How a billion-dollar industry’s mission transformed from assessing creditworthiness to chasing profits and holding consumers hostage.
Remember the old idiom, “Don’t become a statistic”? Well, you already are.
The Minneapolis-based Fair Issac Corporation, popularly known as FICO, keeps close tabs on your credit files and uses a secret formula to reduce that information to a number that can powerfully impact your life. If you pay a bill late, they know about it. When you use your credit card, they see it. They even know if you are making inquiries to learn about your credit score.
There’s also a lot they don’t know. Some things, like your race or marital status, are prohibited by law from being considered in credit scoring. Other things, like your employment history, where you live, or how much you’ve saved, don’t fit into the algorithms FICO uses. Any normal person might suspect they are relevant to assessing the quality of your credit, but they won’t make a difference in your score.
We are all living, breathing human beings, but big businesses and banks have turned us into half-baked statistics in order to grease the wheels of capitalism – wheels that often catch us in their spokes. At best these statistics are inexact; in many cases, they are much worse than that, with disastrous consequences for the humans they purport to describe.
How did this happen and what can we do about it?
A Bit of History
Credit reporting in the U.S. kicked off in the 19th century when retail merchants and other interested parties created loosely organized local exchanges of information. In a big, young and mobile country, lenders understandably wanted to know something about the people doing the borrowing. Given the cultural norms and the lack of reliable data around, creditworthiness was closely connected to popular notions of “character,” like honesty and thriftiness. This emphasis led local retailers to collect intimate details about peoples’ health, drinking habits and sexual behavior from newspapers and gossip. Being Jewish could also earn you a bad credit rating, or being Chinese, or Catholic, or unmarried, all of which were associated with questionable “character.”
As communication technology developed in the 20th century, the loose-knit organizations evolved into credit bureaus that went national – they were actually among the first businesses in the U.S. to do so. They got quite savvy and efficient about zipping information about consumers from coast to coast. FICO was founded in 1956. Two years later it began selling its credit scoring system. It was the first company to develop algorithms for generating credit scores and got paid royalties for their use.
As these systems grew and became more deeply embedded in the nation’s financial system, they increasingly impacted the the lives and opportunities of citizens. The work of advocacy groups defending consumer rights led to new laws that tried to address fairness and accuracy in credit scoring. In 1971, the Fair Credit Reporting Act (FCRA) gave consumers, among other things, the right to view and dispute reports. The laws continue to be tweaked in an effort to keep up with a rapidly expanding and increasingly influential business. In 2003, an amendment was passed giving consumers the right to view one free credit report a year.
The Federal Reserve inherited consumer rule writing in the 1960s, and for a long time, officials at the Fed took their role seriously. Paul Volcker, Fed chairman from 1979 to 1987, was widely regarded as reasonably tough on consumer affairs and maintained a decent apparatus to regulate industry players and investigate abuses.
Then along came Alan Greenspan. Greenspan’s fanciful free-market economic theories and world view rendered him completely uninterested in consumer affairs matters. Consumer affairs work at the Fed declined sharply in quality and strength. In the past, the Fed had promoted fairness and accuracy in credit scoring as a shield for banks that might face discrimination charges. But in the 1980s and 1990s, bankers turned the shield into a sword. They began holding the scores over consumers’ heads.
Pressures from Wall Street convinced banks to chase consumer fee income, and they began to use credit scores as a device for justifying higher fees. Ever wonder how bank CEO pay started skyrocketing? Socking consumers with above-average interest rates and collecting fees on late payments and other penalties is a big chunk of bank earnings today. If consumers balked or missed a payment, they would be threatened with lowered credit scores. Consumers became hostages.
Today, FICO sells its assessment of your creditworthiness to credit rating bureaus – the three giants are Equifax, Experian and TransUnion, and their reports influence everything from credit cards to mortgages to job offers. A bad score is expensive. You could end up paying more than $5,000 in extra interest on a $20,000, five-year car loan. Most banks use the scores to set finance charges; the lower the score, the higher the interest rate on a new loan.
Millions of Americans have seen their credit scores plummet since the financial crash. Meanwhile, the credit-scoring business is rife with problems and abuses, ranging from processes that favor speed over accuracy to preferential treatment for the rich and powerful. Unless you are wealthy, you will likely have to borrow money at some point in your life, whether to buy a house or attend college. Here are a few things you need to know about these all-powerful scores that dominate our lives.
