The Crash of Two Iconic Business Models — 1

How Fair Isaac and Arbitron let their customers down

January 2008 By Denny Hatch

multipage

Naturally, orders from the obvious crooks were discarded, saving us many thousands of dollars over the course of the year.

It was a primitive system, but it worked.

Enter Messrs. Fair and Isaac
In 1956, Bill Fair and Earl Isaac invested $400 each to start a company that would “use computers and mathematics to solve tough business problems.” Their first employee, Earl Follett, figured out how to predict the credit worthiness of an applicant based on analyzing a multitude of financial dealings:

* Punctuality of payments

* Total amount of debt—mortgage, car payments, credit cards, etc.

* Kinds of credit used—revolving, installment, etc.

* Length of credit history

In a 2002 Business Week story titled “How Fair is Fair Isaac,” Jane Black explained:

Scores range anywhere from 300 to 850. The higher the score, the better the credit risk. A consumer with a FICO score of 700 will pay approximately $382 per month for a $20,000 auto loan over 60 months, according to E-LOAN, a California-based Internet lending institution. The same loan for someone with a score of 680 costs $393, while a borrower with a FICO of 580 will pony up $495.

The Sub-Prime Fiasco
“Where Was FICO?” screamed the headline of Michael Maiello’s story in the September 17, 2007 issue of Forbes. The subhead: “The widespread use of no-money-down mortgages in the U.S. flummoxed the country’s best-known scorer of creditworthiness.”

“FICO became as generic a name in credit ratings as Bic in ballpoints and Kleenex in tissues,” Maiello wrote. “Over the past decade this Minneapolis firm’s earnings quintupled to $100 million on $825 million in revenue. And then something bad happened. FICO scores got entangled in the U.S. sub-prime mortgage mess.”

Missing from the Fair Isaac algorithm were two key elements:

1. How accurate (honest) was the mortgage applicant’s declaration of income and net worth?

2. What was likely to happen when a consumer was given the keys to a home without parting with so much as a nickel for a down payment?

Background
In 2000, Standard & Poor decreed that the “piggyback” mortgage was okay—that borrowers who took out a second mortgage to make a down payment on the first mortgage were no more likely to default than anyone else. It was a deeply flawed theory that greedy lenders glommed onto and started making mortgage loans at usurious interest rates to people with insufficient income or net worth to keep up the payments. The borrowers fell into three categories:

* Dumb consumers that did not understand what they were getting into.

* Greedy investors who bet property values would rise, enabling them to collect rent from tenants while they waited to flip the property and make a fat profit.

* Out-and-out crooks committing naked fraud.

These loans were bundled into myriad funds and slivers were sold off to investors. The second deeply flawed theory was that since these funds were made up of loans from lenders all over the country, investors would be protected from individual failures.

With loan defaults all over the country, owners lost their homes and these funds were worthless. Hundreds of billions of dollars were lost. The result was the so-called sub-prime catastrophe.

Glengarry Glenn Ross
At the end of last year (Vol.3, No. 86) I described seeing David Mamet’s play Glengarry Glenn Ross in London starring Jonathan Pryce—the story of a bunch of desperate, sweet-talking land salesmen operating in Chicago during the 1960s who would say anything to sell a property to a prospect.

I have since rented the movie—brilliantly acted by Jack Lemmon, Alan Arkin, Kevin Spacey, Alec Baldwin, Ed Harris and Jonathan Pryce. These are sweaty, conniving, whining, third-rate guys who lead mediocre lives from paycheck to all-too-occasional paycheck.

However, in comparison to the purveyors of sub-prime loans, the Glengarry and Glenn Ross characters are blue-ribbon royalty. The reason: in order to get a commission, David Mamet’s frantic, fictitious salesmen had to get a signed check from a customer along with a signed contract for the property.

In the world of sub-prime loans, the buyers parted with zero cash. With a wink and a nod, the salesmen gave a cursory glance to their income statements and sent the names to Fair Isaac, only to receive back a deeply flawed, upbeat credit score.

The name of this e-zine is Business Common Sense. Common sense dictates that:

* If a home buyer cannot afford a down payment, chances are a mortgage cannot be afforded either. And, at the very least, the family’s finances should be put under a microscope.

* The old rule of thumb, that housing should cost no more than one quarter of a person’s income, is still viable. Whether it’s gross income or net income (after tax) is negotiable.

Ignoring common sense, the suckers were urged to sign on the dotted line—agreeing to adjustable-rate mortgages and believing the wildly extravagant guarantees that they could get refinancing at low interest before the grotesque double-digit APRs kicked in. With no money changing hands, these sad sacks were presented with their front door keys. The salesmen got their commissions, the banks got their fees and happy days were here again.

It is astonishing that some of the biggest—and previously most respected—names in the world of financial services did not understand consumers’ mindset, investors’ greed or the business model of sub-prime loans. They bet the farm on this financial bubble and lost hundreds of billions. Among the sub-prime losses so far:
UBS: $13.5bn
Citigroup: $11bn
Bank of China: $9bn
Merrill Lynch: $8bn
Capital One: $4.9bn
Morgan Stanley: $3.7bn
HSBC: $3.4bn
Bear Stearns: $ 3.2bn
Deutsche Bank: $3.2bn
Bank of America: $3bn
Barclays: $2.6bn
Royal Bank of Scotland: $2.6bn
Freddie Mac: $2bn
Credit Suisse: $1bn
Wachovia: $1.1bn
IKB Germany: $1b
Source: Various reports

The numbers above do not take into account the additional hundreds of billions of dollars lost by individual investors and the million-plus homeowners—and tenants—tossed out on the street.

In addition, more than 100 lenders went belly-up and over 100,000 jobs are expected to be lost in the financial services sector when the whole mess shakes out.

What of Fair Isaac?
Fair Isaac VP Ronald Totaro tried to extricate the company from blame by telling Maiello of Forbes that “FICO scores an individual’s risk over time. It’s not an assessment of the riskiness of the loan made.” He said creditors should not make lending decisions based solely on FICO scores.

So Fair Isaac has announced a tweaking of its scoring algorithm.

That’s called locking the barn door after the horses were stolen.

A Final Word About Financial Services
The word “services” (as in financial services) reminds me of a story told by the late Barry Gray, the mellifluous-voiced fixture on New York talk radio for 50 years.

On a late-night broadcast, Gray did a riff on the boyhood of the great American humorist and trick rope artist Will Rogers and the meaning of the word “service.”

When Rogers was about 10 years old, he was sitting on the split-rail fence of his family’s 400-acre spread located on the shore of Lake Oologah, Oklahoma. He looked up and saw an immense, blue-ribbon-prize bull from the adjoining ranch being led across his property to an adjacent ranch where he was scheduled to service a prize heifer.

“Since then, every time I hear the word ‘service,’” Rogers said years later, “I know somebody is going to get screwed.”