Chapter 5: Credit Scoring
IN THIS LESSON
Before credit scores, credit was evaluated using credit reports from credit bureaus. During the late 1950s, banks started using computerized credit scoring to redefine creditworthiness as abstract statistical risk. The Equal Credit Opportunity Act banned denying credit on gender or marital status in 1974, along with race, nationality, religion, age, or receipt of public assistance in 1976. Credit scoring adoption accelerated to shield against discrimination lawsuits.
During the 1970s and 80s, the credit reporting industry relentlessly consolidated and moved aggressively into prescreening. The FICO score burst into public consciousness in 1995 when Freddie Mac had lenders use credit scoring for all new mortgage applications.
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Credit risk assessment is largely a job for credit score algorithms, mass-market models, and systems that are relatively new in terms of the modern credit industry’s lifespan.
The FICO score, for example, was first introduced to lenders in 1989. VantageScore, another scoring service from Equifax, Experian, and Transunion, was created in 2006.
Before the credit sector fully adopted computers and data science, lending decisions were made by credit managers employed by banks or department stores, who then collected information about each individual borrower.
“Part of the job of the credit manager was to try to make inferences about the person’s personality, whether they seem to be organized and mature and responsible,” said Josh Lauer, a professor of media studies at the University of New Hampshire and the author of the book “Creditworthy.”
In other words, borrowers who were judged to be disorganized, immature, and irresponsible were usually turned away. A credit manager could reject an applicant if they suspected they were an alcoholic or for more blatantly discriminatory reasons related to someone’s race, sex, or, for women borrowers, their marital status.
Borrowers had to prove their creditworthiness under these conditions, which is why educational films like the 1960s short “The Wise Use of Credit,” came to exist.
Transition to algorithmic credit scoring
A surge in demand for credit during the second half of the 20th century helped motivate lenders to adopt credit scoring algorithms. For one thing, algorithms were more efficient.
“It just took too long to have each of these credit applications vetted by an individual in real-time,” said Lauer.
Credit bureaus started to computerize their massive consumer records in the 1960s and 70s. But computers had limited memory back then. Bureaus kept data like how many credit cards someone had, while more nuanced variables, like how responsible a borrower seemed, were dropped from credit records.
Regulation in the form of the Equal Credit Opportunity Act of 1974 made it illegal to deny credit based on factors like race, sex, marital status or religion.
In some ways, it was only a matter of time before lenders would move toward a data-science approach to credit scoring and lending.
“It replaced a lot of the human underwriting with an algorithm that allowed them to make decisions consistently and also to monitor how much better their decisions were,” said Sally Taylor, vice president of FICO Scores.
Introduction and adoption of “universal” credit scores
Credit-scoring algorithms existed as early as the 1950s. FICO, since its founding in 1956 by William Fair and Earl Isaac, designed credit score models for lenders.
But these algorithms were specifically designed for individual businesses and their unique customer base. You couldn’t apply a bank’s credit scoring model to a department store because they served statistically distinct customers.
In 1989, FICO released its first “universal” credit score that lenders could buy and use instead of commissioning a custom-designed score for customers. But it took time to convince lenders to adopt it.
“I did a lot of mortgage broker, mortgage originator, you know, lunches, at that time, explaining the concepts of scoring,” said Taylor, who was then a FICO product manager.
The watershed moment for FICO and the mass market approach to credit scores came in 1995 when mortgage giants Fannie Mae and Freddie Mac decided that every mortgage application would need a borrower’s FICO score. That effectively cemented the credit score as one of the basic metrics of credit risk today.