Impressions

The Credit Score is the Problem

By Tim Holland

It seems to me that in the forest that is defined as the current credit melt down, lots of trees are being identified as the problem: sub prime mortgages, a seemingly unregulated mortgage industry, unscrupulous mortgage officers and lenders, collateralized mortgage obligations, hedge funds, and of course, Greed – on everyone’s part. Personally, I think its time to step back and look at the whole forest and see what really brought us to this point.

The very first culprit I would identify would be the “Pay for Performance” concept. There are some places where pay for performance should not be permitted and the credit extension process is one of them. The idea that someone is paid based on the volume of the loans they bring in is just crazy. No matter how many checks and balances a lender thinks they have put in place, lots of garbage will slip through. Somewhere along the way the concepts of sales and credit extension have become confused – they are not the same. The payment of a commission for making a sale is a good thing; a commission for making a loan is not.

This is not a new argument. Ever since Congress started deregulating the banking industry, which was one of the major causes of the Savings and Loan disaster (the way Congress did the deregulating and not the deregulation itself), we keep encountering financial disasters. The concept of bankers becoming sales people and bank branches becoming retail stores has virtually replaced the fiduciary responsibility of bankers with a sales culture.

Banks are supposed to be different from ordinary corporations. The deposits that are placed with financial institutions are to be guarded by the bank for the benefit of the depositor. The banks first responsibility is supposed to be to the depositor and not to the shareholder. That is reportedly the concept under which banks are permitted to take deposits, raise funds and make loans and thereby able to obtain FDIC insurance for their customers. Congress has dropped the ball and so has the Federal Reserve System.

When extending credit to consumers, the biggest impediment has always been the loan approval process. If you, as the originator of the loan, are being paid based on the number of loans being approved, the approval process is your enemy. Those people with the green eye shades pouring over financial statements and credit reports, who don’t participate in the commission structure, are holding back the bank and its profits. The answer: eliminate them. After all, 99% of the consumer loan population is honest and always pays back their debit so why are we going through all these checks and balances and internal loan reviews. Why don’t we automate the process and outsource it like everything else? Welcome to the credit scoring process.

Now, in all fairness, the credit scoring process in not entirely a bad idea it just has a bad flaw: it focuses too much on individual credit capacity, i.e., how much unused credit you have outstanding and your on-time repayment record. It does not take into consideration your income and its capacity for growth. You don’t need to be the proverbial rocket scientist to figure out that if consumer debt for the average person (those are the people that do not pay off their credit cards every month) is growing at a positive rate and the real rate of income growth is declining, the negative spread between the two is the 800 pound gorilla in the room. Any banker with any understanding of fiduciary responsibility, would never tell a customer that the way out of debt is to borrow more, i.e., take a home equity loan to pay off your credit cards. But then, of course, they are not bankers any more they’re commission sales people.

The solutions are not easy and they’re not simple. You really can’t go back to the way it was: home equity loans can only be used to improve the underlying asset, i.e., the home improvement loan and the originators of mortgages have to be able to fund a major portion of the loans rather than just pass them onto third parties. There are a good deal more nuances to deal with now but its about time someone did.

The ultimate responsibility is with Congress. They created the problem and its time they took ownership of it. Laws and regulation only work if they are reviewed and adjusted on a regular basis. The lawyers and accountants employed by the financial industry specifically and the corporate world in general are always going to find their way around any regulation put in place and the longer a law is on the books without revision and analysis of its effectiveness the more holes it will develop.

It’s time for Congress to re-evaluate deregulation and start determining what has worked and what hasn’t. Laws and regulations are only effective as long as the environment in which the regulations exist remains unchanged. The creation of a new playing field (commissions, mortgage brokers, credit scoring, etc.) should trigger regulatory review and amendment. It’s Congresses responsibility not just to create laws but also to make sure they are effective.