Inflated Credit Scores Put Lenders At Risk

Goldman Sachs and Moody’s Analytics are warning that credit scores of consumers have been inflated during the past ten years, hiding the danger of defaults and increasing the risks for lenders.

According to a report in Bloomberg citing Goldman Sachs and Moody’s, the warnings out of the two are backed by Federal Reserve data which points to an increase in credit scores during the economic expansion of the last decade, saying it led to so-called grade inflation. That occurs when borrowers are riskier than the credit scores they have. The higher credit scores make the borrower less risky in terms of paying back debt. But if a slowdown happens, lenders could face more defaults than expected because of the inflated credit scores.

Bloomberg reported there are about 15 million more consumers that have credit scores of more than 740 today than back in 2006. What’s more, Bloomberg cited Moody’s as saying there are around 15 million fewer consumers with scores under 660 today then back in 2006. “Borrowers with low credit scores in 2019 pose a much higher relative risk,” said Cris deRitis, deputy chief economist at Moody’s Analytics, in the Bloomberg report. “Because loss rates today are low and competition for high-score borrowers is fierce, lenders may be tempted to lower their credit standards without appreciating that the 660 credit-score borrower today may be relatively worse than a 660-score borrower in 2009.”

While all lenders face a risk, Bloomberg noted, smaller, less sophisticated companies that lend to people with less than stellar credit scores are more at risk. Many of the lenders base their decisions on the FICO score and don’t include other measures to gauge creditworthiness. Moody’s said car loans, retail credit cards, and personal loans are the areas that are most exposed to these higher credit scores, amounting to about $400 billion. Of that, Bloomberg reported $100 billion is bundled into securities that are sold to investors. “Every credit model that just relies on credit score now — and there’s a lot of them — is possibly understating the risk,” Goldman Sachs analyst Marty Young told Bloomberg in an interview. “There are a whole bunch of other variables, including the business cycle, that need to be taken into account.” The report noted big banks have recognized that the FICO score isn’t the be-all end-all and include other factors beyond credit scores when underwriting loans.