A change in how the most widely used credit score in the U.S. is tallied will likely make it easier for tens of millions of Americans to get loans. ~Wall Street Journal Online, August 7, 2014.
According to a recent Wall Street Journal online article [FICO Recalibrates Its Credit Scores], FICO is going to get under the hood and re-jigger some of its proprietary algorithms, to deal with the realities of the damage wreaked on distressed homeowners over the past five years. During this time, the multitude of clients I counselled on these issues were invariably good credit risks. They regularly paid their bills, and had decent credit scores. But when the housing and credit markets collapsed, and folks stopped making their mortgage payments, it was often due to one of the 3 Ds, death, divorce or debt. In all other aspects of their financial life, they had been good credit risks.
And when the decision to stop paying the mortgage was not precipitated by a major life event, it was driven by – in my opinion – an equally legitimate purpose: To do the economically prudent thing. For example, regular folks were asking themselves if they should continue making payments on a mortgage that was twice the value of their home. Their view was that they would not build up any equity in the foreseeable future; it seemed they were making sizeable payments on something they would never “own.”[1] In effect, they were making outsized monthly payments of principal, interest, taxes and insurance for the pleasure of being “renters.” And in many case, I saw folks tapping their own retirement funds and kids’ 529 Plans, to continue their mortgage payments.
Then there were the empty-nesters, or young marries with no kids, wanting to downsize or upsize, but stuck in a home that did not meet their current needs. But they could not sell the home, because the mortgage dwarfed the sale price. In the context of rationale business decisions, there is little question that a company would never continue making payments on an asset that had lost half its value and had little prospect of recovery in the foreseeable future. The shareholders would not stand for it.
To its huge embarrassment, even the Mortgage Bankers Association, the 2,200 member industry group representing lenders across the country, was forced to short sell its flagship Washington D.C. property in early 2010.[2] Undoubtedly, it was the economically prudent thing to do. So why should we expect the average homeowner to ignore prudence, common sense, and good economic decision-making? We shouldn’t.
But the big difference between consumers and companies is that the average homeowner takes a battering on their credit report when they stop paying their mortgage – even if they are paying every other creditor on time! And Fair Isaac Corp., now known as “FICO,” routinely downgraded these homeowners’ credit scores, as a result. Why? Because FICO is in the business of predicting a person’s likelihood of defaulting on their debts. Here is how they describe themselves:
FICO provides analytics software and tools used across multiple industries to manage risk, fight fraud, build more profitable customer relationships, optimize operations and meet strict government regulations. Many of our products reach industry-wide adoption — such as the FICO® Score, the standard measure of consumer credit risk in the United States. FICO solutions leverage open-source standards and cloud computing to maximize flexibility, speed deployment and reduce costs. The company also helps millions of people manage their personal credit health. FICO: Make every decision count™.
Founded in 1956, FICO introduced analytic solutions such as credit scoring that have made credit more widely available, not just in the United States but around the world. We have pioneered the development and application of critical technologies behind decision management. These include predictive analytics, business rules management and optimization. We use these technologies to help businesses improve the precision, consistency and agility of their complex, high–volume decisions. [http://www.fico.com/en/about-us/]
Today, it’s almost impossible for anyone to obtain an extension of credit, without the prospective creditor running their credit score, which is frequently provided by FICO, Equifax, Experian, and/or TransUnion.
So the recent news that FICO is “recalibrating” is algorithms should be good news to anyone who’s had a distressed housing event, especially resulting from unpaid medical bills. Kudos to the company – let’s hope others follow suit. Herewith are snippets from the Journal article:
FICO +0.02% said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.
The moves follow months of discussions with lenders and the Consumer Financial Protection Bureau aimed at boosting lending without creating more credit risk. Since the recession, many lenders have approved only the best borrowers, usually those with few or no blemishes on their credit report.
