will signal a return to sub-prime borrowing under a new name – though both FICO and VantageScore note that their system does not exist to qualify all borrowers, or as a tool for those with bad credit to get a different result. Consumers who do not pay bills on time – an indicator of a bad loan risk – will be ruled as unworthy of credit as consumers who don’t pay credit card bills on time.

The primary concern, however, is that banks – particularly small and mid-sized ones, just aren’t interested in getting involved with a new credit scoring system when they have a system that already works.

“We look at everything that comes down the road, but I have not personally seen something that I feel is superior to what FICO has already created and supported through the years,” Al Engel, chief retail lending officer of New Jersey’s $19 billion-asset Valley National Bancorp, told American Banker.

And it seems the Al Engels of the world will be the mountain alternative scoring has to climb. There is a method already to score consumers – and one that banks are comfortable with.

But then again, that method is a traditional FICO score – and it is certainly a sign when the trusted source is going about disrupting itself because it realizes it is leaving a lot of the market behind.

The next test is for that market – will those borrowers live up to the new scoring’s great expectations?