Since 2008, forests of paper have been sacrificed to assign blame for the financial crisis, and Congress and regulators have worked to avert or mitigate a similar future crisis.
Most of those efforts have focused on the financial giants at the center of the crisis, from the handful of major investment banks to the three credit rating agencies and two government-sponsored enterprises, Fannie Mae and Freddie Mac, with their dominant positions in the secondary home mortgage market.
Yet while Wall Street CEOs got starring roles in the HBO docudramas, one of the most significant players in the credit market remained offstage, quietly operating without industry-accepted competition in a legacy system that could contribute to a future crisis unless diversity is embraced.
That mysterious market player is not some unscrupulous lender, freewheeling investment bank, or opaque bundle of collateralized loans.
Instead, it's the little-discussed legacy system of a dominant credit score provider, Fair Isaac (FICO). No market should over-rely on one entity. This is particularly true with access to affordable consumer credit because 70% of the U.S. economy depends on consumer spending. Yet most private lenders rely on this single provider to grant credit.
Serving as the gatekeeper to consumer credit, this legacy credit score provider has been baked into the lending process and incorporated into banking guidelines and financial regulations as a "too basic to fail" proxy for all consumer credit evaluations.
The tacit government endorsement of a single credit score provider has had negative ripple effects through our financial system. The dearth of widely accepted alternative sources for third-party credit scores, particularly in the mortgage context, poses serious safety and soundness concerns, as well as operational risk, to lenders and financial regulators by centralizing power over consumer credit approval with a single entity.
The fact that there exists a single dominant entity responsible for the provision of credit scores necessary for the safe and sound operation of financial institutions and the lending they do on its face presents an operational risk to the institution. Should this single entity withhold or be unable to provide the necessary information to lenders, those lenders would be unable to satisfy the relevant laws and regulations, subjecting the lender to compliance and legal risk. (Full disclosure: my law firm has lobbied on behalf of VantageScore Solutions, one of the few providers of alternatives to scores from FICO.)
Expanding the third-party credit score system and validating new entrants would reduce that risk. Competition would inspire transparency, innovation, and choice, all of which would improve the reliability of consumer credit scores while greatly expanding the number of consumers who can receive such scores.
What is restraining that robust and competitive market for consumer credit scores? The answer lies in tradition as well as laws and guidelines that unintentionally codify a legacy provider to the exclusion of new entrants.
Over the years, implicit and explicit references to the dominant legacy credit score provider have spread through government regulations and lending guidelines, creating unintentional brand endorsement.
For instance, the GSEs' seller-servicer guidelines explicitly require mortgage originators to use credit scores from that sole entity. These guidelines effectively prevent any other company from providing credit scores for use by lenders conducting underwriting for conforming mortgages.
More subtly, the Consumer Financial Protection Bureau's "ability to repay" or qualified mortgage regulation contains a safe harbor provision stating that certain loans will be eligible for safe harbor if they meet the GSEs' underwriting requirements. Once again, that limits the eligibility to loans based on credit scores from the legacy provider. Other direct and indirect endorsements of that legacy credit score provider abound through congressional testimony, speeches, and interviews with government officials.
The solution to this endorsement of a single third-party provider of consumer credit scores is simple. Federal agencies should undertake an immediate review of all policies related to consumer credit scores. The review should ensure that any such references or requirements are generic in nature and that they do not tilt the playing field in a single company's favor, stifling competition and increasing risk. The Federal Housing Finance Agency should also direct the GSEs not to require one credit score provider to the exclusion of all others.
In the 2008 crisis, the housing bubble was driven in large part by lockstep lenders that did not adequately evaluate the ability of borrowers to repay their loans or pay attention to credit score trends. In the crisis of the future, a single point of failure may rest on a legacy third-party credit score system dominated by a single provider that presents a large, and largely unexamined, risk for our financial system. We need to address that risk today.
John E. Bowman is a partner at Venable LLP and a former acting director of the Office of Thrift Supervision.