A quick primer on credit card economics

Dreamer Tatum

(1000+ posts) Send PM | Profile | Ignore

Mon Feb-16-09 07:49 PM
Original message

A quick primer on credit card economics

After the billionth angry and uninformed post on how credit card companies work and think,
I thought I would explain a couple of current phenomena. Believe me, I am in a position
to explain a great deal of card company behavior to you.

NOTHING WRITTEN HERE IS MEANT TO CONDONE OR DEFEND CREDIT CARD COMPANY POLICIES AND
TACTICS.

Issue/Claim: "They just raised my rate to 25%, when I pay my bill in full every month!"

Explanation: There is a segment of non-revolvers (or transactors) who pay very little in interest
or fees to lenders; their average balance is close to zero, and the only money they
make is the interchange they share with Visa and Mastercard. However, when times get
tough, a portion of this segment begins to revolve debt, and another portion starts
to charge up the card because their financial situation is becoming dire. Once exposure (ie, the total
amount people borrow) starts to build, it is difficult for lenders to discern who is
changing their behavior, and who is revolving debt, yet can't or won't pay. Historically,
accounts that begin to revolve debt after transacting for so long tend to roll to loss pretty
quickly, yet there are no or very few balances in the sub-segment that doesn't revolve. This
means that losses in this segment rapidly approach 100%. The 25% rate is the lender's attempt
to mitigate some of that loss potential.

Solution: If you never revolve, this is a non-issue. If you don't like the credit policy,
get rid of the card.

Issue/Claim: "I transferred a ton of balances at zero interest, so HA, I'm screwing the bank!"

Explanation: Um, probably not. When you transfer balances, or when you charge something at a
temporary, low rate, payments go to that part of your balance first, while your balances under higher
rates continue to accrue interest.

Solution: Don't transfer balances or use convenience checks unless you have a zero balance, or unless
you can pull a double-switch and move all balances to intro rates.

Issue/Claim: "Credit card companies charge usurous rates!"

Explanation: Actually, no, they don't. Their underwriting criteria is based on historical losses,
and almost every lender would be ecstatic to make a 3% profit (ie, post-loss, post-servicing, post-G&A) per dollar lent
on an annualized basis. Where they pad their earnings is on fee income, as I will now demonstrate.

The easiest way to think of credit card profitability is as a percentage of money lent. The main sources of
expense for lenders are money cost, losses, servicing, and management and administration (not in that order,
necessarily). For subprime customers, annualized, steady-state net credit losses often run over 20% (ie,
20 cents of every dollar lent). Money cost in this day and age runs roughly 2%. Servicing of subprime cards
is very expensive, owing to the amount of collections calls and customer service reps necessary; it can
run as high as 5%. The cost of management and administration (marketing, banking, credit policy, etc)
should run around 1.5%-3%.

For a 30% APR, on average the profitability looks something like 30% - 20% - 5% - 2% - 1.5% = 1.5%. That is, even with an
allegedly "usurous" rate, like 30%, profits can very easily run as low as 1.5% or less. To put that in perspective,
grocery stores high-five themselves if they can run at a 2% net return on assets.

Lenders mitigate that margin, of course, by charging $39 fees for late and overlimit. Here is how they make out like
bandits: a typical subprime credit limit is $500. Late accounts are by and large also overlimit (you have to trust me
on this), so that $500 turns into $578, not including interest. That's interesting, but what's more interesting is that
$78 / $500 = 15.6%. Even if the bank realizes HALF of those fees, the net margin is now 1.5% + 7.8% = 9.3%. Notice that the
more delinquent accounts, the more money the bank makes, without ever having to expose investors' money.

The moral is that the interest rates themselves are actually defensible, given losses. The late and overlimit fees, which
are supposed to cover excess servicing expense, actually account for most of the profitability of a subprime portfolio.

To preserve fee income, banks will do whatever it takes to confuse cardholders into paying late, or they'll make on-time
payment cumbersome and confusing.

Solution: Send your payment the moment you receive your bill. Send your payment via registered mail, if economical.
Dispute all late/OVL fees as soon as they appear. Keep track of your balance and payment status electronically, if possible.

Issue/Claim: "Credit card lending should be nationalized to bring rates down."

Explanation: That wouldn't change much, and in fact it would eliminate credit offered to the most risky segments.

Solution: Regulate credit card company (or division) profits to no more than a 4.00% risk-adjusted return on annual average assets, with overages to be rebated back to cardholders.

This will create incentives for card companies to (a) lend more intelligently, (b) manage credit limits more carefully (c), hire more people so as to increase the pay base when net assets grow, (d) scale back fee structures, or (e) all of the above. Notice that I am not regulating interest rates.

Issue/Claim: "Credit card lenders are all fat cats who feed on the blood of cardholders."

Explanation: Bullshit. For every credit card executive, there are ten $40,000 analysts who make sure marketing campaigns occur. For every credit card executive, there are at least one hundred hourly-paid call center employees who man phones. There are also IT people who make systems work, and low-level admin staff who make sure the OCC and OTS get what they need.

Solution: Drive around Dallas, Chicago, Phoenix, and central Florida until you lose count of the buildings.

Issue/Claim: "Credit card lenders export all of our jobs to India."

Explanation: Some of them, sure.

Solution: Drive around Dallas, Chicago, Phoenix, and central Florida until you lose count of the buildings.

Issue/Claim: "Banks write off debt, so why can't I?"

Explanation: Banks write off balances that they deem are uncollectable, a practice which is standardized and highly (federally) regulated. It is not the same as banks writing off amounts of money that they owe to their creditors.

Solution: If you want to write off your debt, file bankruptcy.

Issue/Claim: "We should all protest abusive practices by a complete stoppage of payments."

Explanation: You might also frame your credit cards, since they'd be the last ones any of us will ever see.

Solution: There are three practices that should be protested forever: changing terms on a whim, obfuscating the payment
process, and charging exorbitant fees. Dealing with each of these three will drastically reduce the ability of the lenders to seize
supra-normal profits.

Now then: flame away.