Fast, Cheap and Out of Control
Businesses and banks rely on consumer credit bureaus as authoritative sources of accurate information and analysis. But are their calculations up to snuff? Not really, alas.
A credit score is created when an algorithm is applied to the data in your credit file. This system started out with limited pencil-and-paper calculations, and later clunky operations on early computers. Things took off in the 1980s with the development of turbo-computing power and the ability to do massive data mining. A new branch of applied science was born, and by the 1990s, firms were using large databases in order to make predictions about consumer behavior.
Proponents hailed this as a major intellectual breakthrough. What was once a slow and cumbersome process of pouring big data sets into computers and then painstakingly figuring out correlations became a fast, easy operation on mega-computers. Once the firm ponied up the large initial investment in computers, it was home-free. New consumers and more data could be added at very little cost. This system was irresistibly alluring to mathematicians and statisticians – and to profit seekers.
But the new statistical models could best be described by the title of an Errol Morris documentary: Fast, Cheap, and Out of Control. The beauty of credit scores for the financial industry is that they’re inexpensive to produce. Profit incentives have led to a sort of cut-and-run, brute force data mining in which the possibility of errors is enormous. Political economist Thomas Ferguson, who uses large data sets to do analysis of voting patterns, political money and stock market phenomena, scoffs at the crudity of systems used in credit scoring. “The results probably would not pass muster in any serious academic journal,” he says. “You almost certainly couldn’t publish the results.”
One problem with credit scoring is related to the so-called “lantern problem” common to scientific inquiries, illustrated in the stock image of a person looking for lost keys where the light is shining rather than where the keys are actually lost. In the case of evaluating credit risk, the statistician will use whatever data is around to plug into the algorithms, rather than ferreting out information that would best determine actual credit worthiness. She may be able to get a certain type of history this way—drawn from your checks, purchases and other typical activity. But she can’t get at the atypical parts, such as whether or not you are out of work, about to come into an inheritance, or have co-signed a note so your children could get a mortgage.
Because credit scoring and reporting firms sell their products to banks, and banks like to assign high interest rates, guess what kind of information about you they don’t like to put in their reports? Positive information. Negative information, like missing a payment on your phone bill, is welcome. Positive information, like your steadily increasingly salary or the fact that you paid down a credit card, is not.
Credit scoring has some predictive accuracy, but not nearly enough to justify its influence. In old-fashioned risk evaluation, a loan officer at a bank would sit down with an individual and study the typical and atypical factors that make up a person’s credit history. Then he or she would make a judgement about credit worthiness that incorporated what wasn’t in the statistical models, as well as what was. Obviously, you can’t rapidly and cheaply assess credit risk on tens of millions of people using personal interviews. And so now we have a fast, cheap, effectively hit-or-miss system that can prevent you from renting an apartment or getting a job. The motivation of the industry is now less about actually finding out if you’re credit worthy, and more about finding out how lenders can make profits off you.
The Oligopoly Game
Competition is not exactly robust when it comes to consumer credit scoring and reporting. The industry, which does $1 billion a year in business, is dominated by four players: FICO controls the vast majority of the credit score market in the U. S. and Canada, and its scores are distributed by only three major companies, Experian, Equifax and Transunion. FICO is at the very top, condensing our credit worthiness into the three-digit FICO score. Experian, Equifax and Transunion use the FICO scoring system to come up with their own credit scores, based on data they collect about you in their systems. They then sell access to those scores to millions of businesses that want to make various decisions and judgments about you.
Around 90 percent of banks use FICO scores, along with the 25 largest credit card issuers. Talk about industry dominance!
When an industry becomes an oligopoly, several things that are bad for consumers tend to happen. Product innovation becomes limited. Players can collude to raise prices, even as the cost of doing credit scoring and reporting goes down. Up until very recently, you could not get a credit report or score without paying for it, a major reason for the 2003 law requiring that consumers be allowed to view one free report per year.
Worse still, there’s not much incentive to get things right when oligopoly conditions exists. The law provides little penalty to these giant firms when they screw up, and it’s not like consumers can vote with their feet when the product is shabby. You can’t remove your information from the bureaus without enormous hassle, and you can’t take your business elsewhere.
