In these terribly hard economic times—massive federal bailouts meant to loosen credit aside—lenders have to do whatever they can to protect themselves, and they are. Since the 1990s, they have been slipping universal default language into their terms and conditions. That allows them to change the terms of your loan (interest rate, credit limit and so on) based on how you do with other, unrelated creditors. Pay late on your Capital One card, the interest rate on your Chase card goes up. Universal default has been around since the heady deregulatory days of the 1990s, but until the recent economic crisis hit, it was not something that regularly came into play. Now it has, but at least it is based on something that the borrower did.
Now we hear of a little tactic that American Express is using. They are examining where you shop. American Express is making the connection between merchants and their customers’ payment habits. Say you own a shop and you have—at least as far as you are concerned—a nice, healthy customer base. If American Express, and any other credit card issuer that does this, finds that a lot of your customers don’t pay their bills on time, they will punish anyone who shops at your store with their card by lowering their credit limit. So, in other words, Customer A, with sterling credit, comes into your shop and pays for a widget with his American Express card. American Express looks at the purchase and sees that other customers—Deadbeats A-X—also shop there. This leads them to lower the credit limit on Customer A.
The Rationale: Risk-based Pricing and Predictive Analytics
Risk-based Pricing is a methodology adopted by the financial services industry to help lenders measure loan risk in terms of credit limits, interest rates and other fees. These factors are determined by the time value of money, as well as the lender's estimate of the likelihood that the borrower will default on the loan. The lender considers a number of factors in assessing the probability of default like the borrower's credit score and employment status or characteristics of the loan itself. The lower the overall perceived risk, the easier the terms for the borrower.
The problem is that until recently, most people considered these terms to be static, that they were determined at the start of the business relationship and would not change too much or too fast. That has changed. Credit card companies are reassessing risk based on a number of factors at a very high rate, which results in their raising interest rates, lowering credit limits, and eliminating lines of credit entirely—all in the name of lowering risk in order to protect themselves from the economic downturn. In this way, the same methodology used to expand the number of people who could qualify for credit is being used to limit or eliminate credit from certain people.
Helping that process along is something called predictive analytics. Essentially, that means you analyze a pattern of behavior and then make some predictions from that pattern. If a person is chronically late with the mortgage payment, it is easy to imagine that they will also be late with their credit card payments. However, does the same reasoning hold if you are on time with all your payments and the one chronically late with their mortgage payment is your neighbor? How about your neighbor on the other side as well? Does the rationale hold up if you have a good payment history and are flanked by deadbeats? How about adding deadbeats across the street in front and across the alley behind? There you are, surrounded by deadbeats, but you pay your bills on time and your credit is solid: Does it make sense that your interest rates get jacked up because you live near deadbeats?
No, it doesn’t, but that is, essentially, the reasoning of American Express. You shop with deadbeats, you will be treated as a deadbeat. According to US PIRG’s Ed Mierzwinski, these predictive analytics and the databases the information goes into is forming a new kind of score used to make lending decisions, a behavioral score.
According to press reports, American Express, at least, (MSNBC story) has admitted lowering the limits of otherwise good customers because they might shop at stores that customers who've defaulted on their cards also shopped at. I am sure other majors are also using behavioral scores. A credit score is derived from a regulated credit report. A behavioral score could be derived from a variety of unregulated information sources, including, in this case, where you use your card. "Experience and transaction" information is something that the bank obtains from your own account data. The bank can enhance it with commercially available outside data sources to develop a virtually unregulated dossier on you. Consumer groups including U.S. PIRG have long argued that "experience and transaction" information—one of the richest sources of detailed information about you—should be subject to greater privacy rights. It is not.
The Bottom Line
This is bad enough for individuals who have to deal with the credit ramifications and privacy issues that these practices raise, but what about a retailer or other business that is marked as a center for deadbeat activity? After all, it is really no business of the retailer if its customers are deadbeats, as long as they get paid, right? Is this going to cost them customers? Will it go onto some other “Experience and Transaction” database for other reasons that might come back and harm the retailer? This practice—unregulated and not covered by privacy laws—poses too many ethical and practical questions to be allowed to continue.
Behavioral scoring needs to be addressed by Congress and the incoming administration and it must be regulated at least as closely as credit scores in order to ensure that the information is used correctly and fairly. Frankly, the idea that your credit can be affected by the actions of consumers that you don’t know should be appalling to everyone and it should be stopped—not in the year-and-a-half the current credit card regulations will take to come into effect—today, now. If Obama, Pelosi, Reid and company want to show us all how much they care about The People, they can start by outlawing this obvious injustice to consumers and tacit threat to businesses.
