Why Credit Scoring is Choking Lenders

A recent news article from the Associated Press detailed that credit scores for Americans are at all-time lows. What a surprise! The article reports that over 25% of consumers — nearly 43.4 million people — now have a credit score of 599 or below, marking them as poor risks for lenders. It's unlikely they will be able to get credit cards, auto loans or mortgages under the tighter lending standards banks now use.

How did we reach a point where credit scores became the singular measure of a borrower’s capacity and willingness to repay their loans? Just like everything else in this recent financial meltdown, a number of contributing factors evolved that now has reduced many lenders to loan robots. Consider this:

• Credit Scoring took flight in the mid-90’s and became the centerpiece of new Fair Lending regulations. Lenders could prove to the regulators using an “objective”, empirically-derived math model that they were not discriminating against loan applicants who belonged to a “protected class.”
• Simultaneously. deposits at financial instructions eroded as consumers turned to mutual funds and stock market investments as the means to manage their “new” 401k plans.
• As a result, financial intuitions turned to the capital markets for funding loans. This led to a huge expansion of the secondary market where lenders could risk-price loans according to the credit score and bundle these portfolios.
• As a result, lenders no longer had to say “no” to their customers. Depending on the credit score, they could grant the loan and then sell it to the corresponding investor. Poof! No more credit risk, no more collateral risk and no more interest rate risk. Sell the loans, use the money to make more loans, and earn income from the transaction fees.
• Internet commerce becomes a mainstay of consumer spending. Consumers develop an addiction to immediate gratification and this evolves to their loan applications. Lenders develop online application systems that, based the credit score, the application is immediately priced, granted and in some cases funded. No more waiting 2-3 days for a loan decision.

Well, here we are. A dramatic recession with high unemployment rates, high foreclosure and loan delinquency rates and now low credit scores. Everyone is treating this as something new – it isn’t. Does anyone remember the real-estate crash here in the early 90’s? New Hampshire led the country for three consecutive years in the highest percentage increases of bankruptcy filings in that decade.

And still, financial institutions still lent money – why? Because there is more to a good borrower than just his credit score. It seems to me that the old-school “Three C’s of Lending” – (Credit, Capacity & Collateral) when handled appropriately, helped many people who experienced recent hardship but who were still fundamentally good borrowers. This allowed them to buy cars and houses, get home improvement loans, personal loans, etc. etc.

I fear those days are gone and lenders are boxed into a situation that handicaps their ability to lend:

1. Consumers will not wait 2-3 days or longer for a loan decision (immediate answers determined by credit scores)
2. Financial institutions still need the capital markets to fund loans (risk will be evaluated by credit scores)
3. Lenders will need to prove “prudent lending standards” (translation: credit scores)

And this “economic recovery” is in danger of a complete stall. Why don’t we score THAT?