High-yield paper is out of favor with Wall Street as an economic slowdown raises concerns about credit quality. One in five issuers have paper trading at distressed levels. Consumer lenders are under particular pressure due to worries about a looming recession. But investors in companies that make consumer loans should worry about more than a slowing economy.
Consumer lenders write off an average of 6% of loans each year. That's a bad enough record, but investors ought to realize that the industry's own sloppy screening practices contribute significantly to the losses.
Identity theft is the fastest-growing crime in America and costs companies $25 billion last year. Much of the cause lies with one factor completely avoidable by lenders; the use of Social Security numbers as identifiers.
One of my in-laws--I will call her Jean to protect what remains of her privacy--was the victim of identity theft in 1999. Jean is a teacher who lives in Westchester County, New York, and drives a Volvo. She and her husband have perfect credit. About a year ago, Jean called in a panic, saying that her bank had frozen the family checking account because someone had a judgment against her. Being the banker in the family, I agreed to act for Jean. What I discovered during more than a year of investigation was a personal outrage and an investor's nightmare.
Every investor who buys securities back by consumer loans or the equity of companies that are significantly involved in the consumer-loan business should think twice before investing in such paper.
One of the world's biggest nonbank financial firms--wee'll call it Megacorp--provided credit to a criminal who used Jean's Social
After the perpetrator defaulted on the loan payments, Megacorp obtained a judgment against the alias. Using the Social Security number, Megacorp's agents found Jean's family checking account at a big New York commercial bank. Even though the name and address were clearly wrong, Jean's bank enforced a garnishment order from Megacorp and froze $5,000 in the account.
I contacted the police and Secret Service, who were familiar with the Bronx address used to commit the fraud against Megacorp. I then called and wrote to the lawyer for Megacorp, a lowbrow law firm and collection agency that handles hundreds of such claims per month. I explained that Jean was the victim of identity theft and that Megacorp wrongly garnished her bank account.
Lawyers for Megacorp refused to back off and responded with a torrent of verbal abuse, accusing Jean of committing other misdemeanors. The law firm used a similar tone in telephone calls to Jean's mother. We responded by filing with the court a strongly worded show cause motion, as well as a motion seeking sanctions. Megacorp's attorneys subsequently began to back-pedal and eventually withdrew the garnishment. The cost of this exercise was roughly $1,500 in legal fees, plus the time to draft documents and letters, and two visits to the Bronx Civil Court, a venue too near Yankee Stadium for comfort.
I contacted Megacorp and the three major credit reporting agencies, Experian, TransUnion and Equifax. I asked how a criminal using a dubious Bronx mailing address and a false, oddly spelled name could
By making the false report to Experian, Megacorp apparently created a window of opportunity, enabling the Bronx lawbreaker to open accounts with Home Depot, Exxon, and AT&T Wireless, eventually involving over $10,000 in bad debt. I contacted these vendors to correct their misimpression that Jean was their customer.
Significantly, neither Megacorp nor Experian nor any of the other credit reporting agencies attempted to contact Jean to verify the significant change in name and address reported by Megacorp.
I confronted representatives of Experian and the other credit agencies about the false information place in Jean's credit report, yet they disclaimed any responsibility for the validity of the information. Representatives of Experian say they aren't responsible for the accuracy of the data provided by financial institutions and that they don't even review the information. ``The banks do that,'' they asserted.
Experian's representatives were courteous, however, and amended the reports after we provided copies of the relevant court documents.
Megacorp continued to send Jean demand letters from various collection agencies for months after my first telephone and written responses. I kept on asking: How could anyone of even minimal competence look at the credit reports from Experian and other agencies and approve credit to the fictions Bronx resident?
Answer: The credit report tied to Jean's Social Security number wasn't reviewed. One Megacorp representative told me unofficially that the Social Security number was simply checked for defaults, judgments, etc., and when it came up clean--the number, not the name and not the application--the credit was approved.
The Secret Service agent in White Plains, New York, who took the report on Jean's experience confirmed that he sees dozens of such cases every month in which Social Security numbers are used to commit fraud. The perpetrators are rarely caught.
Lenders and the providers of credit information have created a system that is inadequate to its purpose if a valid Social Security number and a couple of other pieces of information are sufficient to defeat most credit controls. Lenders may complain that it would be too costly to manually screen applicants and verify identities, but how much more costly would it be if they had to bear the costs they now push off onto Jean and other victims of fraud?
Financial author Martin Mayer rightly says that there are no economies of scale in banking, but the loan approval operation of too many consumer lenders suggests there are dis-economies of scale. It seems that the bigger a bank gets, the sloppier it gets. To maximize revenue growth and control costs, consumer lenders use statistical screening tools and computer models to make credit decisions. In other words, they use the law of large numbers and simply roll the dice. If a criminal finds a Social Security number with a clean history, he's off to the races.
Eliminating the use of Social Security numbers as identifiers by law seems like a logical solution. Texas Rep. Ron Paul has introduced legislation to prohibit the commercial use of Social Security numbers as identifiers, but Congress needs to more thoroughly examine the issue.
Even if Social Security did not exist, the financial system would invent another system of universal identification. Congress should place the blame where it belongs, on the lenders and credit bureaus. It should require credit bureaus to obtain written affirmation from consumers prior to accepting a change in the name, address or other details on a credit history. Lenders should be held liable for reporting false information to credit bureaus, especially in cases where false reports lead to acts of financial fraud.
Additionally, Congress needs to afford consumers greater protection from asset seizures based solely on Social Security numbers.
We are, after all, innocent until proven guilty. A bank or Megacorp that treats us otherwise has committed a gross injustice. And it--not we--should pay.