Sunday, April 29, 2007

Opinions differ on effectiveness of FICO score, Posted by Robert Paisola

Opinions differ on effectiveness of FICO score

Fair Isaac says its FICO score works just fine. But rising defaults have prompted some to question whether the system has flaws.

By Thomas Lee, Star Tribune

Don't blame the messenger.

That might not be anyone's idea of a great corporate slogan, but executives at Fair Isaac Corp. are finding themselves playing defense this year about the company's most vaunted product.
As subprime mortgage defaults continue to rise, some lenders are questioning the value of Fair Isaac's FICO score, which measures a consumer's ability to pay back a loan.

"FICO scores were one of the best predictors of early defaults," said Glenn Costello, an analyst with Fitch Ratings, a credit-rating agency based in New York. "Today, that is not true."

In December, a top executive with HSBC Finance, a major subprime lender, told investors that FICO scores were "less effective or ineffective" in predicting behavior during a period of aggressive lending and low interest rates.

Defenders of the FICO score say the product works just fine. They say overaggressive lenders, hungry for profits, are more to blame for the increasing number of defaults among homeowners, because they loosened underwriting standards to take in more marginal borrowers and also sold riskier products such as adjustable-rate mortgages.

"We're confident that FICO does what it is supposed to do," said Ron Totaro, vice president of global scoring solutions for Minneapolis-based Fair Isaac. "Lenders develop their lending strategies, and they use as little or as much information as they want."

Totaro said there is "no evidence" that FICO scores are not effective when applied to borrowers who fit in the riskier subprime portion of the market.

Any perception that FICO is faulty could have serious consequences for Fair Isaac. FICO is both the company's best-known product and the most popular credit-scoring system in the United States. Last year, FICO scores generated $177.1 million in sales, about 21 percent of Fair Isaac's total revenue.

What's worse, the company has already been struggling to boost its sales. Last week Fair Isaac said second-quarter revenue fell 3.4 percent to $201 million.

FICO also faces a challenge from VantageScore, a new credit-scoring system developed and marketed by Experian, TransUnion and Equifax, the country's three top credit-reporting agencies. Fair Isaac is suing the agencies, claiming VantageScore violates antitrust laws. By jointly offering VantageScore, the agencies are in the position to shut out FICO and other competitors from the credit-scoring market, according to papers filed in U.S. District Court in Minneapolis.

VantageScore executives see the subprime fallout as an excellent chance to promote their product.

"Absolutely, it helps us," said Barrett Burns, VantageScore's chief executive. "It offers us a great opportunity for lenders to look at VantageScore. Since our score is more accurate and predictive, there would have been improvement" in mortgage defaults had the industry used VantageScore instead of FICO, he said.

A recent Fitch Ratings report seems to lend some support to Fair Isaac in the debate. Some of the industry's riskiest subprime products -- high loan-to-value mortgages, piggyback loans and others that required little or no documentation of income -- made the FICO score "less significant relative to other attributes as an early default indicator," Fitch said.

In 2003, loans that defaulted within 12 months of issuance had FICO scores that were 30 points less than loans that did not default. Last year that difference shrank to 10 points, according to Fitch.

Others say the troubles among subprime loans simply show the limitations of credit scores. Loan officers can't look to FICO scores when trying to weigh how changes in interest rates, the type of loan or sudden events could affect a borrower's ability to pay, said John Ulzheimer, president of Educational Services, a San Francisco-based financial services company.
"The score is the score," said Ulzheimer, a former Fair Isaac manager who helped build credit-scoring models. "It doesn't take into account external factors."
For instance, Hurricane Katrina's devastation could have turned healthy FICO scores of 750 among Gulf Coast residents into 450s in a relatively short period of time, in which case "the credit scores looked like they had failed," Ulzheimer said.

Still, credit-scoring companies must do a better job in establishing consistent scores for borrowers with patchy credit, said Craig Focardi, an analyst with TowerGroup, a research and consulting firm in Needham, Mass. Credit scores below 640 fluctuate more often than scores of 700 or better, he said. Companies such as Fair Isaac also should develop credit scores that take into account additional categories of risk instead of "lumping customers into similar brackets," he said.

Fair Isaac sells a product called NextGen FICO that Focardi says better measures the credit risks posed by subprime borrowers, but mortgage lenders have been reluctant to adopt it because it costs more than a standard score. VantageScore could inject some needed competition into the business, Focardi said.

"The mortgage industry needs to reevaluate whether one score is good for all customer segments," he said.

Totaro of Fair Isaac said the company constantly updates and refines FICO scores. Asked if some subprime lenders are unhappy with the service, Totaro replied: "We have talked to numerous clients. We will work with them to show them how the FICO scores work."

Ulzheimer said lenders never liked FICO scores, especially when a low score disqualified a potential borrower from getting a loan. Most lending operations are set up so that fees are generated by granting loans, not turning people away. But in the recent housing boom, lenders just got too greedy and sold unsuitable products to consumers, he said.

"You do your best to explain how the model is built and what it can do," Ulzheimer said. "But some lenders are going to do whatever they want to do. You never hear from lenders when things are going well. But the minute the FICO score doesn't do what they want it to do, it's amazing how loud they scream."

Thomas Lee • 612-673-7744 •

©2007 Star Tribune. All rights reserved.

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