Credit scores 102: A crisis, and some changes

Having taken a look at what credit scores are -- and what they aren't – in Friday's column, we're ready to look at how they came to be used for purposes for which they were never intended and how they gave birth to a cottage industry aimed at manipulating them.

You might be surprised to learn that even the people who invented credit scores say their use has gotten out of hand. And if lenders learn a simple lesson – that they should rely a little less on a number and a little more on interpersonal skills when making loans -- the current credit crisis might have a silver lining.

"There became an over-reliance on credit scores," said Lisa Nelson, vice president of global scoring for Fair Issac, who is in the unusual position of telling banks they put too much stake in her product. "Lenders became came too overly focused on credit scores."

Express mortgage vetting that leaned too much on credit scores made a lot of companies a lot of money during the go-go days of the housing bubble. Bear Stearns was one. Now, many of those companies are in the cross-hairs.

Bear Stearns' collapse was precipitated by the implosion of two hedge funds last year that invested chiefly in risky mortgages. That turned out to be a mortal blow to the company, and Bear Stearns' collapse may yet do wider damage to the economy.

But can credit scores themselves be faulted?

'Very smart but very limited'
You can blame credit scores for a lot of things -- unfair mortgage interest rates, sneaky auto insurance premium hikes, to mention a few. But you can't blame them for the housing meltdown, say supporters of the three-digit numbers that control so much of consumers' lives.

"Credit scores are very smart but very limited in what they do," said John Ulzheimer, who worked at Fair Isaac for nearly a decade and now runs consumer advice Web site Credit.com. He's also recently wrote a book called "You're Nothing But a Number."

Fair Isaac is on a crusade to correct overly ambitious descriptions of just what credit scores can do. They do not, strictly speaking, predict a borrower's ability to repay a loan, says Fair Isaac spokesman Chris Groppa.

"The score actually quantifies the odds that borrowers will become seriously delinquent in repaying ANY creditor within the next two years -- card issuers, banks, retail stores, etc," he wrote in an e-mail. "The score does not predict the risk for one specific loan or credit account unless, of course, the consumer only has one credit account on file at the credit bureau. This mischaracterization is a subtle but common misperception about FICO scores (the original credit score invented by Fair Isaac)."

The distinction apparently was lost on banks, which during the past 10 years came to rely more and more on credit scores. Some even bet their business on the numbers, and lost.

Credit score fixers
Meanwhile, the increased reliance on credit scores forced home buyers in competitive markets into a shadowy den of thieves -- credit score fixers. There are now hundreds of companies who say they know the secret sauce that goes into calculating a credit score and claim they can help you improve your number quickly -- for a fee.

The shroud of secrecy around credit scores encourages this behavior. There are, in fact, legitimate ways to improve your score quickly, through what the industry calls "rapid rescoring." But it's nearly impossible for consumers to tell the difference between legitimate rapid rescoring and the snake oil salesmen.

The latter may take hundreds of dollars from consumers and merely send in automated disputes of every item in a credit report in an effort to remove one or two black marks.

On the other hand, the rapid rescoring industry has the blessing of the credit bureaus. Generally, consumers only discover mistakes in their credit reports when they are applying for a loan, when time is of the essence. It normally takes 30 to 60 days to clean up mistakes on a credit report because creditors only send in items to the bureaus once each month, Ulzheimer said. Rapid rescoring firms can fix errors and update credit reports within a day or two -- for $50 per report, per item, Ulzheimer said.

"You could spend $1,000 or more just to update your own credit reports," he said. "That's a joke."

While the service can be a life saver for consumers struggling to get a decent rate on a loan, its mere existence points out problems in the system, he said. If someone can change their credit score from 620 to 670 overnight, which number is the accurate reflection of their risk to a lender?

Credit 'scorecards' are key
Consumers can easily be tempted to use illegitimate firms to improve their scores – in part because it seems some consumers really do win the credit score lottery. There are countless stories from consumers who say they've removed one black mark on their report and pumped up their credit score 30 to 40 points -- which as we've seen could means thousands of dollars in savings each year.

If any single credit item could have that much of an impact on a credit score, it would cast some doubt on the efficacy of the scoring system, which would seem fragile if it were subject to such wild swings.

Both Ulzheimer and Nelson say no one change could have such a dramatic impact on a score. In fact, they say, there is no way to assign a point value to individual items. Each time a lender gets a credit score, the scoring formula is re-run on an entire credit report, and a new score is generated from scratch. Because account balances are generally fluid, there is no way to assign exact values to any item.

There is an explanation, though, for large swings. Ulzheimer says that consumers fall into different buckets, or scorecards, within the Fair Isaac formula. One scorecard is for those with short credit histories, or "thin" credit files. Another is for those who have filed bankruptcies. Another is the "derog" scorecard, for those who have derogatory (unpaid) accounts in their files. Each scorecard uses a different formula. When a consumer shifts from one to the other -- something called "scorecard hopping" -- their score can shift dramatically up or down. So, a consumer who jumps from the "derog" scorecard to the "clean history" scorecard may indeed see a big credit score increase, for instance.

That means consumers with perfect credit can suffer much more from a single mistake, or a single dispute with a lender, than a consumer with bad credit.

Meanwhile, the Internet is awash with ways to improve your credit score by small increments. One that seems to work is to shift balances among your existing credit cards -- it's better to have several cards with modest balances than one card with a huge balance and several cards with a zero balance.

Changes coming
Many score-enhancing tricks will be "gamed" out of the system, however, by FICO 08, the new credit scoring system that Fair Isaac is expected to release later this year.

One trick that will lose its oomph is the practice of adding "authorized users" to an account. Consumers have been able to tack other users onto their credit cards and essentially "borrow" their good credit. A small cottage industry formed during the housing boom to match up willing credit "donors" with consumers who had poor credit scores.

Fair Issac says the new scoring formula in FICO 08 will eliminate that trick and do a better job of assessing risk for consumers with so-called "thin" credit files, meaning they have few credit accounts. Recent immigrants frequently fall into this category.

But still unaddressed is the problem of unfair scores that arise from inaccurate credit reports, and the difficulty consumers can have fixing them. Ulzheimer said that simplest thing the industry could to do to clean up its act would be to force the credit bureaus to quickly repair errors.

"The score is only as good as the report it's based on," he said.

But even that isn't enough to save lenders from themselves when they rely too much on credit scores and don't take into account other obvious factors like income and assets. In his recent book, "The Two Headed Quarter," mathematician Joseph Ganem talks about the seductive power numbers have over people. Many can't resist the notion that numbers are objective and infallible, when in fact, they often require context to understand and can easily be manipulated. SAT scores, for example, once measured students' verbal and math ability. Today, they largely measure students' ability to afford expensive preparation classes, he says.

"People are very adaptable and very responsive to how they are being rewarded," Ganem said. Hyper-focus on credit scores naturally encourages lenders and banks to simply focus on improving those scores, rather than focus on being responsible borrowers. And mortgages lenders – and the investors who buy up mortgage loans – use credit scores to rationalize risky investments. "People give great weight to numbers so there can be accountability," Ganem said. "But in fact they have the reverse effect, because numbers can be manipulated."

De-emphasizing the credit score would get under control some of the lunacy of credit repair, rapid rescoring charges and credit score mythology. It might also take the jingle out of those credit score television ads, something that would likely benefit all consumers.