Unregulated FICO has key role in each American's access to credit

New consumer bureau analysis of opaque credit scoring due July 21

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Like Kleenex or Xerox, the word “FICO” has become shorthand for an entire industry, in this case the credit scores that determine every American’s access to loans, credit cards, apartment rentals and insurance.

Despite a name that vaguely sounds like it must be federal something-or-other, FICO actually stands for Fair Isaac Corp., a Minneapolis company that creates proprietary mathematical algorithms used to calculate consumer credit scores. But FICO, which had $605 million in revenue last year, is not directly regulated by any government agency and its credit rating formulas are secret.

Credit scores boil down consumer payment histories on short and long-term debts ranging from a home improvement loan to phone bills into a three-digit number between 300 and 850. A score over 650, for example, is generally considered to be pretty good, while a score of 580 is not.

The scores largely determine whether people can qualify for mortgages, car loans, insurance, credit cards or other major financial transactions. Bad scores can mean applicants will be denied outright or pay higher rates. According to Fair Isaac, “A 100-point difference in your FICO score could mean over $40,000 extra in interest payments over the life of a 30-year mortgage on a $300,000 home loan.”

“That number is a passport to whether people can get ahead in life,” said Ed Mierzwinski, director of the U.S. Public Interest Research Group’s consumer program. “And nobody knows what it’s derived from.”

Consumer groups also complain that without knowing how the formula is put together, there’s no way to be sure it’s reasonable or accurate. Furthermore, they say errors in credit reports can be devastating, and difficult to fix.

In one extreme example, a Virginia man killed himself in 2006 after repeated attempts to correct an inaccurate credit history that blocked him from getting a mortgage, according to the National Consumer Law Center. Kenneth Baker, who had always paid his bills on time, left a suicide note referring to his ordeal of failing to clear his credit record of the delinquencies and judgments that belonged to another man with the same name.

An impartial government agency will soon issue its evaluation of whether FICO and the credit bureaus are playing fair.

The new Consumer Financial Protection Bureau has been specifically tasked with producing by July 21 a study analyzing disparities in reports the credit bureaus sell to creditors and to consumers.

"You can buy [credit] bureau scores directly from the bureaus for a fee, but the score they sell you may not be the same score that a lender might use. CFPB is studying how much the scores you can buy from the bureaus are different from the ones the lenders use, and whether that difference is important in how lenders judge your credit worthiness," said Corey Stone, assistant director of the agency's credit information markets team.

FICO officials did not respond to iWatch News requests for an interview.

How scoring works

The FICO formulas don’t do anything on their own; they are purchased by credit risk information companies and applied to individualized consumer data.

TransUnion Corp., Equifax Inc. and Experian Plc — the three major credit bureaus — vacuum up information on customers’ payment histories with banks, retailers, credit cards, utility companies, landlords, mortgage loans, student loans, phone bills, and even parking tickets.Think of it this way: If credit scores were chili, FICO would write various recipes then sell them to the credit bureaus, which gather the raw ingredients themselves.

The industry is huge.

Experian and TransUnion each say they have credit histories on 500 million consumers worldwide.

Experian, the industry leader, saw its revenue grow to $3.9 billion last year while No. 2 Equifax reported sales of nearly $1.9 billion. TransUnion, the third-largest credit bureau which was privately owned last year, had revenue of more than $1 billion, according to one industry analyst’s estimate.

Together, the three companies plus FICO “control all this data and control the access to credit for every American,” said Chi Chi Wu, a staff attorney at the National Consumer Law Center. “The main force that’s been keeping them somewhat in line is private litigation.”

Until now, the Federal Trade Commission has overseen the credit bureaus, and thereby FICO, indirectly. But the FTC’s limited authority meant that for the most part, the agency could only respond to complaints rather than acting in advance to stop any problems, leaving private lawsuits to take up the slack.

The FTC’s power to make administrative rules that could proactively stop financial services abuses are “complex, cumbersome and time-consuming, resulting in rule making proceedings lasting many years,” agency Chairman Jon Leibowitz told Congress last year.

The new Consumer Financial Protection Bureau (CFPB), on the other hand, will be able to write rules policing “large participants”in certain financial markets. That means it could potentially require reports and conduct examinations to make sure the credit scorers currently comply with the law, not just enforce complaints after the fact.

Equifax and TransUnion did not respond to requests for comment. 