A shockingly high portion of consumer credit reports contain errors. But just as firms are not rewarded for including positive information in your credit report, neither are they rewarded for removing erroneous information.
Horror stories abound. Like the man who was refused a mortgage for money owed on an appendectomy he never had. Chances are high that if you just ask amongst your friends, you’ll find someone who was inconvenienced–or worse–by a credit score or report error. A study released by the U.S. Public Interest Research Group in June 2004 found that 79 percent of the consumer credit reports surveyed contained some kind of error. Of these, a quarter contained mistakes serious enough to result in the denial of credit, such as false delinquencies or accounts that belong to somebody else.
Several years ago when I was looking to buy an apartment, I checked my credit reports and found a listing for a bank account I supposedly opened in Texas, a place I have never lived. I had to go through an irritating and time-consuming process of writing dispute letters in order to get this false information removed.
Typical errors include credit bureaus mixing the files and identities of consumers; attributing a debt to the wrong consumer; incorrectly recording payment histories; and inaccuracies caused by identity theft or compromised data, which the agencies often try to conceal.
Credit reporting agencies have a legal obligation to address errors, but the Federal Trade Commission (FTC) is lax in enforcing the rules. The perfunctory, mechanized system currently used by the industry to deal with error complaints is a travesty. (For more on this, see the 2009 report by the National Consumer Law Center, “Automated Injustice.”) Credit bureaus don’t have much incentive to carry out thorough investigations, and the burden of proof is placed squarely on the consumer. The consumer, after all, is not the primary paying customer, so why should the credit reporting agency spend its dollars and time resolving her disputes?
If you get screwed by this system, you can take your complaint to court. But that can be a slow, costly, and frustrating experience. An entire sub-industry, the credit repair business, has arisen to address this consumer nightmare – and to profit from it. The scoring and repair industries have a symbiotic relationship. Repair firms charge stiff fees for promising to do things you should, in theory, be able to accomplish yourself, like writing dispute letters. Why do they have better luck? Maybe because they get the V.I.P. treatment. And they aren’t the only ones.
Preferential Treatment for the 1 Percent
The major credit ratings bureaus are known to have a two-tiered system for addressing errors. If you’re rich and powerful, you get special treatment. In May 2011, a report by the New York Times revealed that Equifax, Experian and TransUnion keep a V.I.P. list of celebrities, politicians, judges, and other muckety-mucks who will get rapid response to error claims. And for the other 99 percent? Expect to have your complaint funneled into an automated system and farmed out to overseas contractors where a worker will spend an average of two minutes figuring out the problem.
Perhaps this explains why members of Congress are so uninterested in credit scoring issues. They don’t have to worry about them. Time to Occupy the credit bureaus?
Who’s Looking at You?
Credit reports are a goldmine of information on consumers. Landlords, insurance companies, employers and potential employers, child support enforcement agencies, and others can now gain access to your report. According to the New York Times, 40 percent of employers now do credit checks on their employees. This creates a vicious cycle whereby a person may get into financial difficulties, say, from an illness, and then find that getting or maintaining a job is impossible due to a low credit score. Which leads to foreclosures. And broken families. And untold human misery.
Who else gets gets to see your scores? Marketers, for one. Generating and selling lists for use in “pre-approved” credit and insurance offers is allowed by law. TransUnion, Experian and Equifax all engage in selling lists of consumers who meet certain criteria in order to receive an offer of credit or insurance. This is the source of the many pre-approved credit offers that clog your mailbox. In order to opt out you must remove your name from any marketing list compiled by a credit rating bureau, whether the list is for pre-approved credit offers or direct marketing. (Call 888-5-OPTOUT or 888-567-8688, or go online towww.optoutprescreen.com.)
Control of information on consumer credit has always been a problem. When you want to borrow, you do expect to give up some privacy in return for the privilege. But with high-speed, error-prone, profit-driven transfers of information, plus toothless national laws, the chance of your information ending up in the wrong hands is too high for comfort.
Criminals interested in identity theft are delighted by the easy availability of confidential financial information, coupled with sloppy practices by creditors and credit bureaus, which routinely lose data. This makes it a cakewalk for crooks to do things like open accounts in your name. The credit scoring and reporting agencies will now sell you products and services that are supposed to protect you from identity theft — which is ironic, considering that their activities make much of this identity theft possible in the first place!
