Credit Card Reform

Kevin Drum reports some depressing news about whether or not Congress will be able to pass a weak or strong form of a consumer credit bill of rights:

The proposal, sponsored by Senate Banking Committee Chairman Chris Dodd (D-Conn.), would prohibit rate hikes on existing balances, give cardholders longer notice to pay their bills, and prevent card companies from charging fees when customers pay their bills on time.

….A similar credit card reform proposal, sponsored by Rep. Carolyn Maloney (D-N.Y.), passed the House easily last week, but the Senate bill goes even further to protect card users from unexplained fees and surprise rate hikes. The question now on the minds of many anxious consumer and lending advocates is this: How strong can Senate Democrats keep those consumer protections and still have the bill pass the upper chamber?

Kevin brings his attention to two practices: retroactive rate hikes and universal default. In his comments that are critical of his points, and in general on the interwebs, you heard vague allusions to ‘credit risk.’ The argument goes: What the credit card companies currently engage in is managing their credit risks – it’s a similar process as in the financial markets. If you become less credit worthy, you should be charged more because you are more risky. A credit card having an interest rate hike is just like a mortgage having a variable rate or a company having a revolving (revolver) line of credit. Let’s look at those questions.

Isn’t this just like a home loan that has a resetting interest rate?

No. A home loan that has a variable rate has two inputs – a credit spread and the LIBOR interest rate. Add them together and that’s your interest for your home loan. The dates that the resets happen on, the first of the year, every quarter, etc., are well laid out in the mortgage contract. More importantly, the credit spread is also agreed on at the start of the contract. What the credit card companies do is set the interest rate to what they decide, regardless of LIBOR, at any point they can justify a credit event. There is no spread that is agreed on. There is no comparison there.

Isn’t this just like a line of credit, or a revolver, that a lot of companies have?

No. A line of credit is a better comparison, but the spread over LIBOR is fixed in most cases. In this sense it functions as a put option, as failing companies can unload more expensive debt there. Kicking it over to my boys Brealey and Myers:

Revolving credit agreements are relatively expensive, for, in addition to the interest on any borrowing, the company is required to pay a commitment fee on the unused amount. In exchange for this extra cost, the firm receives a valuable option: It has guaranteed access to the bank’s money at a fixed spread over the general level of interest rates. This amounts to a put option, because the firm can sell its debt to the bank on fixed terms even if its own creditworthiness deteriorates. (6th, p 929)

So high fees up front, fees for not using the full balance, fixed credit spreads and an embedded put option where the debt becomes more valuable the worse you are doing. That is the exact opposite of how credit cards function.

Doesn’t this have something to do with credit risk?

Correct me if I’m wrong, but there are very few instruments in financial markets where the interest rates fluctuates as much as it does with credit cards. In general, credit risk for debt should look like: rate = Interest Rate + Default Probability. In practice for the bond market, we see credit agencies adjust ratings up and down, from AAA to AA, from BBB to A, etc. with the spreads from Default Probabilities moving basis points up and down.

What do we see with credit cards? We see: miss one payment, and your rate goes to 24%. Check out this guy: David C Nelson, CEO of DC Nelson Asset Mgmt. LLC and former Lehman Portfolio Manager, misses one payment on his AmEx card and his rates go to 27.99% He immediately pays off the balance, and is flabbergasted at the results.

In general, we see one missed event, and the rate skyrockets. We also see rates skyrocket over FICO adjustments, which are often poorly observed and arbitrary in the short run. In what metric space is that increase in interest rate reflective of the increase in default probability on the underlining? As for the CEO, it’s the same exact increase a graduate student sees when he misses a payment. How is that coherent risk measure?

Isn’t a man entitled to the sweat of his brow?! This logic won’t cut it on the Seastead. The credit cards companies and people can enter into whatever contracts they want.

One can always point to a move like this and say it reflects some sort of underlining risk. Let’s look at counterfactuals. Here’s my challenge. Let’s say I got an enterprising young financial engineer for my new credit card company and told him: “Instead of writing a program that changing the interest rates and outstanding balances to reflect new credit information to reflect risks, I want you to write a program that maximizes the profit we can squeeze out of a debt carrier the moment he’s indebted enough to make it worthwhile and once we have legal cover to do so.” I, of course, am not accusing anyone of doing this, but I can’t see a difference in that approach and what is done in the credit market.

How else can you explain credit card companies decreasing limits when consumers charges to Walmart? That’s a sign that consumers are becoming more credit worthy (since they are reducing consumption and thus increasing savings); if anything their rates should go down. In these situations it’s much more profitable to not get paid back, perhaps ever, than actually make sure there is a way for the loan to amort properly.

But Universal Default…

Also: universal default is bullshit. It takes the problems above, but then throws in a nice cartel situation to boot. Normally we want creditors to be in competition, but here they can form a nice cartel front ready to swoop at the first sign of a missed payment. If the credit cards are charging rates not to reflect risk but to grab as much as possible, missing your water bill because of a simple confusion is enough to give the credit card companies enough legal cover to run amok on the rates they charge you. That situation, where credit is monitored across all entities on the individual basis, is very complicated and difficult for consumers to navigate. It is also counter-intuitive to how they tend to massage bills in bad times: I can miss the phone bill once, and pay the minimum on the electric, and then next month, etc.

Credit markets are fluid. Credit card rates, limits and features will adjust in light of any regulation. By turning off the features that act most predatory, or against the normal month to month budgeting that consumers do where they play bills off each other, credit cards can become a more healthy part of the consumer financial sector.