As loan defaults rise, worries grow about how creditors pick borrowers. Ever since the tech bust in 2000, consumer spending has been keeping the economy afloat. In addition, consumer lending rather than pay raises or job growth has been fueling that spending. Now, the techniques that allow profit-hungry lenders to make bigger loans faster are coming under intense scrutiny. First among them the credit scores that banks, credit-card issuers, and mortgage companies plug into complex mathematical models to figure out how likely borrowers are to repay their loans. Under the stress of weak growth and rising unemployment some models are breaking down because charge off accounts had increased 30% in the past 12 months far above expectations, both in home loans and credit cards.

Most major banks and other financial companies have announced big jumps in bad loans this year. The credit issuers put a lot of trust in their credit scoring models and at the end of the day no one really knew how these loans would perform in a stressed environment. And, depending on whether or not there is another shoe to fall economically, such as in commercial lending, things could get worse.

Credit score models have become an integral part of the financial system and have been used extensively since the 1990s. About 70% of the home loans issued, since then and nearly all of the $2.7 trillion in credit card, auto, and personal loans outstanding were made using a customer’s credit score to determine how much to lend and at what interest rate. Credit scoring is also an important tool for investors who buy pools of these loans, because it allows them to evaluate hundreds of loans in minutes.

The problems have not been restricted to home loans. The problems have now grown to include credit-card loans to customers and not just those with poor credit histories, called sub-prime borrowers. The models underestimated the impact of an economic slowdown on them. Sub-prime borrowers are affected disproportionately by many economic factors. They tend to have the highest debt-to income ratios because they are the last to get hired and the first to get fired, unless they are self-employed and that has dangers as well for income. Regulators are getting worried about credit scoring, especially the way it has been used to pump up lending. With more riding on credit scores than ever before, a new financial services field has opened up to help would-be borrowers improve their ratings to get lower interest rates. Did you know there are few checks on the accuracy of the credit report data? Three credit bureaus, Experian Information Solutions (formally once known as TRW), Equifax (EFX), and Trans Union (TU), each keep account information on approximately 295 million customers and collect about 45 billion pieces of information annually. This information is then sold to third parties, who use it to create credit scores and to lenders who use it to base lending decisions and interest rate quotes.

The information may be and usually is (with a 70% error rate in credit reporting) incomplete because lenders aren’t required to report all of the consumer data to the credit reporting bureaus. Furthermore, the credit reporting bureaus don’t check the credit information before it is listed on the credit report. Unless consumers complain the credit bureaus continue to report the information as if it were true and valid. No one has determined what percentage of credit report data overall may be flawed. All we know is that 70% of the credit reports generated have inconsistent and unverifiable information and that 82% or more of the people who have those credit reporting files now have at least 1 mark of derogatory information showing on their credit report.

We should all be worried and concerned.

Randall W. Britt

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