Do Credit Scores Mislead Lenders?

Lenders have often touted high credit scores as an indication that increasingly risky loan products are not being handed out indiscriminately, but one analyst at an independent research firm here says those credit scores may not be as predictive as lenders think.

CreditSights sees evidence of credit score inflation in recent years. And after years of impressive credit performance even as debt levels rise to record levels, analysts at CreditSights say they see signs that consumers are due for a "correction in their debt repayment behavior."

And it's not just credit card companies that will feel the pain. In fact, CreditSights believes that mortgages, despite being "at the top of the food chain," could drive weakness in consumer credit quality. And the "bull market" in housing may have masked some potential problems in recent years.

While lenders have reported seeing improvement in credit scores in recent years, CreditSights suspects that the credit score providers may have experienced gradual score "inflation" over the past decade, and especially during the past five years. That means the mean credit score has elevated, even as consumer debt burdens grow and risky loan products gain popularity.

Credit score providers such as Fair Isaac & Co. and the credit bureaus aren't offering much help in refuting the charge, Dave Hendler, an analyst with CreditSights, told MSN.

"They don't really discuss how they come up with these scores in much granular fashion," he said.

Particularly as the scores have evolved - FICO has revamped its scores several times in recent years - Mr. Hendler suspects the systems are looking at more data with an eye toward approving more loans, rather than as wholly impartial judge of credit.

In addition, FICO faces competition in the credit scoring market from Vantage Score, a product developed by Experian, TransUnion and Equifax. Still, score providers may be responding to pressure from lenders that want to approve as many loans as possible.

"There is more competition, but it's not competition to say no, it's competition to say yes," Mr. Hendler said.

If that score inflation does translate into higher-than-expected losses in the mortgage sector, CreditSights believes some companies may have more at risk than others. Countrywide, Washington Mutual and ResCap could be particularly vulnerable to a downturn in consumer credit performance.

By contrast, Wells Fargo, Citigroup and J.P. Morgan Chase have more "cushion" from diversified retail banking and capital market operations, making them less dependant on the mortgage sector.

Mr. Hendler and his colleagues at CreditSights say that during the past 18 months, relatively "unseasoned" mortgage and home-equity loans helped to sustain a low charge-off environment for the banking industry. But as those home loans season into their peak age for default risk, that could change. Add in the unknowns associated with new and seemingly risky loan products, and the industry could be in for a wakeup call. In addition, the "bull market" in housing values may also have masked credit problems in recent years, but many believe that housing prices are due for a correction or at least a slowdown in appreciation.

Consumer spending "bravado has been met with a similar and perhaps even stronger hubris from lenders" eager to keep loan volumes up, the CreditSights report said.

Those improvements in scores are misleading lenders, according to the independent analytics firm. Over the last 10 years or so, CreditSights believes that the average FICO score has risen by 50-60 points. But this may be more a case of "grade inflation" than real improvement in consumer debt behavior.

The result is a concern about a "growing disconnect" between the condition of consumer credit and the predictive ability of credit scores.

"We believe deterioration in real estate could be a key driver in exposing the consumer's vulnerabilities," the report said.

"Our concern remains that the credit scoring system seems to be increasingly catering to lenders more in the sense of a rubber-stamp approval for making loans rather than an impartial assessment of credit risk."

Officials from Fair Isaac did not respond to a request for comment by MSN's deadline.

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