Then there are potential national security issues. What if a foreign company, say, a Chinese company, decided to buy up an American credit reporting bureau? Or maybe a Mexican drug cartel? What use would they make of that information? Let’s hope we don’t find out.
A People’s Revolution?
The system of credit scoring and reporting is clearly in dire need of reform. But how are we ever going to get it?
The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by Congress in 2010, ensures that you are now entitled to a free copy of your credit score if you are denied a loan based on that score, and also if you get a high interest rate on a new loan. This is a positive development. But what is themantra of nearly every Republican candidate for president? Repeal Dodd-Frank! Meanwhile the Obama administration is less than eager to push on consumer rights — which is why Elizabeth Warren is running for Senate in Massachusetts, instead of heading up the new Consumer Financial Protection Bureau.
Warren conceived CFPB as a watchdog that would oversee credit scoring and reporting practices and serve as a recourse to consumers. The bureau released a helpful preliminary study in July 2011, which looked at how scores purchased by consumers and those shown to lenders can vary, leaving consumers in the dark about their actual creditworthiness. We can be thankful that the bureau is doing these ongoing investigations. But without Warren at the helm, and given CFPB’s placement inside the bank-centric Federal Reserve, its impact will be restricted. The industry, along the politicians it lavishes money upon, will try to stymie even its most modest efforts.
The truth is that fundamental reforms are required if we want to truly take back our lives from these credit scoring juggernauts. Attorney Walker Todd, who spend two decades in the legal departments of the Federal Reserve Banks of New York and Cleveland, assured me that in order to even begin to address the systemic and structural problems of the industry, a full-dress congressional hearing is order, ideally in three parts, as follows:
1) Role of regulators in the industry. Regulators would come in and testify under oath exactly how they conceive of their role. (You get a maximum potential for embarrassment here.)
2) History of the industry. Focus on how the purpose and design of the industry have changed from the pre-1990s to the present. This section would also address structural changes in the banking industry that have made credit reporting a mess.
3) Testimony on misuses. Consumers would get to tell their stories about the misuses of credit scoring and reporting.
The overall purpose of the hearing would be to determine whether current arrangements and systems have improved the availability and condition of credit, degraded it, or left it about the same.
The bad news is that our broken political system makes such a hearing a very difficult proposition. In the House, Rep. Maxine Waters, the ranking Democrat on the Financial Services Committee, may not have the necessary support to lead such a hearing. In the Senate, the chairman of the Committee on Finance, Max Baucus, wouldn’t touch the subject with a 10-foot pole. Senator Richard Shelby, the ranking Republican on the Committee on Banking, Housing and Urban Affairs, has sometimes exhibited a healthy distrust of bankers. But his colleague, Senator Tim Johnson, the chair, hails from South Dakota, where Citibank reigns supreme.
Which brings us to the White House. It’s critical to have an executive branch agency that can deal with consumer issues. But of course, CFPB is conveniently housed in the Fed, where the very bank-friendly Ben Bernanke will have to go along with regulations and scrutiny. What we need is a president willing to go to bat on an issue that affects the daily lives of so many of his constituents. But we probably shouldn’t hold our breath. With bank-loving advisers like Timothy Geithner and former JPMorgan exec Bill Daley roaming the White House, consumers’ interests are an afterthought. Besides, the president is trying to raise a billion dollars for his election campaign, a great deal of which will come from the financial sector.
What’s left then? A people’s revolution may be the only thing that will truly get the ball rolling. The Occupy Wall Street movement has shined a light on the problem of money and politics, which is crucial to address if there is to be any hope of getting our elected officials to act in our interest. Robust reforms like a constitutional amendment regulating money in elections have been floated, and should remain front-and-center in the national dialogue.
Or how about a credit-reporting agency of the people, for the people and by the people? Similar to the Move Your Money campaign, a Move Your Credit Score campaign might be an experiment worth running, if only to keep the topic in the minds of the public. The idea is that we would all volunteer to submit our information to our own agency, which would agree to sell its scoring to banks and other lenders at a lower fee that those currently charged by credit ratings bureaus. The banks would certainly try to squash it, but a national campaign would be a good way to expose the mess and gain the attention of the mainstream press, which has so far largely confined its reporting to “How to Improve Your Credit Score” pieces.
Taking back the control of our financial destinies is something the 99 percent can certainly rally around. Left, right and center, this is an issue none of us can escape.
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