"We support the CFPB’s study of credit scores and believe it will inevitably conclude that consumers are best served by focusing less on the different types of consumer credit scores available, and more on the underlying document that is used to generate a score — the credit report — and how it can be an empowering tool for consumers," Experian said in a statement.  

Privacy concerns

Wu says that the U.S. form of credit reporting is relatively rare in other countries. Privacy laws prevent companies from collecting personal data in France and Argentina, while a government agency compiles the information in some countries.

FICO contends that credit scoring is not an invasion of privacy because it evaluates the same credit bureau report, application form, and bank file information that lenders already look at.

“A score is simply a numeric summary of that information,” the FICO website says. “Scoring has proven to be an accurate and consistent measure of repayment for all people who have some credit history.”

Defenders of FICO say a federal law giving consumers free access to one credit report each year also gives them more power over their financial futures.

Terry Clemans, executive director of the National Credit Reporting Association, Inc. is not convinced. While consumers can get a free credit report each year, or buy additional ones, he says there is no guarantee they will reflect the score that credit bureaus give to creditors.

“It’s a real roll of the dice for a consumer to rely on any score they can buy, because the score the lender buys may not even be close,” Clemans said.

That is because credit bureaus commonly buy multiple FICO algorithms. The credit bureaus use different ones to generate scores depending on what the end use will be — a general overview of a consumer’s credit history, for example, or one tailored to indicate default risk to a mortgage lender.

Experian uses FICO-branded scores for its creditor reports, Clemans says, but the scores the company sells to consumers are not calculated with a FICO algorithm.

Critics also say that the opaque credit scoring algorithms ignore the distinction between a person who suddenly falls behind in payments because of a huge medical bill, and a genuinely irresponsible borrower with a flatscreen-TV habit.

A former FICO executive says those distinctions are eventually reflected in the credit scoring formula.

Efficient scoring cuts costs for consumers

FICO is “trying to build the best predictive model they can,” said Tom Quinn, FICO’s former vice president of scoring who now works for the consumer education website Credit.com. “If the data predicts a different pattern,” between people with different kinds of debt, “then that would be picked up eventually. They let the data tell them what’s fair.”

A credit score also helps protect consumers from discrimination, Quinn said. “The creditor is looking at just the information in the credit,” he said, “versus back in the old days when you sat in front of a loan officer.”

The computerized system of credit scoring and distributing also makes it more efficient to process credit applications, ultimately reducing the cost of credit to consumers.

According to Hoover’s Inc., a clearinghouse for company profiles and industry information, the newest FICO formula “reduces penalties for multiple accounts and is more lenient on occasional late payments, which don't necessarily indicate a poor credit risk. Additionally, authorized credit card users (such as teenagers on a parent's account) no longer benefit from activities of the account owners, which prevents artificial score inflation.”

Another concern of consumer groups: Credit bureaus have little, if any, financial incentive to treat consumers fairly.

Before extending credit to a consumer, an auto dealer or a landlord buys the customer’s credit score from one of the three big credit bureaus to assess the risk of default. That means the customer for the credit bureaus is the creditor, not the consumer, critics say.

“Consumers can’t choose Equifax over Experian,” Wu said. “I can’t say ‘I don’t like the way TransUnion handled my data.’ So even normal market forces, which are supposed to keep the market in line, don’t.”

As for increased transparency of how scores are calculated, Quinn says the new consumer agency should have some insight into how FICO models are developed to ensure fairness and accuracy. But too much sunlight might ultimately undo the consumer benefits that having a trusted metric has brought.

“There are years and years and years of intellectual property that have been built into these scores and [companies] should have a right to have that protected,” Quinn said. “If a company like FICO were to reveal the coding for the model, then [consumers] could potentially use that to manipulate their score for short-term benefit. … The creditor will lose confidence in the tool and ultimately raise the cost of credit for everyone.”

The value of the proprietary data underlying their business is not lost on the three credit bureaus, which together spent more than $6 million on lobbying during the past four years (see related table).

What will happen with oversight of FICO and the credit bureaus may become clearer as the new Consumer Financial Protection Bureau pulls itself together. The bureau, created by the Dodd-Frank financial reform law, officially opens on July 21, but political gridlock threatens to stall the appointment of a director, and the agency’s powers will be limited until it has one.

As Fair Isaac Corp. prepares for more attention, a final note about its unusual moniker:  The company was named after its 1956 founders:  Bill Fair, a mathematician, and Earl Isaac, an engineer.