Dr. Raynor teaches finance at the State University of New York at Delhi, and is periodically a visiting professor at Universidad Catholica Santo Toribio De Mogrovejo in Peru. He has worked on a number of projects in other areas of Latin America, and was also a visiting professor in China. He is especially interested in international trade and labor issues, and has previous private sector experience in the banking industry.

As everyone knows, the credit report has become an increasingly important part of our lives. We use it anytime we want a car loan, credit card, mortgage, etc. Credit reports also are used in non-credit areas, like getting a job or determining car insurance premiums.

In fact, the use of credit reports recently has become even more controversial in Massachusetts because of their linkage with other socioeconomic variables. Hospitals increasingly are using credit reports to determine credit risk factors with patients. Thus, the use of credit reports is broadening at a time when they are coming under increased scrutiny.

Credit reports were used differently years ago when I worked in the banking industry as a loan officer. In those days, banks made loans that were based on sound lending principles:

Credit history Repayment patterns and responsibility in meeting other financial obligations. The credit report was used to determine this.

Capacity The ability to pay back a loan. Current capacity, capacity stability, and future capacity potential were considered. If capacity was marginal, the credit report (repayment history) might be a mitigating factor.

Collateral Can the loan be secured, or is it even necessary? Often times, the strength of the credit report helps determine this decision.

Conditions Are their other extenuating circumstances? Again, the strength of the credit report may provide guidance to better understand special circumstances.

Intangibles Other factors that may not fit neatly into the above categories, but may still have an impact on the loan decision. The credit report was use in conjunction with other factors to take intangibles into consideration.

Banking certainly is different now, especially after credit scoring systems evolved from credit reports in the 1990s. Credit scoring systems were well-intentioned as tools for banks in making more objective lending decisions. With technology advances and other developments, however, many financial institutions automated at a pace that was unprecedented. In some cases, loan officers were replaced with computer-based systems that made a loan decision based on the credit score almost exclusively.

It doesn't take a financial genius to realize what a mistake it was to put so much emphasis on the credit score. Sound lending practices could not simply be boiled down to a single number. Now this is cited as one of the primary causes for the current mortgage crisis. Too many mortgages were made to individuals based on a single credit score number, not taking into consideration other factors that were important. These factors were often intangible in nature, and also harder to identify and quantify, but nevertheless are still very important.

Measuring intangibles is extremely important, something I advocated many years ago here at BNWW. On one hand, it is necessary to move the ball forward in quantifying intangibles. This can be very difficult because intangibles tend to be much more vague and abstract. Since our economy is increasingly knowledge-based, consisting of more intangibles, such as intellectual property, R&D etc., new models are needed to quantify value.

On the other hand, a model or measurement that takes intangibles into consideration must be tested over time for reliability and validity. It should be evaluated simultaneously against the old system--such as pre-credit score lending criteria in the case of many financial institutions-- to determine relevance. Too many lending institutions rushed to implement the credit score-only method for making loans. Credit score numbers cannot substitute for these intangible attributes and the sound lending practices mentioned above.

In many cases, poorly informed or intentionally deceived individuals were given mortgages they could never realistically repay. The credit score sometimes provided a smoke-screen or cover for individuals in the mortgage industry who were motivated by greed.

Banks that needed more loan assets while collecting fees or points certainly were not complaining. Neither were the real estate agents or mortgage brokers who received a commission on each deal. Include the legal firms, title companies, appraisers, and home inspectors, etc, and no wonder such a big part of our economy is affected. While there are honorable exceptions, too many individuals had an incentive to let the automated credit scoring system keep approving mortgage loan after mortgage loan.

Financial institutions involved in the mortgage melt-down have an obligation to help "unwind" the damage they help to create. While many of the institutions that relied so much on the credit score neglected their due diligence responsibilities, they can exercise some due diligence now in mitigating the damage.

In the interim, auto insurance companies and others who now use credit reports for various reasons should use due diligence up-front to make sure the reports are not misused. Is the use of credit reports in their modeling methods really capturing the intended purpose? If not, what other types of problems are looming in our financial future?