California Reinvestment Committee
The use of credit-scoring models to evaluate creditworthiness has become widespread, even finding its way into the insurance arena, despite serious concerns about the fairness and utility of these models. Credit-scoring models were developed and adopted primarily as a means of helping financial institutions manage credit risk. The California Reinvestment Committee (CRC) believes financial institutions should be working instead to develop and adopt innovative methods of safely extending low-cost credit to underserved borrowers and communities. Most observers accept that the use of credit-scoring models has had a disparate impact on people of color. Following are various reasons to question whether heavy reliance on credit scores furthers the nation's interest in fair lending and equal access to credit, as well as the safety and soundness of financial institutions.
The Larry Rule. In early 1996, an unlikely report came out that then-Federal Reserve Board Governor Larry Lindsey, now President Bush's chief domestic economic adviser, was denied a Toys "R" Us credit card because he did not have an adequate credit score. This incident raised questions about which and whose values underlie credit-scoring models and how financial institutions react to these models. American Banker reported that "the result of all this flap will be what we call the Larry Rule," whereby financial institutions look harder at credit scores to ensure the factor that apparently tripped up Mr. Lindsey—too many credit inquiries—didn't result in denials to creditworthy borrowers. All of this leads us to wonder if the credit denials of any low-income, immigrant, of color, or elderly credit applicants resulted in similar introspective industry discussions.
The underlying data may be inaccurate. Credit scores are based on reports from the main credit bureaus, even though these reports often contain errors. The Home Buyer Assistance and Information Center, located in Oakland and serving consumers in the San Francisco Bay area, estimates that at least half of all credit reports reviewed by trained counselors contain errors. What may be an inconvenience for many becomes a significant barrier to credit for people who lack the resources to discover the mistake, appreciate its significance and correct the error. Further, we now know that unscrupulous creditors, such as predatory mortgage lenders, often do not report their borrowers' good payment history to credit-reporting agencies in order to keep them in the subprime market.
People who understand the game can improve their score. With some knowledge about how credit scores are derived, credit applicants can improve their credit scores. Prospective borrowers can even pay a fee to find out how to improve their score. Apparently, such programs are being offered by none other than the companies that devise the credit-scoring model themselves. But which consumers will find out about these services, and who will pay for them? Is the person who opened a new account or closed an old one in order to manipulate her score really a better credit risk than she was before she was advised to make these changes? Is she really more likely to pay off her mortgage than the applicant who did not know how to manipulate her score?
Disparate levels of assistance. Much can happen in the handling of a home loan application. Often, a lender or broker wants to see additional documentation to support the application of a nontraditional borrower. Problems can arise when applicants are not given equal assistance in securing the necessary documentation. Testing conducted by fair housing councils in California revealed that customers of color are treated differently than white customers upon entering a bank or thrift, less often given a home loan application, less often encouraged to speak to bank staff and less often given key information that could strengthen their application.
The two-tiered banking system is perpetuated and punishes the victim. Disturbingly, credit-scoring models may downgrade borrowers who have accounts with finance companies or subprime and payday lenders. These borrowers are in the subprime market because they and their neighborhoods have been abandoned by mainstream banks and thrifts. A recent CRC study of subprime borrowers in California revealed that a shocking 72 percent of respondents did not even approach a bank or thrift for their mortgage loan, even though most reported they had seen their credit score or credit report and that it was "good" or "excellent." These figures are consistent with estimates by Fannie Mae that up to 50 percent of borrowers in the subprime market could have qualified for prime loans. Using the subprime market may lower one's credit score, essentially punishing those with few real or perceived mainstream credit alternatives, many of whom have good credit.
Not all borrower behavior is based on the values that likely underlie credit-scoring models. Credit-scoring models are based, by and large, on how the majority of mainstream consumers use credit. Such models are designed to match credit applicants with the manifest behavior of middle-class consumers. It is unclear how such models account for our legacy of discrimination in access to credit. Credit-scoring models that penalize people with no established credit are not a good indicator of whether a borrower will repay the mortgage. Instead, lenders should accept alternate forms of credit, such as utility and rent payments, as evidence of a borrower's creditworthiness.
Given the disparities that may result from credit decisions based solely on credit scores, there is a role for secondary review of loan applications. Unfortunately, existing secondary review programs can appear more theoretical than real, merely affirming the initial decision to deny low-cost credit to low-income borrowers and borrowers of color. In designing and implementing a process for secondary review, the following principles should be observed:
Clear guidelines must be established. The danger of disparate treatment of applications based on impermissible considerations such as race, gender and age are heightened when underwriters are allowed to override credit-score determinations. Thus, clear rules regarding overrides must be developed and applied consistently. When exceptions or overrides are made, the file should clearly reflect the reasons for doing so.
