I personally don't think legislation is the answer but I think banks rely too much on credit scores and not enough on other factors when making loans. It is a good tool but not the entire solution.
Sliding economy raises questions about credit scores
By Kathy Chu, USA TODAY
Through all the foreclosures, staggering stock market losses and dissolved personal fortunes, one measure of Americans' financial health has remained surprisingly steady during the recession: the consumer credit score, used by banks and lenders to determine how much credit to give borrowers, and at what rates.
But that's finally beginning to change, and the economic turmoil in households is not solely responsible.
Banks and lenders are shoring up risks — closing a record number of credit card accounts and reducing millions of dollars in credit lines. As they clamp down, even some consumers with excellent credit and spotless payment records are seeing their credit scores reduced because of the diminished credit lines. That, in turn, can hamper consumers' ability to get credit elsewhere.
Mary Lou Reid, 61, says two of her credit cards were closed recently because of inactivity, eliminating $47,000 of available credit. Her credit score dropped to 726 from 757. The most widely used credit scores run from 300 (very poor) to 850 (pristine).
"They didn't give me any warning," says Reid, of Arcadia, Calif. "One needs to feel in control of one's life, and what they've done here is cut me out of the equation."
As lenders' appetite for risk wanes, they're pulling back on an unprecedented amount of credit — up to $2 trillion on cards alone by 2010, estimates analyst Meredith Whitney.
"It becomes this self-fulfilling problem," says Mark Zandi, chief economist at Moody's Economy.com. "Lenders cut credit lines, and if consumers simply do what they had been doing, their credit score could fall. Other lenders respond by cutting their own lines or raising rates."
The cycle concerns consumer advocates and some legislators. Some wonder whether restrictions should be imposed on lenders' ability to slash credit limits and close accounts. And if scores can drop even if consumers do nothing wrong, they say, it raises the question of whether there's a flaw in the credit scoring formulas relied upon by the nation's lenders, insurers, and increasingly employers and landlords.
USA TODAY, in previous stories in its "Credit Trap" series, has reported that during the housing boom, banks sharply raised card limits in part because of a surge in home equity, then guided borrowers to use mortgages to pay off card balances.
Now, when it's already difficult to qualify for loans, lenders' actions can lead to deteriorating credit scores that can put much-needed credit out of reach for a growing number of consumers. Those who get loans may have to pay higher interest rates. Lenders also may seize upon lower credit scores to increase interest rates, pushing consumers deeper into distress.
Jobs, and even auto insurance, can be affected if consumers don't have good credit ratings. Most auto insurers now take credit scores into account in determining their rates. And 42% of U.S. employers routinely do credit checks on job applicants, according to the Society for Human Resource Management.
Bank officials say they're aware of growing concerns about the effects credit-line reductions and account closures are having on credit scores. But as the economy worsens, they say, more consumers are struggling, so it's only natural that institutions take steps to reduce risk before borrowers default.
Bank officials also say they have no control over credit score calculations — and, like consumers, they don't know exactly how such scores are determined.
"It's tough to connect any one action (by the lender) to consumers' credit score," says Scott Talbott, senior vice president of government affairs for the Financial Services Roundtable, which represents large banks.
Even so, banks are concerned enough about the issue that they've asked Fair Isaac, the creator of the widely used FICO score, to study whether — and to what extent — their tightening of credit affects scores. Fair Isaac plans to complete its preliminary study in the next few weeks.
The cycle of one bank's actions potentially affecting a consumer's credit score and leading to other banks taking similar steps is troubling, says Sen. Chris Dodd, D-Conn. "Banks can only stay in business if they've got creditworthy customers. If you're destroying people's credit ratings ... then you've got a customer base that can't afford your products."
The problem, he says, should provide impetus for "future examination of how credit scores are determined."
Tom Quinn, vice president of scoring at Fair Isaac, says he believes credit scores remain effective in predicting the likelihood consumers will repay their bills.
"The challenge is that we haven't had a recession like this since the Great Depression, and we didn't have credit scores back then," he says. "We haven't really had an opportunity to see" what will happen with credit scores in such an environment.
Seth J. Chandler, a law professor at the University of Houston, says although credit scores are "incredibly powerful, lenders might start to revise the importance they put on (them) if they no longer reflect reality."
A 'downward spiral'
Reid says she's always paid her credit card bills on time and worked hard to get her credit score to the mid-700s. Having two accounts closed will erase decades of good credit history on the cards, she says. And because she's near retirement, "I don't have another 37 years to repair this problem."
Talbott says that only a minority of borrowers will get their card limits reduced. For those who do, it's "unfortunate" if scores drop, he says.
"This is sort of the downward spiral of the worsening economy," he says, "that leads to increased risk, the closing of credit lines, a lower FICO score and increased cost of credit when people can't afford it."
It's understandable, says John Ulzheimer, a former executive at Fair Isaac and Equifax credit bureau, that lenders want to reduce risk in this economy. "Having said that, you can't simply ignore the reaction of your actions," says Ulzheimer, now the president of consumer education at Credit.com. "That would be irresponsible for a large lender."
Credit scores caught on in the 1960s as a uniform way to measure consumers' likelihood of repaying their bills — and thus, their potential profitability to lenders. Before then, merchants shared information about consumers to decide whether to extend credit.
