Sunday, July 25, 2010

Credit Scoring: Faces at the Bottom of the Bell Curve

Frank Pasquale

I agree with Prof. Levinson's recent posts on the importance of a Warren nomination for the CFPB. Just to add some context on the challenges the CFPB will face, I want to talk about the social importance of credit scores, including FICO scores. Joe Nocera recently noted that while a "credit score is derived after an information-gathering process that is anything but rigorous," it "has become the only thing that matters anymore to the banks and other institutions that underwrite mortgages." It turns out that's only the tip of iceberg of problems with credit scoring.

Credit scores are becoming a cornerstone of a new "reputation economy," influencing the decisions of insurers, landlords, and employers. Yet the industry remains highly opaque, with scored individuals unable to determine the exact consequences of late payments, changes in location, or other decisions. You may think you're just reducing your risk of fraud from a card if you reduce your credit limit on it--but as Nocera's article shows, that might just up your "debt utilization radio," reducing your score via certain crude algorithmic methods of determining creditworthiness. Since scoring is opaque, consumers are navigating a financial world where they can have only a vague idea of the rules. How much worse is it to have a 90-day-late notice on one’s credit report than a lien that might result from not paying at all? The only quantitative measure is its impact on one’s score, and scorers do not entertain prospective queries.

Several disturbing reports have alleged discriminatory effects from credit scores. In part because of concerns about unreliability and unfairness, use of credit scores by insurers has been regulated by many states. Credit scores have also come under attack for having a disparate impact on vulnerable groups.

The National Fair Housing Alliance and other groups have criticized the scores for embedding biased assumptions into an ostensibly neutral process. A report to the Ohio Civil Rights Commission in 2003 concluded that "it is our opinion that insurers’ use of insurance credit scoring for underwriting, rating, marketing and/or payment plan eligibility very likely has a disparate impact on poor and minority populations in Ohio."

The scores themselves may be self-fulfilling prophecies, creating the financial distress they claim merely to indicate. If a scorer determines that one missed $10 payment for a woman with two children earning $30,000 per year lowers her credit score by 200 points, she will be more likely to default because her low score means that she is going to be paying much more in interest for any financing she can find. Since the scores are black boxes, we have no assurance that scorers try to eliminate such endogenicity or whether they profit from such self-fulfilling prophecies. Without a proper appeals process and transparency in scoring, this panoptic sort may end up as unaccountable as the "Top Secret America" recently described in the Washington Post.

There is something deeply troubling about secretive credit rating. Such a system can simply spit out a life-changing result without giving any explanation for it. Suspicion about FICO scores has led some states to prohibit their use in insurance rating. The CFPB would be well-advised to investigate their role in the economy.

Admittedly, some may say that credit is all-too-available in a massively indebted US, and that scorers are merely tightening up standards that will help push the nation toward a needed structural adjustment. I still believe that such adjustments should be made on the basis of public, open, transparent criteria--not secret scores. It's not just a matter of who gets a new flatscreen, as demonstrated in Robert Berners's Businessweek article "Hospitals X-Ray Patient Credit Scores: More and More are Buying Credit Data to See if the Sick Can Afford Treatment:"

[Medical credit scorer] SearchAmerica says that it has 1,000 hospital clients. The three major credit bureaus . . . are marketing their own customized software for medical providers. And this summer, private equity giant Bain Capital invested $50 million in MedeFinance . . . . Lawmakers in one state, Minnesota, have tried to restrict medical credit scoring. But Republican Governor Tim Pawlenty vetoed a bill in May that would have required hospitals to provide care before seeking a patient's financial data.

The finance and insurance industries have enormous power in the US, and in many circumstances exercise it unaccountably. We can only hope that the President appoints someone to the CFPB with a proven track record of holding these entities responsible for the problems they create.

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