Thursday, March 13, 2008

Blame FICO for Sub-prime crisis?

Ron Shevlin has a interesting post regarding whom to blame for the sub-prime crisis, and he analyzes if FICO is responsible and to what extent.

I have something to add on the discussion.

I. Blame the Decision not the Algorithm.

Fair Isaac sells algorithm for FICO Score but decisions are taken by the Banks. Normally Credit Scores are tested in the internal portfolio and the operating point is chosen. This process of choosing operating point depends on various business reasons of the operating bank.

i. Case 1 : New Bank and No Internal Data
This is a typical scenario when the FICO score is taken as the only decision platform. Normally any customer having FICO Score above 600 is given a loan or a credit card, with higher the score getting higher loan amount or credit balance.

ii. Case 2 : Stable Bank starting a new Portfolio
Here the Average FICO score on the several bucket of customers on some other existing portfolio is seen and a strategy is formed to fix a certain FICO cut-off for the new portfolio. If there is closely related portfolios then the customized models and the business rules on that portfolio can be used for the new one. Like, many banks use Personal Loan or Credit Card Models and business rules for the other in case of thin file customers.

iii. Case 3 : Bank has mature portfolio
When Bank has mature portfolio, there is little reliance on any Generalized Score, be it FICO, Vantage or any other scores. But still the customers are segmented on the basis of FICO score and then strategy is formed using customized solutions.
The customized solution could be:
1. Predictive Models (Risk, Revenue, Attrition, Response)
2. Business Rules based on Value Segmentation
3. Business Rules by Expert Judgment

II. Portfolio Monitoring is as important as Strategy Forming.

Now let me discuss something on the second part after the strategy formation. It is very critical to monitor the portfolio and fine-tune decision making process. It is solely on Banks discretion and Fair Isaac has no role in it.
This is done by constantly following the market movement and the portfolio shifts. Many a times operational problems within the banks lead to loss of most valued customers while the customers while the low value still remain. This creates the portfolio look bad. This is a common case and is commonly referred to as Adverse Selection. This has to be detected in the real time of Bank functioning and reported to correct the operations.
This step however does not seem to happen as the Banks have come up with bad results. In the presence of good portfolio monitoring system, it could have been reported well ahead in advance and checked.

III. Analyst vs Marketers

Now, this is again a critical thing happening in any bank. All the Business Leaders go to the Marketers to grow the Bank or a particular portfolio. They are given the power to execute their plans and are given a very tight target. Marketers do it and get applause.
Suddenly when the results start getting worse and the bad rate increases, the focus is turned to the Analysts. The analysts have no control on the past decisions but he makes sure that the future decisions is on track. But again by doing this he will be hurting the Marketers interest.

IV. Wrong Bureau Reporting

Many Banks often hide the actual information of the customers to retain their valuable customer base. They report false or rigged information.
Typical scenarios would be
i. to report the failure of payment but hide the clearance done their after.
ii. offer customer add-on cards on the common credit card while reporting multiple card issue in the bureau.
iii. report the data correctly but not on time.
iv. make unnecessary inquiries to the bureau for good customers without him asking for any service to rig the inquiry variables.
v. maintain internal negative list and not inquire the bureau for them for cost savings. The Banks then do not report his application too.

There can be plenty of such examples. Banks are obliged to certain regulations but I doubt either don't follow or find a way to rig the law. Here the Banks forget that if everyone in the market does the same they are ones who suffer.

V. Bureaus, Banks and the Analytics Companies

There are many Analytics Companies playing in Credit Scoring area apart from Fair Isaac and even the Bureaus provide such services. The space is crowded and the competition is getting intense day by day. Result is mixed.

i. Fair Isaac is believed to be squeezing the profit margin for Bureaus with the FICO score Algorithm Licensing. This is creating a scene where Bureaus are not competing against each other to better service but getting together to end the dominance of FICO score once and for all through the launch of Vantage Score. But it has minimal success, mainly because market is heavily dependent on FICO for long and there is inertial friction to change. The other reason being the bureaus not being able to compete with the Technical Depth that Fair Isaac has acquired with around 50 years of Research.

ii. Analytics Companies and Bureaus are coming together to provide solutions to certain interest groups. This is sometimes done through cross investments also, where the deal could be between Bureau, Bank and the Analytics Partner.

My take:

All these were some of the ongoing scenes of the market. Now let me come to the point of whom to blame for the Sub-prime Crisis. I would blame the whole system and the business leaders who tried hard to use Decision Management area as their pet area. They used it in a very unprofessional way and limit it as a tool to serve their interest. I would say, mostly the Analytics Results are used either to support a thought business case or discarded.

Decision Management is a completely different professional service and it has to be given that respect.

Now is the time when the company board or the CEO has to listen to what the Analysts have to say and bring them into the value chain well before crisis comes. If the company has the good Analytics Team in-house, thats great. Else its the time to start outsourcing to the Specialist Companies. The specialist companies are the companies who not only provide Analytics Services like Scores and Segmentation results, but take it forward to decision making and strategy formation space. The safe future thus either lies in Enterprise Decision Management process implementation or outsourcing Analytics Functions completely.

So no blaming FICO at all for the crisis. Bullish CEOs went on aggressive and the Bears had to make their presence felt. Sad news for the world. But certainly, it has strong message for us. Hope everyone learns it right, and overcome without letting it spill over other areas.


Anonymous said...

Unfortunately your focus is on the technology, because the technology has nothing to do with loan products ("No Doc" and "Stated Income") where the lenders, in an effort to get more volume, lowered the risk parameters (taking less information from borrowers)and coupled that with allowing for "no money down" loans (100% loan-to-value). The result was as follows: banks were effectively 'buying' the home and the borrower paid rent (call it 'voluntary mortgage' if you want) to the lender. IF the property price went up, the borrower was happy and stayed in the home and, at a later point, sold the home for a profit. IF the value of the home declined, the borrower walked away from the home and bank had to foreclose. FICO and 'credit decisioning' has nothing to do with it.

Bhupendra said...

I agree with you to some extent but I feel the crisis has something to do with Analytics Area. I see companies like CapitalOne doing good Risk Assesment and they have been able to lower their risk exposure, while many others could not.

I see the problem in two ways:
1. weakness of the analytics team involved
2. low importance given to the analytics team and their findings

The business pointers that you have pointed are correct, but if the Analytics team is not bale to find such risks then their very existence may be questionable.

-- Bhupendra

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