Today, 90 of the largest 100 financial institutions rely on FICO scores, according to Fair Isaac. Credit bureaus also sell proprietary credit scores, and team up to put out the VantageScore, a competitor to FICO.
Scores are starting to fall in the parts of the country most affected by rising home foreclosures and credit card debt, according to analyses of credit bureau data for USA TODAY by Experian credit bureau, and separately, Moody's Economy.com and Equifax.
Nationally, median scores dropped five points between the fourth quarter of 2007 and 2008, Experian's data show.
But in the Riverside, Calif., metro area, median credit scores dropped 17 points during that time. Credit scores in and around Phoenix dropped about 14 points, and they fell 12 points in the Miami region.
Yet scores lag the economy, because it may take awhile for consumers' financial situations to decline, says Michele Raneri, senior director of analytics for Experian.
It's likely that scores have a ways to fall. "Given surging unemployment, I'd be surprised if we don't see a measurable erosion in credit scores," says Zandi. "I think it's happening right now."
Because credit cards are more common than mortgages — 51.4 million households have first mortgages, while nearly all the nation's 114 million households have at least one card — card-related actions can hurt overall scores more than mortgages.
"There are a lot more card holders than mortgage holders," Zandi says. "It's credit cards that are really going to cause people problems on their credit scores."
Fair Isaac and the credit bureaus don't disclose exactly how credit scores are calculated. But a key factor in the score is what the industry calls "open to buy," basically how much of a consumer's credit line is drawn down on plastic. Also called the credit utilization ratio, this — along with a handful of other variables — makes up a combined 30% of your FICO score, Fair Isaac says. Other important components include overall payment history, how long a consumer has had credit, and the types of credit.
When lenders close accounts or slash credit limits, it often boosts the percentage of available credit consumers are using. That's the key reason scores could fall.
Mike Century, 48, of Bloomington, Ill., says Bank of America closed one of his card accounts because of inactivity and reduced limits on three other cards, eliminating about $20,000 in available credit. That caused his scores to drop 17-44 points, he says. Even though he still has enviable scores — the lowest is now 710 — he worries he no longer qualifies for the best rates on loans.
Some lenders have tightened their underwriting criteria and now require a FICO score of 750 to qualify for the lowest rates.
Lenders' "actions make you appear riskier than you are," Century says. Bank of America declined to comment on Century's case, citing privacy concerns. However, Betty Riess, a spokeswoman, says the bank is "taking a more aggressive look at accounts to control risk, given the current environment."
As part of this review, the bank may close accounts inactive for a year and also adjust credit lines, Riess says, "based on (consumers') risk profile and their performance with us."
As more banks pull back on credit, it's straining their relationships with longtime customers.
Russ Reed, 46, says he and his wife, Darlene Guinto, 38, no longer want to use their American Express card after the bank slashed the limit more than 80% to $4,600. The bank, in a letter, cited a history of late payments. Reed says they paid late only twice over several years, and never on American Express bills.
Reed later was denied a Wells Fargo business loan. It's likely his $35,000 in low-rate credit card debt — from starting an environmental engineering firm — was a factor. But Reed says the bank cited his available credit.
American Express spokeswoman Molly Faust says that while the bank does monitor credit bureau information, it mostly looks at borrowers' debt compared with their financial resources in deciding whether to cut credit lines.
Banks warn against limits
The Federal Reserve has approved a new policy — which takes effect in 2010 — that restricts lenders' ability to raise credit card rates and impose fees. But it doesn't address lenders' ability to change credit card limits and close accounts.
Consumers Union, the publisher of Consumer Reports, is lobbying for legislation designed to ensure that lenders conduct "sound underwriting" when they extend credit, so they don't have to slash credit lines and close accounts when the economy slumps — dragging down credit scores.
Lenders also should be banned from raising interest rates or taking other adverse actions against consumers if their credit scores dropped solely because they had their credit lines reduced or accounts closed, says Lauren Zeichner Bowne, a staff attorney at Consumers Union.
This ripple effect is "absolutely happening," saddling consumers with higher fees and rates, and more closed accounts, says Ken Lin, who developed credit models for banks before becoming chief executive of CreditKarma.com, a consumer website.
Banks warn that imposing restrictions on their business practices could raise costs for everyone and reduce credit further for those who need it.
"The need to adjust for changing risk is the only way (banks) can make revolving credit available," says Ken Clayton, a senior vice president at the American Bankers Association.
Charleen Lee, 62, of Albany, Ore., says she's taken her complaints about banks' actions to state legislators.
Lee says Chase closed a card with a $15,000 limit in December, citing "inactivity" and the potential for fraud. Angered, she closed another Chase account because she no longer wanted to do business with the company.
Chase says it can't comment on individual consumers. But the bank is reviewing affected customers' situations, says spokesman Paul Hartwick, and "evaluating their validity." The bank understands consumers' concern about account closures, adds Hartwick, but is "committed to prudent risk management."
Lee's main gripe, she says, "is that good clients are being treated like people at risk. What if I want to buy a house? Should I be put in jeopardy (of higher loan rates) when I've done nothing?"