FICO scores under suspicion

When I eventually managed to get my FICO score over the 800 level, I wanted to buy a t-shirt to commemorate the event, but was quickly talked out of it by friends who thought it seemed a bit arrogant (hey! I worked hard for that score). But now it seems that there are numerous ways to game the FICO system, so now the Fair-Issac Corporation is again tweaking their scoring methods for 2008 (the first major change since 1989) since the scores were used during the recent boom as a substitute for detailed underwriting procedures. But will it make a difference? From a recent cover story in Business Week:

From humble beginnings in 1956, Fair Isaac Corp.'s credit score— developed by engineer Bill Fair and mathematician Earl Isaac to help banks and department stores calculate their customers' creditworthiness—has come to loom over consumer finance like no other statistical measure ever has. The ubiquitous three-digit FICO score now helps determine everything from the interest rates people pay on their credit cards to their attractiveness as job candidates...

But with mortgage defaults surging and credit-card issuers bracing for more problems, the wizard seems to have lost some of its magic. A slew of unforeseen problems, some of Fair Isaac's making and others not, have combined to weaken the credit-scoring system on which most U.S. lenders and investors rely. The FICO score, last overhauled in 1989, is based on a complex formula using many variables—and yet it can be manipulated fairly easily by ordinary people. In the past few years a group of "credit doctors" and mortgage brokers began devising tricks, some illegal, to help borrowers juice their FICO scores to qualify for credit cards and mortgages on homes they couldn't afford. At the same time new, exotic mortgages were bursting onto the scene and Fair Isaac was slow to keep up with the changes. By the end of the housing boom in 2006, FICO's accuracy in predicting the likelihood of a borrower's repaying a debt had slipped...

Yet as FICO was becoming less effective, lenders were relying on it more and more. In earlier times, banks would go to great lengths to vet potential borrowers, checking pay stubs and tax returns, calling employers, poring over investment account statements, and on and on, a process called underwriting. The mortgage boom changed all that: Wall Street investment banks were buying up every loan in sight, and lenders had to race to keep pace with the surging demand. The FICO score became as important as a pitcher's earned run average: It was a single, universal statistic that, in theory, could communicate a loan's quality to lenders, investment banks, and investors. Emboldened by its success, Minneapolis- based Fair Isaac marketed the score for other purposes and began offering new products for different industries.

Now the credit markets are in disarray, and big mortgage players like HSBC (HBC), JPMorgan Chase (JPM), and Washington Mutual (WM) —perhaps opportunistically—are laying much of the blame at Fair Isaac's feet, arguing that its score didn't predict delinquencies as expected. (Meredith Whitney, an analyst at CIBC World Markets, called FICO scores "virtually meaningless" in a December note to clients.) Consumer advocates and state regulators are clamoring for Fair Isaac to disclose its formula. And credit-card providers are beginning to question the score, too...

It's unclear, however, whether FICO 08 will address all the problems that hampered the previous version. What's more, the firm isn't rolling out the new score until later this year, and banks won't fully integrate it into their lending models until 2009. Even if the new score is all it's cracked up to be, credit doctors will likely try to manipulate this one, too...

...as the housing market was heating up, borrowers and lenders were figuring out methods, both legal and fraudulent, to game the scoring mechanism—and Fair Isaac failed to keep pace. Consider the rise of credit doctoring, a legal if highly questionable method for boosting a borrower's credit score. Larry D. Hall, a former drug addict who once lived in a homeless shelter, has made a name for himself on Atlanta's south side as the man to see if you can't get a car loan or mortgage. For $500, Hall arranges for a client to become an "authorized user" on the credit- card account of a retiree with sterling credit, a tactic known as "piggybacking." The method, says Hall, can boost a score by 50 to 100 points within a few months. A study by credit-rating agency Fitch Ratings, which looked at loans with average FICO scores of 686, found that 16% had employed the "authorized user" ruse to boost the applicant's score. Fair Isaac says FICO 08 will close this loophole...

Credit doctors weren't the only ones manipulating FICO scores during the housing boom—many independent mortgage brokers found ways to cheat the system, too. One software program, PDF Password Remover 2.5, is easily found on the Web. It's designed to help users override the passwords on protected documents; brokers have misused it to hack into the credit reports being sent from credit bureaus to lenders to boost FICO scores. The tactic "was common enough that everyone on the underwriting desk made sure they pulled credit reports [themselves] so they won't get duped," says one mortgage underwriter in Dallas.

Whole companies have formed to help brokers exploit FICO's flaws. Credit- Xpert, a Towson (Md.) startup founded in 2000, claims to have reverse-engineered the formula. With its tools, which are legal, mortgage brokers can run endless "what-if" scenarios to see which moves would boost their customers' scores enough to qualify for a loan. "Demand for our services has gone up dramatically," says CreditXpert CEO David G. Chung. "We're now getting more requests from brokers for advanced user training." Says Fair Isaac's Greene: "We don't believe it's possible to reverse-engineer the FICO scoring formula."

Until a few years ago, FICO was just one factor in the underwriting process. But as Wall Street grew hungrier for mortgages it could stuff into securities and sell to investors, it came to value FICO as an easily understood risk measure. Lenders were all too happy to use it as a substitute for laborious underwriting. "There were investors around the world demanding more and more deals, with investment bankers happily supplying the business," says Ron Chicaferro, a mortgage consultant in Scottsdale, Ariz. "It trickled down to the lender, who told their sales force, The faster you can get me a score and close a loan, the better. We'll forgo the documentation.'"

Throughout the housing boom, Fair Isaac promoted FICO's usefulness for other purposes, too. Bond rating agencies relied on it to assign grades to mortgage-backed securities and other more exotic bonds. Over the years, Fitch Ratings upped the score's weighting in its model, reflecting the lending industry's growing reliance on the measure. "Fair Isaac worked with us to develop the [securities] ratings model with FICO," says Glenn Costello, co-head of Fitch Ratings' U.S. residential mortgage-backed securities group.

FICO 08 could well help matters. The new system still spits out scores in the 300-to-850 range, but its analysis goes deeper. Whereas the current score penalizes consumers equally for any type of delinquency, FICO 08 is fine-tuned to reflect how many times a borrower is delinquent and the types of debt involved. Overall, Fair Isaac estimates, FICO 08 will improve the accuracy of lending decisions by as much as 15%, cutting default rates.

But only two of the three major credit bureaus have agreed to use FICO 08 with their consumer data. (Equifax (EFX), based in Atlanta, says it won't implement the new score. Fair Isaac sued it in 2006 over a rival credit-scoring product.) Even after the credit bureaus get on board, lenders may need 6 to 12 months to revamp their systems. Meanwhile, credit doctors and other characters will start lining up to take their whacks at the new system. Says Hendricks: "I don't expect any of this to go away."