Consumer credit scores have been artificially inflated over the past decade and are masking the real danger the riskiest borrowers pose to hundreds of billions of dollars of debt.
That’s the alarm bell being rung by analysts and economists at both Goldman Sachs Group Inc. and Moody’s Analytics, and supported by Federal Reserve research, who say the steady rise of credit scores as the economy expanded over the past decade has led to “grade inflation.”
This means debtors are riskier than their scores indicate because the metrics don’t account for the robust economy, skewing perception of borrowers’ ability to pay bills on time. When a slowdown comes, there could be a much bigger fallout than expected for lenders and investors. There are around 15 million more consumers with credit scores above 740 today than there were in 2006, and about 15 million fewer consumers with scores below 660, according to Moody’s.
“Borrowers with low credit scores in 2019 pose a much higher relative risk,” said Cris deRitis, deputy chief economist at Moody’s Analytics. “Because loss rates today are low and competition for high-score borrowers is fierce, lenders may be tempted to lower their credit standards without appreciating that the 660 credit-score borrower today may be relatively worse than a 660-score borrower in 2009.”
The problem is most acute for smaller, less sophisticated firms that lend to people with poor credit histories, deRitis said. Many of these types of lenders rely mainly on the data supplied by Fair Isaac Corp., the so-called FICO score, and are unable or choose not to include other measures -- such as debt-to-income level, economic data or loan terms -- into their models for measuring risk, he said.
Car loans, retail credit cards and personal loans handed out online are the most exposed to the inflated scores, according to deRitis. This kind of debt totals around $400 billion, with nearly $100 billion bundled into securities that’s been sold to investors, data compiled by Bloomberg show.
What has analysts concerned is that cracks have already begun to show up in the form of a rising number of missed payments by borrowers with the highest risk, despite a decade of growth. And now with the economy showing signs of weakness, as seen with the recent inversion of the Treasury yield curve, those delinquencies could grow and lead to larger-than-expected losses for investors in riskier asset-backed securities.
“Every credit model that just relies on credit score now -- and there’s a lot of them -- is possibly understating the risk,” Goldman Sachs analyst Marty Young said in an interview. “There are a whole bunch of other variables, including the business cycle, that need to be taken into account.”
Fair Isaac Corp. created its FICO credit score product in 1989, and it’s still used by more than 90 percent of U.S. lenders to predict whether a would-be borrower is an acceptable risk. Most scores range from 300 to 850, with a higher score purporting to show that someone is more likely to pay back debts. A competitor, VantageScore, was created in 2006 by the three major credit raters Experian, TransUnion and Equifax.
The concern that’s come up, Goldman and Moody’s say, is that lenders haven’t adjusted their underwriting standards as average credit scores have risen during one of the longest economic recoveries on record. So as cracks start to appear in the economy, someone whose credit score rose to 650 from 550 since the Great Recession may pay their bills more like they did 10 years earlier.