Focus on compensating factors for low-side overrides. Override guidelines should be geared toward ensuring that applicants whose credit scores fall below a given cutoff will be evaluated in a comprehensive fashion. Underwriters should review the whole file, considering character issues. For applicants with little or no credit history or those with spotty credit, underwriters should consider the existence of alternate credit, such as utility payments and history of making housing payments in a timely fashion. This is especially important for applications for prime credit because denial could mean the unnecessary and costly relegation of a creditworthy borrower to the subprime higher-cost loan market.
High-level review. Secondary reviewers who consider overriding a decision based on credit score should be senior-level staff. The more people at an institution who may override a credit decision, the more opportunity there is for applications to be treated differently and the more risk there is for fair-lending violations. Override authority should rest with a small number of key staff.
Fair-lending training at all levels. Staff at all levels of the institution should be trained in fair lending and its implications for the institution's use of credit-scoring models. The same should hold true for mortgage brokers who account for the majority of home loans today.
Institutions should have clear non-discrimination policies that are adhered to at all stages of the loan process.
Periodic loan file review. Implementation of a company's credit-scoring policies must be monitored periodically for consistency in acceptance and denials of home loan applications, as well as the terms of loans originated. All loans that have gone through secondary review must be examined and analyzed to determine whether the secondary review and override process is having a disparate impact on any group. Similarly, lenders should review whether the company's general use of credit-scoring models is having a disparate impact on protected classes and should revise the model or its usage appropriately.
Equal assistance to loan applicants. Lenders and brokers should always and consistently explain to credit applicants the meaning and significance of their credit scores, and they should assist all borrowers equally in improving their credit scores to qualify for a loan. Lenders should develop a policy on how to assist applicants who disagree with an initial determination of the lender.
Heavy Reliance on Credit Scoring Means More Must Be Done to Ensure Equal Access to Credit
Prime lenders must develop better marketing, outreach and products for underserved communities. Prime lenders need to better serve qualified low-income, elderly and immigrant borrowers and borrowers of color. The fact that half of all subprime borrowers might qualify for prime loans means that thousands of borrowers are losing thousands of dollars in home equity and wealth because they are not being well-served by the prime lending banks, thrifts and mortgage companies. The other side of this equation is that these borrowers also represent lost business opportunities for financial institutions. Los Angeles Neighborhood Housing Services recently reported having difficulty finding prime lenders to originate home loans to hundreds of high-credit-score borrowers who presented linguistic and other underwriting challenges.
Refer qualified borrowers for prime products. Several banks and thrifts own subprime lending subsidiaries and affiliates that do not refer qualified loan applicants with appropriately high credit scores to the prime lending bank or thrift. Given that subprime applicants are more likely to be people of color and the elderly, failure to have an effective referral-up program raises serious fair-lending questions.
Improve HMDA. The Federal Reserve Board must help root out discrimination in home lending more aggressively by enhancing Home Mortgage Disclosure Act (HMDA) data to include credit scores and the annual percentage rate on all HMDA-reportable loans. Without such price and credit data, HMDA is very limited. Each year, community groups analyzing HMDA data note disparities in lending. Each year, industry groups respond by pointing out the limitations of HMDA. At the same time, industry groups continue to oppose efforts to include credit-score data in HMDA, and they have successfully lobbied the bank regulators to postpone implementation of changes to HMDA that will include the reporting of APR data on home loans for the first time.
Investigate these issues further. The Federal Reserve should conduct a study that includes a review of existing loan files to examine the impact of credit scoring on borrowers, especially protected classes. As with credit-scoring models, the public is in the dark when it comes to the validity of credit decisions. The Fed, which has access to bank loan files, can illuminate these issues for the public, thereby enhancing the public's faith in the lending industry. The Boston Fed went a long way in this direction when it developed its study on mortgage lending and race in the early 1990s.
Credit is not available to all consumers equally, and the public knows it. The National Community Reinvestment Coalition commissioned a national poll, which found that three-quarters of Americans believe that steering minorities and women to more costly loan products than they actually qualify for is a serious problem. Eighty-six percent feel that laws are needed to ensure that banks do not deny loans to creditworthy borrowers based on race, religion, ethnicity or marital status. Prime lenders are missing out on significant business opportunities, and the public continues to view banks, thrifts, and mortgage and finance companies with distrust.
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