Are you a bankruptcy risk? Enigmatic score may tell lenders
Tool used to supplement consumer credit score, mitigate issuers' risks
It's a number that lenders may consider when deciding whether or not to lend you money, but it isn't the well-known credit score. Meet the bankruptcy score, the credit score's more mysterious cousin.
|How bankrupt consumers compare with bad credit consumers|
BAD CREDIT CONSUMER
|Lines of credit||14.34||Lines of credit||10.42|
|Credit inquiries||1.78||Credit inquiries||1.41|
|Collection items||0.76||Collection items||1.02|
|Age of credit||42.14 months||Age of credit||40.61 months|
|Credit utilization||65.99%||Credit utilization||52.71%|
|New lines of credit*||3.77||New lines of credit*||2.78|
|* Newer than 24 months|
Source: "The Science of Predicting Consumer Bankruptcy" by David R. Kelly and Gregg A. Weldon
While the popular FICO credit score gives lenders an indication of how likely a borrower is to repay a loan, a bankruptcy score -- as the name implies -- suggests how likely a consumer is to file for bankruptcy. "Lenders are in business to extend credit to borrowers, not to refuse them credit. Lenders use tools like bankruptcy scores to protect their ability to stay in business and continue offering credit at competitive rates," says Craig Watts, spokesman for FICO, which also produces bankruptcy scores. FICO's website notes that its bankruptcy scores can be used in combination with FICO scores to "sharpen" a lender's risk assessment.
Bankruptcy scores remain secret
What gives the bankruptcy score its air of mystery? For one, bankruptcy scores, unlike credit scores, remain unavailable to the general public. The credit industry isn't hiding the score's existence. For example, FICO's website says, "Like FICO scores, Fair Isaac Bankruptcy Scores include reason codes that can be used in notifying the consumer about the factors that led to a credit decision."
But unlike its credit scores, which can be purchased many places, the company won't tell consumers their bankruptcy scores. Other companies that have their own versions of these scores take a similar approach.
"Financial institutions do not normally provide bankruptcy prediction and other internal management scores to their customers," says Steven Wagner, president of Experian Consumer Information Services. Still, Wagner says financial institutions are required to let consumers know the reason their application for credit was denied, such as due to a deficient bankruptcy score.
Meanwhile, lenders are also hesitant to discuss their use of these scores. Banks contacted for this article were unwilling to provide much comment on the subject. "We use various analytics and look at a number of factors to determine credit risk. We do not comment, however, on our proprietary modeling," says HSBC spokeswoman Cindy Savio. Nevertheless, it seems clear that bankruptcy scores are used when considering credit card applications: Fair Isaac's website promotes its bankruptcy score as "an effective tool for retail cards, bank cards and other revolving accounts, as well as for installment loans, telecommunications/utilities accounts and other credit portfolios."
Further complicating the picture is that, unlike with credit scoring, there isn't a single, commonly used bankruptcy score. "There are a lot of bankruptcy scores out there," says Gregg Weldon, chief analytical officer with AnalyticsIQ Inc. in Atlanta. For example, credit bureau Equifax's Bankruptcy Navigator Index (BNI) uses scores that range from 1 to 300, with a higher score indicating a lower predicted risk. Meanwhile, Experian and Visa offer BankruptcyPredict, a bankruptcy score that "uses patented technology and processes to create a more comprehensive view of consumers most likely to drive bankruptcy losses over the next 24 months," according to its website. BankruptcyPredict scores range from 50 to 950, with a lower number indicating a higher risk of bankruptcy, Experian's Wagner says.
Improving your bankruptcy score
Because borrowing behavior plays into the calculation of both traditional credit scores and bankruptcy scores, credit cardholders may want to take the following steps to lessen the odds a lender will view them as a bankruptcy risk:
- Make on-time payments. A rash of recent delinquencies can signal that a consumer is headed for bankruptcy. By staying current with their credit card bills, cardholders should be able to improve their bankruptcy score.
- Maintain a low credit card balance. Consumers who go bankrupt tend to borrow up to their credit limit in order to pay for expenses. Therefore, a cardholder's bankruptcy score may benefit from keeping a low utilization ratio, or the amount of credit used compared to the amount of total credit available.
- Don't apply for too much credit in too short a time. A rush to secure additional lines of credit can signal danger to potential lenders. Consumers should therefore spread credit applications out over a longer time frame if at all possible.
All of this is proof that the bankruptcy score remains far less mature than the credit score. "Bankruptcy scores are where traditional risk scores were 20 years ago," says Weldon, who built generic and custom models for Equifax in the mid- to late-'90s. He says that while developments in the economy and bankruptcy law have brought about changes in the number of bankruptcy filings -- nearly 2 million bankruptcy petitions, a record number, were filed in 2005 ahead of the enactment of a bankruptcy law reform -- bankruptcy scores remain more "piecemeal," with various private companies and credit bureaus using their own bankruptcy scoring models, Weldon explains.
Credit score versus bankruptcy score
Although they attempt to predict different outcomes, credit scores and bankruptcy scores have much in common. "Fair Isaac's bankruptcy scoring models use consumer credit reports as input, just as the FICO score does," says Fair Isaac's Watts. Other bankruptcy scores also incorporate information from the credit bureaus. BankruptcyPredict, which became commercially available as a subscription service in early 2008, uses a "combination of credit reporting agency attributes and trending data, as well as transactional behaviors such as credit card transaction amounts, merchant category codes and cash advances," according to Experian's website.
