The Crash of Two Iconic Business Models — 1
How Fair Isaac and Arbitron let their customers down
January 2008 By Denny HatchIn the News
DEFAULT LINES: THE NEW MATH OF CREDIT SCORESFair Isaac’s Revamped FICO Aims to Forgive Small Slips, Punish Repeat Offenders.
The company that cooks up credit scores for millions of Americans is changing its recipe—and that could affect how easily you get credit in the future.
Fair Isaac Corp., maker of the popular FICO credit score used by most lenders, says its new scoring model will do a better job predicting the likelihood of a borrower defaulting on a loan. For one thing, the new model, dubbed FICO ’08, will be more forgiving of occasional slips by consumers, but will take a harder line on repeat offenders. Fair Isaac predicts its new system will help lenders reduce default rates on their consumer credit by between 5% and 15%.
—Jane J. Kim, The Wall Street Journal, December 19, 2007
What is less understood is the highly complex algorithm of scoring—taking all that bill-paying data on an individual and determining the chances that he or she will fail to pay a credit card charge or default on a loan. The dollar amount of credit extended and the Annual Percentage Rate (APR) charged are pinned to a consumer’s score.
The unquestioned master of scoring alchemy is Fair Isaac, on whom some of the blame for the sub-prime crash—and perhaps the coming recession—must fall.
And it turns out that the Arbitron radio ratings folks have been totally dishonest with the advertising community for years.
The reason: both business models were woefully out-of-date.
Today we examine Fair Isaac. Look for the Arbitron mess on Thursday.
By the way, how state-of-the-art is your business model?
Good Ole Hooper Holmes
As regular readers of this curious e-zine know, I came out of the book business—negative option clubs and continuity series—“Take the first book free and receive one book a month thereafter.”
The offers were always soft: “Send no money now, we’ll gladly bill you later.”
The big challenge was dealing with what consulting wizard Bob Doscher calls “premium bandits”—those folks who send for anything free with no intention of becoming a paying customer.
All the companies I worked for in those early days were members of a very early cooperative database, the Hooper Holmes Credit Index. Membership required us to share all our bad names—premium bandits and accounts suspended for non-payment—so that they could be added to the pot.
Whenever we would send out an acquisition mailing with a soft offer, the names and addresses of all our new customers would be data entered and immediately sent to Hooper Holmes. These names would be bumped up against the unique database of bad actors and the results would be returned to us in short order.
The Hooper Holmes printouts were eye-poppers. Some addresses contained 25 to 100 or more hits—a single address or P.O. Box where the same person with myriad bogus names had stiffed direct marketers by ordering products and failing to pay or return unwanted merchandise.
Sometimes a name would be on the list with just one hit, say from the local Shell station. Chances are this was the result of a dispute between a car owner and a mechanic over a poor repair job. This consumer would be welcomed as a new customer.
Takeaway Points to Consider:
* Do not ever let greed trump common sense.* The person who cannot afford a down payment is probably a lousy customer.
* In 1965, Intel co-founder Gordon Moore predicted that the number of transistors on a chip would double every 24 months. The Moore formula—coupled with the Internet—have made the amassing and synthesizing of data possible at warp speed.
* As a result, consumers and businesspeople have come to expect more information—and more accurate information—to be available virtually in real time.
* Is your organization’s data retrieval and processing able to keep up with these sweeping changes, enabling your people to make decisions quickly and accurately?
* In short, does your business model need tweaking? Or even a complete overhaul?
* Had Fair Isaac done some serious tweaking to its algorithm—and had some real-world (as opposed to ivory-tower) understanding of how consumers’ and investors’ minds work—the enormity of the sub-prime catastrophe might have been lessened.
* This coming Thursday’s edition of Business Common Sense will examine Arbitron, a company built on a 1950s business model that was obsolescent at the outset, proven useless today and still in operation.
Web Sites Related to Today's Edition:
Fair Isaac Changes Its Recipe—The Wall Street Journalhttp://tinyurl.com/2vy97b
Fair Isaac and Sub-Prime Blame—Forbes
http://tinyurl.com/39a9uw
Credit Bureaus Create a Single Rating—The Wall Street journal
http://tinyurl.com/32mfb8
Fair Isaac Web Site
http://www.fairisaac.com
How Bear Stearns Blew It—Business Week
http://tinyurl.com/288v2a
Fraud as a Sub-Prime Driver—The Wall Street Journal
http://tinyurl.com/2ayb7u
Lenders Lobbying Exacerbated Sub-prime Mess—The Wall Street Journal
http://tinyurl.com/ytpmyf
Timeline: Sub-Prime Losses—BBC News
http://tinyurl.com/ypdb65
Financial Bubbles in History
http://en.wikipedia.org/wiki/Economic_bubble#Examples
Sub-Prime Implode-o-Meter (Bankrupt Lenders)
http://ml-implode.com/
Credit Bureaus Create a Single Rating—The Wall Street journal
http://tinyurl.com/32mfb8
Experian
http://experian.com
Equifax
http://www.equifax.com
TransUnion
www.transunion.com
Glengarry Glen Ross
Film History: http://www.imdb.com/title/tt0104348/
DVD: http://tinyurl.com/2jja5c
Script: http://tinyurl.com/3azp92
Companies Mentioned:
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Having equity in a home does not guarantee no default. Homes with equity are in foreclousure all the time - ask any real estate agent, it happens. Not everyone who did a 100% loan is going to default - I know, I'm one of them. GREED is certainly a contributing factor but IMO the greed upon the part of financial institutions is a far greater issue than greed upon the part of consumers. Credit card companies bumping interest rates on customers based on FICO scores who had never been late should have been illegal, it was not. Insurance companies raising rates on customers based on FICO scores who had never filed a claim should have been illegal. It was not.
