Credit scorecards are being used with greater frequency as banks tighten their grip on credit quality. But now that banking is being done by numbers, will lending become another assembly line business?
Thomas Trotter won't mind it one bit if you call him a credit scoring enthusiast.
For the past four years, credit scoring has reduced charge-offs and delinquencies in Wachovia Corp.'s auto dealer finance unit, one of the areas that reports to Trotter, a senior vice president and group executive at the $39-billion-asset banking company. "But more important is that within the score ranges, there has been a better predictability of performance," he says. Generally, the higher an applicant's score, the lower the likelihood of the loan being charged off; the lower the score, the greater the likelihood.
These days, that type of predictability is a much sought-after virtue, and scoring is taking on a greater role in the decision-making process. Scoring is already the key determinant for many large bank card issuers. For larger loans, it's used primarily for the no-brainers, the automatic approvals at the high end of the scale, and the automatic rejections at the low end. The implementation varies by lender, and many banks still have a loan officer review the score, but the trend seems to be to turn over more of the decisions to the scoring software.
In the five years that score-cards have been in use at Nations-Bank Corp.'s dealer finance unit, they've allowed the group to accurately predict its indirect portfolio's performance.
"We know today how the business we hooked in 1994 will perform for the next three yearn within 25 basis points," says Steve Strader, the senior vice president who runs the bank's nationwide dealer business from his office in Greensboro, NC. Scoring has also sped loan processing to the point where the unit can process 3,500 applications a day, up to 3 million a year. Roughly half are approved.
"Scoring has kept our charge-offs within our tolerance level and kept us out of trouble," says Strader.
The experience at yet a third large southeastern bank - which did not want to be identified because it did not want to publicly discuss its consumer lending practices - has paralleled that of Wachovia and NationsBank. In the nine months this bank has been using scorecards for its dealer finance unit, it, too, logged a drop in charge-offs, according to a risk manager there. Moreover, it has gained greater control over the lending decisions of its auto dealers.
Before scoring, they'd been approving a higher proportion of loans to bad risks that later defaulted. They'd also denied credit to some good risks. Once rejected, these people simply bought cars at other dealers who often financed through other banks. Since implementing scoring, the bank has just about brought those practices to a halt.
Bad loans are to a certain degree unavoidable. In fact, they're part and parcel of competing in the dealer finance business. In almost any lending category, if a bank is going to do enough business to earn a decent profit, it will incur some bad loans. But with scoring, many banks have discovered they can keep their charge-offs within a pre-determined level and achieve a level of predictability that was previously unattainable.
Despite scorecards being dependent upon powerful computers and most applicants' apparent lack of awareness of them, there's no real magic involved. Essentially, they computerize the criteria that have been used in underwriting consumer loans for years - job stability, an applicant's length of time at her or his current address, income and debt load. All of these are weighed into the final gore, Wachovia's Trotter says.
"If you're in the indirect lending business, there's a lot of pressure on you not to reject loans," says Bob Sanderson, executive vice president and chief operating officer for Fair Isaac Inc. of San Rafael, CA. To that end, "a lot of lenders will take a certain percentage of bad loans to get a shot at the good loans." Scorecards can't predict exactly which loans out of a pool of 1,000 will go bad, but they do come pretty close to telling how many of those 1,000 will be charged off before they mature.
Taking the Bad With the Good
In the dealer finance business, bad loans are hard to avoid completely because "dealers are more interested in selling cars than worrying about a bank's portfolio quality," NationsBank's Strader says.
Like bankers, car dealers are in a competitive business of their own: A rejected loan application means a lost sale. An approved loan, even one that defaults a year later, is as good as - pardon the expression - money in the bank. The lender loses out if a loan is a charged off, but the dealer has already collected his profit and moved on to the next customer.
For these reasons, dealers may be accepting scoring much more slowly than banks would like. But in a sense, they are only following the example bankers themselves set as scorecards worked their way into lending institutions' everyday practices.
"Initially, a lot of bankers were reluctant to use scorecards," says Scott Freiman, executive vice president of Credit Management Solutions Inc., or CMSI, a software firm in Columbia, MD. It was against many bankers' nature to accept the notion that some piece of software could replace human intelligence and judgment. But this initial resistance has faded, and now Nations-Bank's Strader, Wachovia's Trotter and other bankers believe that it is only a matter of time before dealers accept scoring as well.
Credit scorecards are now used in almost every category of consumer lending. They've been used for years with credit cards and consumer installment loans. By the beginning of this decade, they had become so prevalent in the bank card business that a bank would be hard-pressed to run sizable card portfolio without them, says Sanderson.
Now, as scoring is being used by more banks for more types of loans, bank card issuers, too, have come to rely upon the technique in more areas of their business. It has become common for issuers, as part of their direct mail campaigns, to score targeted customers before the mailings are sent out; hence all those pre-approved card solicitations that get thrown in the garbage.
In the 40 years since they were first introduced, scorecards have evolved from programs that merely tabulated punch cards to a state-of-the-art, personal-computer-based tool.
Two significant turning points in the bank card business accelerated scorecards' usage, Fair Isaac's Sanderson says. The first was the eradication of states' usury laws in 1983, and the second was the rapid growth of the card business in 1989 and 1990 following AT&T Co.'s introduction of its Universal Card.
By the end of the 1980s, scoring had also become common in dealer finance, Sanderson says, and by 1993, most mortgage originators had incorporated scorecards into their underwriting. That last development stemmed from the unprecedented increase in mortgage foreclosures caused by the 1990-91 recession. Prior to that, mortgage defaults were so infrequent that it wasn't statistically possible to score new applications, nor was it thought necessary.
