Credit rating companies and the FICO need more oversight

The recent downgrading of government bonds in the US and several European countries has focused attention on three major rating agencies: Standard & Poor’s, Moody’s and Fitch. While the EU and others have faulted those companies for their lack of transparency and potential conflicts of interest, the three major bureaus that rate individual credit (Equifax, TransUnion and Experian) have largely escaped scrutiny.

That may soon change as the new Consumer Financial Protection Bureau (CFPB), established under the 2010 Dodd-Frank legislation, assumes its oversight role.

In it's report of last July (“The Impact of Differences Between Consumer and Creditor-Purchased Credit Scores”), the CFPB criticized scoring systems that provided scores to lenders that were different from the ones disclosed to consumers. Good, but not good enough. Deficiencies in the credit rating process go much deeper. They raise important questions of transparency and extend to the Fair Isaac Corporation (FICO) rules and their implementation.

Assume, for example, you’ve found the house of your dreams and apply for a mortgage. You believe your credit is good since you have always paid your creditors, with only a few late payments over many years. Then the mortgage company sends you documents that include the credit scores given you by one of the rating agencies. The credit report is accurate, but your score is in the five or six hundreds, instead of the seven or eight hundreds you were expecting.  

Then you see that the “key elements” affecting your credit score were “too many inquiries” and “too many credit cards.” Nowhere is the phase “too many” defined. You request credit reports and scores from the other two credit rating companies. All the reports are accurate. They show no defaults and only a few late payments. Yet they all yield scores around 575 and cite the same “key elements” affecting the score: “too many inquiries” and “too many credit cards.” The mortgage company declines your application or insists that you pay a higher interest rate.

You file a complaint with each of the three agencies, questioning the low scores in view of your default free record. Dutifully each of them sends you another copy of your credit report, but fails to justify the score. You renew your complaint, insisting on transparency. Again you receive in response only another copy of your credit report with no explanation. This is a hypothetical case, but it mirrors my own recent experience. A 73 year history of full and on time debt repayments yielded a less than perfect credit score. I could never find out why.

The rating companies are responsible for the secrecy of their operations and for their implementation of the FICO scoring rules, but the rules themselves also warrant review and revision. As explained in the FICO website, 35 percent of the scoring factors are totally unrelated to the individual’s payment history. They comprise of the “length of credit history” (15 percent), the “number of new accounts” (10 percent) and the “types of credit used” (10 percent), including the “number of recent credit inquiries.” While it may be reasonable for a rating agency to consider the types and duration of credit, one may question how those two factors are graded within the allotted 20 percent. Moreover, it seems unfair for the agencies to penalize an individual borrower for the number of recent credit inquiries and the number of new accounts. How can an individual control the number of credit inquiries, especially when he or she is applying for a mortgage, hazard insurance or a new credit card? Why should one be penalized for ordering a new credit card to replace one with fewer benefits?  

As the FICO says, “credit scoring systems are complex.” Yet that should not excuse either unfair rules, or biased implementation. Individuals need to know not only their scores but how each of the “key elements” was assessed. They should be given an opportunity to explain the rationale for new credit cards and they should not be penalized for credit inquiries over which they have no control.

The Consumer Financial Credit Bureau should extend its review of the individual credit rating process. It should require more transparency of the credit rating agencies and more fairness in the FICO rules.  

Hager is the former Director General of the International Development Law Organisation.

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