Thursday, March 20, 2008

Fooling with Credit Scores

Bob Sullivan of has written an instructive series of articles on credit scores. He explains how credit scores determine the interest rates consumers are charged when borrowing money. Small changes in credit scoring can result in tens of thousands of additional dollars in finance charges a consumer could be required to pay on a mortgage.

What fascinates me is his explanation of how the reliance by the lenders on scoring invites people to “game the system.” Not only do the borrowers look for tricks to enhance their scores, but, the lenders use the scores to convince investors that the loans are not as risky as they actually are. It amazes me the great effort spent determining precise measures (FICO scores) of risk to lenders, while ignoring obvious problems with the bigger picture. It is a classic case of not being able to see the forest for the trees.

For example, while in the process of preparing a talk for a one-day university event this coming April, I made a simple plot using Census Bureau data of the ratio of the median home price to the median household income in the United States for the past 20 years (1987-2007). That ratio is flat at about 3 until the year 2001 when it suddenly takes off reaching nearly 5 by 2007.

Obviously the rise in home prices over the long run cannot outpace household income because a point in time will come when people no longer have the money to make the loan payments. I’m sure all those brokers at Bear Stearns invested a great deal of effort and expense modeling their risk with precise credit score data. But, a simple look at Census Bureau data would have shown them that their business model—betting that even in a foreclosure there would always be another buyer able to pay an even higher price—was doomed to failure.

Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

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