FICO and Credit Scoring

Consumer credit scoring did not arrive quickly even after credit reporting bureaus for commercial firms began to sprout up. In the United States, more than a century divided these moments. Unsurprisingly, to develop consumer credit scores, large volumes of consumer credit data needed to be collected, and this wasn’t feasible until mass consumerism and big retail developed in the very late 19th and early 20th centuries. However, it took decades longer for consumer credit scores, and the FICO score specifically, to make an appearance.

Commercial Credit Scores

Until the advent of large retail chains and mass consumerism around the start of the 20th century, consumer credit was generally arranged only between people who knew each other. As a commonplace example, a small-town merchant might offer credit to a customer who made frequent purchases from him. In the United States, starting from the 1820s, some credit scoring became available for firms but not for consumers. Mercantile Agency, one of the more successful credit scoring firms in the country, was formed in 1841.

Merchant Agency was founded by Lewis Tappan in response to the Panic of 1837. The firm offered qualitative and subjective information rather than a numerical score of creditworthiness. Quantitative and verifiable data was unavailable so Merchant Agency was essentially compiling rumors. Still, it made it more difficult for a fraudulent actor to flee their reputation. The availability of this information meant creditors could become more willing to lend, especially to unfamiliar businessmen.

Bradstreet Company was another such credit reporting agency. Bradstreet and Mercantile Agency both introduced a formal alphanumeric scoring system, but not until 1864 in the case of Mercantile Agency. Again, these credit scores were for commercial firms, not consumers. As it happens, both companies would merge in the 20th century to form today’s Dun & Bradstreet.

Consumer Credit

Just like the town general store before them, department stores began to offer consumer credit on a larger scale starting from the late 19th century. The emerging auto industry thereafter also came to rely on consumer credit in order to sell cars. However, these sellers could not know everyone they were offering credit to. They employed credit managers to approve credit and these employees used some of the methods devised by Dun & Bradstreet and their predecessors for analyzing the credit of firms, but there were still no consumer credit scores in the United States for them to consider.

Credit Bureaus

Even before the advent of the personal credit score though, consumer credit reporting agencies began to develop. Like the mercantile credit firms before them, these agencies still trafficked in what were more-or-less rumors though it was supplemented with other public information like court records and newspaper reports. The information that credit bureaus could maintain was regulated with the Fair Credit Reporting Act in 1970. This law ordered credit reporting bureaus to delete certain types of information on consumers, including all negative information after a certain number of years, and allowed people to access their own credit records.

One of the first such bureaus, the Retail Credit Company, established in Atlanta in 1899, came to develop credit files for millions of people. They rebranded as Equifax in 1975. Together with Experian and TransUnion, Equifax makes up one of the three consumer credit reporting bureaus in the U.S. today. The bureaus grew by consolidation into just these three national operations from a patchwork of smaller regional agencies that existed before. However, these agencies still did not offer credit scores. If one called Equifax in 1940 to obtain information on a prospective borrower, one received an unstructured file of assorted information that would need to be analyzed further. No credit decision could be made quickly simply by accessing credit bureau information.

Fair Isaac Corporation

It was not until the late 1950s that consumer credit scores made an appearance in the United States. The firm introducing this was the Fair Isaac Corporation or FICO, founded as Fair, Isaac and Company in 1956. Bill Fair and Earl Isaac established the company with $400 each. It had no office at first and the two entrepreneurs who met at the Stanford Research Institute, a research center formed by Stanford University, were essentially offering their services as consultants to financial firms.

The pair eventually developed an algorithm for assigning a credit score to consumers on the basis of the myriads of records accumulated by the bureaus and lenders. Fair and Isaac pitched their services to fifty of the largest consumer credit companies in the country, a mix of banks and non-banks; they received one favorable response. So, in 1958, the first such algorithm was devised for its first and then its only lending company client, Louisiana-based American Investment and its Missouri subsidiary Public Finance Company. Around the same time, Fair, Isaac and Company worked with Hilton to establish the billing system for one of the country’s first credit cards, Carte Blanche.

The scoring system Fair, Isaac and Company developed for American Investment reflected the company’s circumstances with a myriad of small offices in rural settings, eight hundred in total. The score needed to be simple; it was unlikely the person calculating or interpreting the score would have a knowledge of statistics. This lack of intersection between statistics and consumer finance is likely the reason why no one else had developed a scoring system any earlier. There was also little access to computers and, ideally, it would be feasible to tabulate the score without calculators either.

In the early days, building such a model was not straightforward. Data was not kept by credit departments in a manner that made statistical analysis easy. Building any model requires data and that was difficult to collect. To accomplish this, data collection trips were organized that essentially entailed going into the stores and offices of clients to compile data from ledger cards, at least enough to build a sufficient sample with which to use for their work. Then the information from the ledgers had to be coded into IBM cards. Only then could Fair, Isaac and Company begin work building a model that could assign credit scores. Of some help, local credit managers also provided Fair and Isaac with their own expertise while they were in the field collecting their data.

Fair Isaac Corporation eventually sold its credit scores to the credit reporting bureaus. The agencies, like Equifax, previously compiled credit information and conveyed it to buyers but they did not make a credit assessment themselves or offer one developed by another party. The partnership with Fair Isaac Corporation was mutually beneficial; while they received credit scores, they gave the company access to a wealth of consumer credit data. The first Fair Isaac credit score using bureau data was called ‘PreScore’.

Fair Isaac’s head of sales, O.D. Nelson, came up with the idea for this partnership which, though fruitful, was not obvious initially. The credit bureaus previously thought of Fair Isaac as a kind of competitor, not because Fair Isaac offered a similar service but because its scores were thought of as an alternative to credit bureau data for lenders.

Fair Isaac Corporation did work on other projects, often on a consultancy basis, just as the credit score business started. For example, the company developed automated tools for processing credit applications all the way back in 1972. They also developed more software in the 1980s that made mass consumer credit more accessible, particularly through credit cards.

In fact, credit cards shifted Fair Issac’s business once more, towards more conservative banks which issued credit cards rather than more risk-tolerant retailers and specialty finance lenders which were its typical clients early on. In 1989, the modern FICO score was devised. Fair Isaac Corporation had been developing and marketing credit scoring algorithms since it was founded. However, the modern FICO score became the industry standard and was intended to be suitable for general purposes rather than a specific kind of loan.

From this point, the FICO scoring algorithm changed little over its 35+ year history. It is also resilient to changes in which credit bureau’s data is used as an input. This was intentional as Fair Isaac scales the score to account for differences, or skew, in the information any one bureau provides. The FICO score further enabled mass adoption of consumer credit without the duplicative overhead of credit departments. Even the application process can be simplified thanks to usage of a credit score.

Lesson

Consumer credit today, especially in the form of credit cards and installment loans but also in the form of car loans, relies heavily on centralized records and credit scoring. These forms of lending would be much more expensive to provide if every lender had to gather their own information and develop their own score. Shopping around for credit options would also be more difficult, making credit more expensive still for the end consumer. There was something of a necessary order in the development of the credit score. It could only arrive on the scene after sufficient volumes of consumer credit data had been collected and this data could only arise once some consumer credit had been made available by more risk-tolerant lenders at the vanguard.

More from the Tontine Coffee-House

Read about consumer credit, from pawnbrokers over two centuries ago to the advent of credit cards. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.