Recently, more banks have been combining scores supplied by the credit bureaus with marketing databases to dram up new car loans. NationsBank's dealer finance group now sifts through its own customer lists and lists from outside vendors and mailing qualified consumers certificates that can be redeemed at NationsBank for car loans up to $20,000. In two years of doing this, Strader says, direct car loan volume has risen incrementally.
Maybe the customers contacted weren't planning on buying new cars just that moment, but the mailing plants the idea in their heads. "I think all the major players are deploying this strategy," Strader says. "Basically, all consumer lending is conducive to scoring."
What makes scorecards practical for most classes of consumer credit is the enormous amount of information available for consumer loans. Lenders have a huge database against which new applications can be scored. There are 430 million bank cards in circulation and perhaps 40 million mortgages outstanding. This has helped make scoring practical, says Patricia McGinnis, an analyst with The Tower Group, a research and consulting firm in Wellesley, MA.
Now scoring is moving beyond the world of consumer lending. Small business loans are considered the next frontier. One of the hurdles that scoring must overcome here, however, is that the amount of historical information pales in comparison to consumer lending, according to McGinnis.
Fair Isaac believes it can overcome this by combining data from a group of 17 banks and putting together enough information to create meaningful scorecards. The software firm worked with Robert Morris Associates, the trade association for commercial lenders, to develop a product called the Small Business Scoring Service. The SBSS was scheduled to be released in March. (See "Small Business Loans, By the Scores," page 49.)
Scoring's proliferation owes much to the rapidly increasing power of PCs and the growing sophistication of PC software. They made it possible to quickly analyze and interpret huge sets of numbers. Two other factors in scoring's growth are the dramatic consolidation in the banking industry and the now-common practice of loan securitization.
As multistate bank holding companies have doubled, tripled and quadrupled in size in the last few years, they've latched on to scoring to help them implement uniform lending practices throughout their far-flung operations, according to William Klein, senior vice president and head of consumer banking for National City Bank in Minneapolis.
A bank has "to be able to make blanket statements about its portfolio" if it's going to securitize loans, he says.
Help With Examinations
This approach also suits the regulatory requirements of laws like the Fair Credit Reporting Act, says Freiman of the software firm CMSI. Since less is left to the lender's discretion, approval or rejection is more frequently based on a score. That enables depository institutions to better respond to examiners' questions about satisfying the Fair Credit or Community Reinvestment Acts.
Yet the $500-million-asset National City is bucking the scoring trend: It uses no scorecards whatsoever.
"The thing about scoring is that it doesn't do anything about the relationship," Klein says. "It does make a bank's portfolio uniform, and it works real well if you have a large number of branches and you don't want to spend a lot of time worrying about them."
But by leaning so heavily on scorecards, banks will be rejecting some good credit risks. That can be costly, and that's one reason why National City doesn't use them. Klein says his bank is more than willing to work with customers to get loans approved.
"Our portfolio lends itself to the relationship," Klein says. Perhaps 30% of the bank's $25-million mortgage portfolio doesn't conform to its credit guidelines, although the non-conforming aspects of almost all of these loans can be quickly justified.
National City's customers are mostly affluent individuals and high-income professionals, such as doctors, lawyers and accountants in small partnerships and single practices. If one of them were to apply for a no-down-payment mortgage at another bank, the scorecard might reject them automatically. But at National City, the mortgage officer would recognize that the prospective borrower may already have more deposited at the bank than they are trying to borrow. Technically, the loan doesn't conform, but it would be approved for a sound reason.
For the banks that are using scorecards, the speed - or more to the point, cost-cutting - they bring to loan processing is too good to ignore. Banking has always been a numbers game, and the growing use of scoring emphasizes that this is more true now than it has ever been. What's to be avoided is spending too much time on any one borrower.
If an applicant gets a high score, approve her; a low score, reject her. If she's in the middle, approve her but charge her a higher rate - otherwise, she'll mess up the portfolio. But whatever the decision is, get it done and get it done quickly. If it's a car loan that used to take an hour to check, now it's done in half that time. Business loans that used to take two or three hours should be done in 30 or 40 minutes. The quicker a loan is processed, the more money saved.
Yet it would be a mistake to characterize scoring as being strictly geared to the massive loan volumes processed by the 20 or so largest banks. There are community banks that are adopting scoring, like City National Bank, a $100-million-asset institution in Taylor, TX, about 35 miles from Austin. It is using scoring for its credit card business and direct consumer lending.
The bank has only 2,500 card-holders, and its program is only three years old. Scorecards were introduced six months after the card program's launch. What the bank has learned from its experience is that cards issued before it started scoring applications were more likely to have delinquencies. Cards issued since then have been far less likely to mm sour, according to James Mark, a vice president at City National.
Securitization has spurred scoring's acceptance because scoring has permitted banks to reasonably assess the quality of a loan portfolio for the purposes of a public offering. A bank and its underwriter can state in a prospectus that of a $50-million portfolio of auto loan receivables, they expect a certain percentage of defaults. The scores are now being used by Standard & Poor's and Moody's to give portfolios investment ratings.
There's also a desire on the part of lenders to link credit scores with tiered pricing in most loan classes. This is already being done in the credit card market to a large degree. But in businesses like dealer finance, acceptance of the practice is coming along slowly. Part of the reason has been dealers' reluctance to accept scoring under any circumstances. Yet a second factor is the competitive pressures lenders face for dealers' business.
"The fact is, with the competitive pressures, market conditions have their play," says Wachovia's Trotter. "In every dealer, you've got three or four competing lenders. Regardless of your business sense, you're not going to price your loans out of the market."
Still, both he and NationsBank's Strader expect that it's just a matter of time before tiered pricing becomes an everyday practice in the dealer finance business - and scoring will have spread its influence that much further.