In short, don't give me the BS that the guy who does the load is always the problem. The problem is a corrupt system in the first place.
You forgot the main star of Glengarry Glenross - Al Pacino!
Is the question of ?sharp practices? being looked at squarely here, Denny?
I always found negative option clubs and continuity series??Take the first book free and receive one book a month thereafter?? clearly aimed to trick me. Not ?persuading? or ?offering??tricking me into forgetting to phone for cancellation or just making it damned hard to do so, so they could keep billing me ad infinitum and move old, unpopular books.
But I was tricky, too: poor collegian, chasing a hardcover offer, ready to cancel soon after. We call it piracy now, but that was the offer! I was no thief. Buyer-side trickery vs. publisher-side trickery. Both legit. Fatigue finally taught me something for nothing isn't; somebody?s gotta pay.
So greedy lenders worked the system (not the first time with something-for-nothing borrowers), pocketed invisible commissions covered by selling the loan book to greedy investors?some of them greedy institutions. Did Fair Isaac ever send its lender clients an advisory letter reminding them of the debacle to be had with zero-down mortgages? My misanthropic guess is, FI just winked and looked at their own increasing pile of profits. ?It?s not my job.?
Banks flooding us with credit cards ever spend a buck to sponsor ?Truth In Lending Training? for teens, Gen-Xers or even overdrawn adults? My son?s pal re-upped for a $20k Navy bonus to stop credit card bleeding from piranha fees. No deadbeat, never bought a house. The Credit Life urged on us by lenders and advertisers just bit him in the butt. Sub-prime dangers/defaults are only the momentary face of this malady.
Glint of a shining offer makes it harder to see what?s next, and where responsibility lies.
Great article as always Denny. Denny - wow are you off the mark, in my humble opinion blaming the consumer and the FICO Credit scoring system. Should be titled See no Evil - Hear no Evil..." And You missed the link & should have given the explaination of a Ponzi Scheme. the Wikipedia for it is below.
After all isn't that what it looks like? And what happened to the Lawyers, title companies, Realtors, and buyers financial advisors? What ever happend to looking after a clients best interets? Every hear of a Buyer Agent? An Attorney? These were supposed to be trusted advisors !
Did nobody (Realtos, Attorneys, Mortgage reps, etc) know that buyers real estate values could go down? Or that adjustible rate mortgages could adjust up?
Unfortunately - we all will pay for this disaster.
Denny -
http://en.wikipedia.org/wiki/Ponzi_scheme
Some of your statements this week are unfair and make you appear out of touch with todays reality.
* If a home buyer cannot afford a down payment, chances are a mortgage cannot be afforded either.
* The person who cannot afford a down payment is probably a lousy customer.
Home prices are WAY out of control - EVERYWHERE. Adjustable Rate Mortgages should be illegal. And people who get involved in "borrowing" money that is in the HUNDREDS of THOUSANDS of dollars should be smart enough to do the homework and know whether they can afford what they're getting into. Getting in over your head and then crying victim is nonesense!
A home purchased in 1970 for 26,500 for a young 20 something couple earning 13,250 is now priced at 550,000. Following the same logic, that same young 20-something couple would have to earn 275,000 per year. It's no secret that home prices have gone up much more dramatically than salaries. I'm going to go out on a limb and guess that you already own your home. Speak to some of your 20 & 30 y/o co-workers and ask what it's like to be first time buyers in TODAYS economy. It's different than it was in the 60's and 70's.
There's plenty of blame to spread around in this real estate debacle. If the government steps in and saves all these foolhardy people from the fate that they sent themselves to, well then, that can be another story for you to write.
Cheers.
Thought provoking as always, Denny. I agree with Ross and David here. I recall your article a while back about that old-time local banker who'd meet a child for the first time and put a dollar in their account. Then, he built life-long relationships with the locals and made loans for education, autos, mortgages, weddings, etc. All done firsthand, with a lot of eyeball-to-eyeball. If you couldn't afford a loan, he probably told you.
Contrast this with the subprime mess. A bunch of MBAs at the mortgage companies trying to cram the loans through as quickly as possible and then sell off the portfolio using the bigger sucker theory.
Let's keep the heat on the originators of the loans--they set up the loose controls on their own people who issued the loans and couldn't be bothered to fact check the applications. Definitely no eyeball-to-eyeball here.
Also like the redesign. Happy New Year!
I don?t know that I fully understand the whole mess, but I think I side with David. Doesn't FI provide the data and the lenders make the decision on how they use it and what risk they are willing to take? I think all the lenders which jumped on this bandwagon are to blame, not FI.
Unless FI originated this lending strategy. Who was the first lender to make these offers anyway?
P.S. I like your redesign.
Fair Isaacs and its FICO scores are not to blame for the mortgage meltdown. F.I. figures out general "creditworthiness" based on data it is provided, such as a person's payment history and credit card balances. It does not receive or judge mortgage applications or property values. It does not determine whether a person is a good risk for a particular mortgage. FI never told any lender that a 0 down payment, variable loan was not insanely risky. The mortgage lenders, Standard and Poors, mortgage brokers, and many others have created the mess, but F.I. did not.
This is a great article. I have never proclaimed to be an accountant or vaguely interested in that career, but with that said, evern I could see that these loans were going to crash our system. I told my mother that 2 years ago and luckily she did not take one out. The folks in charge should pay a HUGE fine to go towards the deficit we face because of their greed.
Another winnah from Denny H. This should be Page One of a future WSJ analysis or an Op Ed in many major dailies.
Happy Noo Year!
Question for Denny: Does Mrs Joe Gibbs qualaify to replace her husband as coach of the Redskins since she's been married to him a long time and has watched countless games?