Credit Scoring and Subprime Lending

The end of "traditional" lending.

    One of the most far-reaching developments in our recent history has been the advent of credit scoring, a seemingly innocuous lending tool that has turned out to be anything but.  Credit scoring not only transformed the lending industry’s business model, it’s also become a personal report card of sorts, wielding influence over much more of our lives than the ability to obtain loans.
    Credit scores were designed to assess the likelihood that a loan applicant would pay the money back.  Banks could screen their applicants more accurately, and thus lend to worthy borrowers, protecting themselves from default.  There’s nothing particularly controversial or pernicious about this.  However, the scores came to be used in a very different way.  The idea was rather than turning away risky applicants, simply charge them higher interest rates that reflect their risk of default. The lower the credit score, the higher the interest rate.  This was the idea that gave birth to subprime lending.
    Credit card companies were the first to apply this concept on a large scale.  It was seen as a way to manage risk while increasing the pool of potential cardholders at the same time.  They quickly found that riskier applicants were the most profitable, so a race to the bottom ensued.  Over time, credit card companies so increased their reliance on the high interest rates and fees generated by risky customers, they actually lost money if too many people paid on time.  An April 21, 2005 Associated Press wire report posted on BusinessWeek.com stated of then-credit card giant MBNA:

    “MBNA Corp., the world's largest independent credit card lender, on Thursday said first-quarter earnings plummeted, hurt by a hefty restructuring charge and unexpectedly high payment volumes from U.S. credit card customers.” (Emphasis added.)

    The AP report also quoted MBNA’s quarterly report as saying  “Additionally, the payment volumes were particularly higher on accounts with higher interest rates, which adversely impacted the Corporation's yield on managed loans.”

    Lending was turned on its head.  Too many timely loan payments meant lost revenue.  This was a truly historical development that could be laid squarely at the feet of the new view of credit scoring.
    The concept of subprime lending greatly enlarged the potential lending pool.  Millions of people who had little access to credit could now become paying customers.  This resulted in the creation of thousands of new lenders big and small.  “Non-bank financial institutions,” regulatory-speak for finance companies, proliferated.  Previously unheard of services like payday lending spread across the country, with a focus on vulnerable areas like poor neighborhoods and military bases.³  Subprime lending was now standard operating procedure throughout the lending industry.