"By using both credit data from Experian and transaction data from Visa, a financial institution can make more informed account management decisions, including when to intervene with education or other actions that may relieve financial distress and prevent a consumer from filing bankruptcy," says Susan Henson, Experian's director of public relations."With greater risk information, financial institutions can better target incentives such as reduced fees and financial education for those having financial difficulties," Henson says. According to Wagner, that Visa transactional data includes date and time of transactions, whether a transaction was approved or denied, merchant category codes and the transaction's dollar amount.
The overlaps mean certain behaviors -- such as keeping balances low, making payments on time and avoiding too many applications for new credit -- should benefit both types of scores. "When it comes to improving bankruptcy scores or any other type of credit score, consumers should follow the same golden rules ... since almost all credit scores, in some fashion, measure how consumers pay their bills, the length of time they have managed credit well and the types of credit they are managing," Experian's Henson says.
Despite the common ingredients, the "two types of models evaluate credit information differently since they are designed to predict different things," Fair Isaac's Watts says. According to Weldon, the "strength of those variables is different for bankruptcy models."
For example, the number of recently delinquent accounts (such as during the past six months) may be more closely watched by bankruptcy models, Weldon says. He also says bankruptcy scores may put added weight on carrying a heavy debt burden from month to month. In the case of people who go bankrupt, "they are actually utilizing their credit much more than the traditional 'bad'" credit borrower, Weldon says, noting that these borrowers tend to live on their credit cards until they can no longer make payments and then file for bankruptcy. This fact is reinforced by research conducted by Weldon and David R. Kelly showing that the typical bankrupt consumer utilizes 65.99 percent of their revolving credit, compared with the typical bad credit borrower who uses 52.71 percent.
Weldon says bankruptcy models also stress the application for new lines of credit, since borrowers who end up bankrupt typically scramble for added funds as earlier sources of money dry up. His research shows that the typical bankrupt consumer initiates 3.77 new lines of credit in the 24 months leading up to his bankruptcy filing. That's compared with 2.78 new lines of credit in a 24-month period for the typical bad credit borrower. When it comes to bankrupt consumers' credit lines, "they've maxed out all the previous ones, and they've maxed out the new ones as well," he says.
Bob Lawless, a bankruptcy expert and University of Illinois law professor, agrees with those conclusions. Since consumers will attempt to borrow until they can no longer do so, "the inability to borrow further often determines the timing of their filing" for bankruptcy, he says. Lawless says there is no disincentive for consumers to stop borrowing as they approach a bankruptcy filing. "You can't become more bankrupt by borrowing more," he says.
The unique traits of potentially bankrupt consumers mean the added scoring models are needed by lenders. "The FICO score is really good for telling you who will pay on time and who won't. But it won't tell you who is going to pay on time and who is also going to go bankrupt," Weldon says.
Lenders pay the costs for consumer bankruptcy
Bankruptcy scores attempt to predict an outcome that costs lenders much more than a mere charge-off. When an account gets charged off, the lender can still attempt to collect the money associated with that account, or the outstanding debt can be sold to a debt collection agency. "There is a lot of flexibility with what you can do with someone like that," says Weldon.
Not so when the borrower goes bankrupt. In cases of bankruptcy, the consumer's debt becomes a legal issue. "Once the court gets involved, your hands are tied," Weldon says. Although Weldon says bankruptcy models usually don't distinguish between the two main types of consumer bankruptcy, whether the borrower files for Chapter 7 or Chapter 13 bankruptcy does matter, Lawless says, with the lender able to recover some funds under a Chapter 13 filing. "It seems what the lender really wants to know is how much money they are going to recover," he says.
Furthermore, the lender stands to lose a significant amount. Bankruptcies tend to involve much larger amounts of money than charged-off accounts, since the borrower often runs up the maximum amount of his or her credit line before declaring bankruptcy, Weldon says.
Role of the bankruptcy score
Scoring models attempt to help lenders head off these threats. FICO's scores "are designed to predict bankruptcy far enough in advance for action to be taken, while there are still losses to be prevented," according to the company's website. Meanwhile, Experian and Visa's BankruptcyPredict enables lenders to take "pre-emptive actions to minimize bankruptcies that erode your profits," according to Experian's website. The product lets customers "choose daily monitoring to take immediate action on high-risk accounts and mitigate exposure. Utilize month-to-month management across your entire portfolio to assess where changes are occurring and apply the most appropriate strategies." That means more risky borrowers get watched more closely.
The scores do not only aim to reduce losses, but to help the lender maximize profits as well. "Fair Isaac Bankruptcy Scores enable you to separate accounts with a high risk for large bankruptcy losses from accounts that look risky but will be highly profitable accounts," the website says.
Lawless sees bankruptcies rising to 1.4 million for 2009, up from around 1.1 million last year. If his and other expert predictions are correct, lenders will undoubtedly rely on bankruptcy scores to help chart the most profitable passage through rough economic seas.
The creators of bankruptcy scores agree. "In these challenging economic times, it is critical for banks to be able to discern real risks and to be able to continue to lend to those that pose less risk," says Experian's Wagner. "Lending needs to continue -- for the good of the economy, our financial system and consumers."
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