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CFPB Scrutinizes Credit Scores

The Consumer Financial Protection Bureau has shifted its attention to the credit bureaus, and their tendency to calculate credit scores they give to the public that vary from the credit scores provided to lending companies.

Credit bureaus sometimes provide Americans with credit scores that are different from those that lenders use in deciding whether to offer a loan and at what interest rate, the government’s consumer watchdog found in a study released Tuesday.

Researchers at the Consumer Financial Protection Bureau found that the discrepancy happens for as many as one in four people […]

Given the widespread use of the scores, even small variations can have huge consequences. Discrepancies could lead some lenders to deny applicants student loans or mortgages, or offer terms that are worse than warranted, the study concluded.

“When consumers buy a credit score, they should be aware that a lender may be using a very different score in making a credit decision,” Richard Cordray, the CFPB’s director, said in a statement. The study was based on a random sample of 200,000 credit files from the three major credit reporting agencies — Experian, TransUnion and Equifax.

Credit scores are an often opaque business, but they have massive effects on people’s lives. The fact that the score given to a consumer may not match the score given to a lender, which will have a much greater influence on an accepted loan or loan rate, is a serious problem, and CFPB in its report hasn’t yet tracked down the reasons why. They didn’t even mind meaningful demographic differences; that is, they didn’t notice that certain subgroups had more discrepancies than others. So this appears more random, and more study must be done to understand the difference between credit scores delivered to lenders versus scores delivered to consumers. CFPB and advocates are calling for disclosure to customers that the credit score they can purchase may not bear a resemblance to the one shown to lenders.

We do know that your FICO score (which stands for Fair Isaac Corporation) is the predominant score that lenders look at to determine creditworthiness. And one thing I never knew about FICO is that they treat a short sale the same as a foreclosure. My understanding was that a short sale would not lead to the same hit to a borrower’s credit score. But that’s not the case, and FICO has a tortured explanation as to why.

…we conducted a study isolating more recent occurrences of mortgage stress events. By studying the subsequent performance of these borrowers on all accounts, we determined the credit risk associated with their mortgage events. Looking at data from October 2009 to October 2011, we were able to verify that short sales and other events of recent mortgage distress continue to represent a high degree of risk. These results closely match earlier studies of the risk associated with short sales and other events of mortgage stress […]

While it is true that short sales represent slightly better risk than foreclosures, they do not perform well enough to merit a more positive treatment in the FICO® Score. Here’s why. In the population we studied, one out of every two borrowers who experienced a short sale went on to default on another account within two years. That is exceptionally high risk. Additionally, the overwhelming majority of consumers with short sales have some other evidence of mortgage delinquency.

By comparison, only about one in every 50 borrowers with a score in the high 700s will default on one of their credit obligations. This strong separation of goods from bads is what makes FICO® Scores so useful.

But as Yves Smith points out, the subjects in their study all came from the 2007-2009 period, the worst time for borrowers, right when the foreclosure crisis began. You cannot make determinations about current short sales and creditworthiness based on that data. What’s more, banks have become more willing to engage in short sales these days, which means that those who managed to get them from 2007-2009 had to be so persistent that it would have a material effect on their individual balance sheet, much more so than now.

This calls into question whether it’s worth using FICO as a credit score guideline at all. It certainly didn’t model credit risk properly in the bubble years. Maybe that should become the next step in CFPB’s analysis.

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David Dayen

David Dayen

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