FICO Ain’t Nothing But Trouble

Last week I talked about how Section 310 of the Senate banking bill could introduce more competition into the credit rating industry by opening up Fannie Mae and Freddie Mac to buy loans underwritten with credit scores other than FICO. Currently, FICO has a monopoly on the two GSEs, but if this bill becomes law other participants could compete for that large slice of the mortgage market.

(Fun fact: the word mortgage is translated as “death pledge”: mort- comes from French meaning “death”, and gage comes from Middle English meaning “pledge”.)

How big is the death pledge market? Fannie Mae and Freddie Mac backed $830 billion in mortgage loans in 2017, out of the total $1.8 trillion market. The remainder is split fairly evenly between lenders keeping the loans on their books and FHA-securitized loans.  At the average 2017 home price of $230,000, that equates to 3.6 million mortgages for the GSEs, which could generate a lot of revenue for the credit score provider.

The four main players in the credit scoring industry collectively make over $10 billion in revenue. Here is the 2017 revenue ranking:
Experian: $4.3 Billion ($20 billion market cap)
Equifax: $3.3 Billion ($14 billion market cap)
TransUnion: $1.9 Billion ($11 billion market cap)
FICO: $932 Million ($5 billion market cap)

Obviously, the mortgage market is just a fraction of the overall credit scoring industry, but the opportunity unlocked just by reducing one regulatory monopoly in the mortgage market would be significant enough to entice new entrants to build a better product since it shows that the industry is ready to move forward. If the government is willing to consider something new, then lenders across the industry will take this more seriously.

FICO Ain’t Nothing But Trouble

One major problem with the existing models from FICO is that they are heavily reliant on having lots of experience with debt, which presents somewhat of a chicken-and-egg problem.  There are approximately 60 million adults in the US who are left out of the current credit scoring methodology either by having not enough history of using debt, or no debt at all. (Of course, the other 185 million adults could use this new model as well.)

Sen. Tim Scott, who co-sponsored the “Credit Score Competition Act”, says it this way:

“The current credit scoring model at the center of our housing market overlooks a large swath of people that are paying their monthly bills on time and deserve an opportunity to pursue homeownership. This is an opportunity to make our system more fair for everyone without lowering the bar for qualification. There are millions of Americans who pay their rent, utilities, or cell phone bills on time, yet aren’t considered ‘credit-worthy’ under federal housing finance standards because they lack access to traditional lines of credit, such as auto or student loans. These ‘credit invisible’ Americans are disproportionately young, new Americans or people of color.”

(Full disclosure: Scott has received over $250,000 in campaign donations from the trade groups and lobbyists that support the bill, most notably the Credit Union National Association, the National Association of Realtors, and the National Association of Home Builders, though that amount is a small portion of the $13 million he has raised over his career. Sen. Mark Warner, the other co-sponsor, has received about the same amount from the same groups (data from Center for Responsive Politics).)

If the Senate banking bill becomes law, it will be a huge coup for VantageScore, which has been trying to break into the mortgage market since its creation in 2006. VantageScore’s argument has been that it goes beyond the FICO components and has been adding in non-credit data such as rent payments (though the new FICO 9 score does include rent payments as well). With additional data, VantageScore believes they can provide credit scores 7.6 million individuals out of the 35 million that have some credit history but FICO doesn’t/can’t review.

What’s In a Credit Score? A Score By Any Other Name (Still Stinks)

While this is a step in the right direction, VantageScore doesn’t go far enough – it is still heavily reliant on debt history and current debt usage, which is more a score of how much debt you can get rather than how financially independent/stable you are. Consumers are rewarded for having multiple types of debt (auto loans, credit cards, mortgages, etc.), and actively using them, which ends up reducing the monthly cash flow that the consumer otherwise could have saved or invested.

It can be argued that the very nature of a “good credit score” does not correlate with financial success. Credit scores incentivize risky behavior by encouraging people to have multiple types of debt and actively use these accounts, rather than being truly financially stable. When another downturn comes, the millions of Americans who are near the edge will get crushed by the weight of their debt. Survey after survey has shown that the majority of Americans don’t even have $1,000 of savings, so playing around with multiple types of debt is not going to help them.

How do we start to capture something more akin a financial wellness or stability score? How can we use this to promote good financial habits, and assess credit-worthiness or financial responsibility in a new way that doesn’t depend on lots of prior debt usage? How do we ensure more individuals get covered by this system? How many more rhetorical questions can I ask?

In part 3, I’ll try to answer some of these questions and explore what some companies are doing in this space, and potential challenges ahead.