The changes are expected to boost consumer lending, especially among borrowers shut out of the market or charged high interest rates because of their low scores. “It expands banks’ ability to make loans for people who might not have qualified and to offer a lower price [for others],” said Nessa Feddis, senior vice president of consumer protection and payments at the American Bankers Association, a trade group.
As of July, about 64.3 million consumers in the U.S. had a medical collection on their credit report, according to data from credit bureau Experian. And of the 106.5 million consumers with a collection on their report, 9.4 million had no balance—and won’t be penalized under the new credit-score system.
***
More than half of all debt-collection activity on consumers’ credit reports comes from medical bills, according to the Federal Reserve. Such activity results in lower credit scores for consumers, meaning that lenders are more likely to be cautious in extending credit.
The number of U.S. consumers struggling with medical debt has been surging. As of 2012, 41% of U.S. adults, or 75 million people, had trouble paying medical bills, up from 58 million in 2005, according to a report released last year by the Commonwealth Fund.
Enter Naysayers. The article also reports that:
Some critics said that loosening standards could bring losses for borrowers and lenders. “A lot of people really just can’t handle credit—you’re not really helping them by allowing them to dig themselves into debt,” said Howard Strong, a lawyer in Tarzana, Calif., who specializes in consumer-protection class-action lawsuits.[3] “It’s like a sharp knife—if you don’t know how to use it, you can cut yourself.”
Thanks for the simile, Mr. Strong. But let me point out that lenders still have it in their power to do more than evaluate a person’s credit score. As we know from the recently CFPB-proposed QM and ATR rules, there are loan-to-value ratios, front end and back end debt-to-income ratios, and other common sense analytics that prospective lenders and other creditors may use if they want. And significantly, if a lender doesn’t like FICO’s new scoring model, known as “FICO 9,” it can use another model that doesn’t make those adjustments.
And BTW, in an ironic twist, today there is again a bustling market for folks that can’t handle knives – it’s called the subprime used-car lending business, and according to a recent New York Times’ Deal/B%k article here, it’s grown by 130% since the 2007/2008 financial crisis. The business model is exactly the same as it was for the residential loans leading up to the 2007/2008 crisis. The auto loans are also bundled and sold as securities by banks to insurance companies, mutual funds, and public pension funds.
With the financial crisis receding into the rearview mirror of history, credit scoring companies are realizing that many of the victims were never true credit risks at all. But because of the collapse in the economy many folks could not survive when struggling with one distressed event or another. Through job loss or illness, they simply could no longer hold on financially. And since these companies’ algorithms did not measure the bona fides of the debtors, they were all treated the same, and lenders reacted in the same way, i.e. by withholding credit. This now appears to be changing, and that’s a good thing. ~PCQ
[1] Remember, in the Portland-Metro area, for five straight years, 3Q 2007 to 3Q 2012, home values declined month- after-month. There was no appreciation – only depreciation. Meanwhile, borrowers’ mortgage payments remained the same, with principal reduction typically being minimal. One does not need to belong to Mensa to figure out where thing were headed. Home values plummeted 50% and more during this time.
[2] According to the WSJ article: “On Friday, CoStar Group Inc., a provider of commercial real estate data, announced that it had agreed to buy the MBA’s 10-story headquarters building in Washington, D.C., for $41.3 million. The price is far below the $79 million the trade group says it paid for the glass-walled building in 2007, while it was still under construction. The price also is far below the $75 million financing that the MBA received from a group of banks led by PNC Financial Services Group Inc. to finance the purchase.” Hmmm. Five percent down on a $79 million dollar property that was still under construction. Sounds like the kind of loans its members were pimping to John and Jane Doe during the easy money days leading up to the financial crisis. For an over-the-top, laugh-out-loud-funny spoof on the irony of this story, see the link [here] to the Daily Show with Jon Stewart. ~PCQ
[3] Let me suggest that the folks who don’t know how to handle knives are Mr. Strong’s best customers. And he knows it. Without them, he’d have no class actions to file against big companies. Some people, including yours truly, believe that it is these class action lawsuits that drive up the cost of credit for all of us.
