jim.shamlin.com

Puzzles and Paradoxes

In this chapter, the author intends to address some of the "misconceptions and misdiagnoses" of the credit card industry by economists, the media, and the general public.

It's worth noting that the author has been something of a cheerleader and can play it fast-and-loose with factual information, so consider his take on the issues to be counter-propaganda rather than an objective examination of issues.

Cause for Suspicion

A few attributes of the credit card industry are contrary to the qualities of a competitive market, notably that companies must compete on price, sacrificing margin to win customers.

However, this does not seem to hold for the credit card market: interest rates remain constant (between 17.8 and 18.9 percent) while the cost of funds fluctuated significantly (between 7 and 15 percent) and the average ROE on credit card operations are between 60% and 100%

The author suggests that competition "works somewhat differently" in the credit card industry - and though I'm a bit skeptical, I'm inclined to agree that this is highly unusual, but probably not evidence of market manipulation.

High and Sticky Interest Rates

During the 1980's and early 1990's, credit cards (compared to other loans) charged a much higher interest rate and these rates seemed to react more slowly to changes in the market.

High Interest Rates

Credit card interest rates are higher that the rates on virtually any other kind of loan. The author uses August 1998 as a snapshot, when credit card rates were around 16% - and mortgages were at 7%, auto loans at 9%, and even unsecured personal loans were at 13% (the T-bill yield was around 5% at the time).

The higher rate of interest is partially explained by risk. Unlike other loans, a credit card is not secured by assets, and the amount borrowed can fluctuate at the customer's discretion. As such, they represent a higher rate of risk, and command a higher return for the issuer.

The author suggests a few other justifications that do not ring true.

First, he suggests that the high rate is used to offset other "costly benefits" such as frequent flier miles, purchase guarantees, and insurance. However, these expenses are often used to generate additional revenue (an "airline miles" card usually requires an annual fee, credit insurance is sold to the customer, etc.). There is also no indication of the actual cost (how many individuals redeem airline miles or take advantage of purchase guarantees?), so the assertion that these are immensely expensive is unsupported by evidence.

Second, he suggests that banks must borrow money in order to have the funds to pay charges immediately, and must pay interest to their own creditors until the customer pays off their balance. However, this also smells of propaganda, as the same would be true of mortgages and auto loans, to which credit card rates are compared.

Third, he suggests that banks incur expenses to service accounts, rent space, pay salaries, etc. However, it seems unlikely that credit card operations would be much more expensive (if at all, given the amount that is automated) than other operations, and any expenses directly related to the business should be figured into the ROE.

Sticky Interest Rates

It is also suspicious that interest rates on credit cards do not fluctuate, as do the rates on various other kinds of loans: mortgages, auto loans, and even personal loans have rates that fluctuate daily, whereas credit card rates remain fixed for long periods of time.

This is primarily the result of fixed-rate agreements, in which the terms of the credit card are set when the card is issued. The issuer is bound to honor that contract, and is not free to adjust the interest rate. Meanwhile, while consumers can renegotiate their rates with issuers, most are not in the habit of doing so.

At the time the book was written, variable-rate cards were beginning to catch on: marrying the interest rate to the credit markets would insulate card issuers should rates increase sharply, and enable them to retain customers who might be wooed away by competitors when rates fell. Ultimately, this will cause credit card interest rates to fluctuate, paralleling whatever indices they are married to.

The author doesn't mention (but really should) that marketing may also be to blame: since credit cards are heavily marketed, and since their main selling point is the rate, a bank must decide what rate to offer in a promotion and decide how long the offer will remain valid, and honor the offer when customers respond, days or weeks later.

The author also has a few goofball explanations/excuses for the stickiness of interest rates:

The author draws a comparison between credit cards and other consumer goods, in which businesses attempt to keep a fixed retail price with periodic increases rather than allowing the daily changes in commodities prices to cause their prices to fluctuate daily. However, this smacks of an apples-to-oranges comparison, as a loan is a significantly different good than a [piece of furniture - and certain consumer goods (such as gasoline) do fluctuate daily when the markets for components are in flux.

He also suggests that all loan products are "sticky" to some degree, in that there is a lag between the time there is a change in the prime lending rate (the cost bans pay to borrow money) and the time a bank can change the rates it charges its own customers. This may have been true before computers, but it seems that a bank can synch its prices to the prime without significant lag - and they seem to do so for virtually every other kind of loan.

The Myth of Exorbitant Profits

The profits earned on credit cards are very high: the ROE can be 60% to 100%, which is significantly higher (three to five times) that banks earn on their other products. Naturally, this has drawn some consternation from politicians and consumer groups.

The author suggests that the standard accounting practices for calculating the rate of return are ill-suited for the credit card industry, as there are differences between accounting depreciation and "true" depreciation and assumes that a company is relatively stable rather than experiencing rapid growth). However, this is clearly bunkum because the financial sector does not rely on significant capital assets that would need to be depreciated, nor does growth require significant investment.

He also suggests that a "true" rate of return must consider long-term trends, especially when it comes to consumer defaults on credit card debt: a single bad year can balance out several good ones. While this seems reasonable, he presents no facts, or even a case study, to support this assertion, and it would stand to reason that banks would seek insurance on outstanding debt to even out their cash flows and defer risk.

He also suggests that there is a great deal of start-up cost to getting a credit card into circulation - marketing to customers and merchants, developing hardware and information systems, developing alliances with various suppliers, etc. - and he points to the enormous losses taken by Discover in its early years. However, this is misdirection: the credit card issuers (banks) make enormous profits by charging high interest rates, whereas the card services (Visa, MC, etc.) make their income from a commission on sales, which is paid by the merchants who accept the card, not consumers.

While all of the author's theses are bunkum, the argument itself is entirely subjective and moot. It is subjective, in that "exorbitant" is entirely opinion-driven. It is moot because it is generally the opinion of third parties to the agreement: in the market "fair" is the price to which buyers and sellers agree.

How Risky Is Credit Card Lending?

The author argues that the income of credit card businesses is largely justified by the riskiness of the industry. Aside of the risk of nonpayment, card issuers also face the risk that even a "good" customer (who pays his bills) will actually be a profitable one.

A customer who pays his charges in full each month pays no interest, and unless the customer pays an annual fee, the card issuer makes very little profit (their share of a commission charged to merchants). If such a customer charges very little each month, the issuer may be taking a loss on their business. Likewise, a customer who accepts a card, but does not use it, generates a small loss for the issuer in servicing a dead account.

When companies find credit cards unprofitable, and sell off their business, it is less often because of defaults than because of customers such as these.


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