Three quick follow up points.
Commenter Another Mike brings up a good point, one I’ve been thinking about:
The main idea is that there is an active secondary market in business debt, and primary lenders take advantage of its availability. When an adverse financial event affects a debtor, the current creditor calls in the loan immediately. This provides the greatest chance that he will get all of his money back. The debtor then has to find a new lender, one who has more experience with evaluating and monitoring distressed borrowers.
This may be what’s happening with credit card rates. When a customer misses a payment, it’s a signal about his type. It may be very crude, but it’s the only up-to-date data the bank has on the cardholder’s financial condition, short of a cumbersome credit check. The penalty rate becomes the method by which the bank forces the revelation of more detailed information. It raises its interest rate to a level where the debtor must take action.
Interest Rates as disciplinary measure. There’s talk about information asymmetries and signaling, so I want to translate that. If you miss a payment to Tony Soprano, he comes to your house and punches you in the face and says “Give me my f***ing money.” It forces a resolution of an informational asymmetry; you immediately want to pay up to get him out of your house. If you can’t, Tony needs to start thinking of ways to launder from your business and/or steal whatever else of worth you have.
The interest rate jump when you miss a payment should feel like Tony Soprano punching you in the face. It is the most they can get away with charging, because they want to scare you. Tony doesn’t punch you just a little bit, he punches you as hard as he can without killing you. Same with these credit card interest rates. This is not how the industry or those defending it describe it. This is not someone describing a rate that is “a rigorous, highly tested credit recommendation pops out of their risk management engine.” It is, by definition, way above the expected loss on your loan.
This is not minute difference. What Another Mike gets in the secondary business market is that the signal is clear: “Pay up now.” That is not the case in the credit card industry – when I asked why my rate had gone up after being two days late, I was told that it reflected my new credit risk, and that it would go down after 6 months. They did not say “we think you are a degenerate who won’t be able to pay this at all, so we are trying to get rid of you.” They in fact want to keep you around.
Mind you, this is the most generous model of credit risk I’m capable of coming up with.
What do insiders have to say about the matter?
Insiders are starting to come out of the woodworks. You should read these emails Felix is getting from insiders. Sample:
Credit card industry works on a bar-bell business model. All the profits (mainly through fees and very very high interest stretching into 30% or more) are made form people below 650 FICO, all the assets (loans or balances) are from people from above 700 FICO. The industry is just a giant wealth transfer mechanism from poor people to wealthly people. The profits from below (subprime) serve to subsidize the interest rate and rewards cost of people in the ’super prime’ category. You can bet that that will disappear soon
This is in line with commenters like John Lounsbury and my own thoughts, who point out that the market is less about your own individualized credit line dynamically assigned, but more about extracting fees and a returns based on the portfolio. The poorest have the highest transaction costs and are most vulnerable to shocks, so they get hit the hardest.
I like how the assumptions are that Obama is overthrowing the industry. He’s really just making information more clear, and making some of the randomness and uncertainty of the rates more smooth. I know a lot of people who want a much harder stick. I’m going to simply quote Economics 101 and say that if your business is predicated on making some people strictly better off by making other people strictly worse off that is a terrible way to be. It’s best that we run a wooden stake through the heart of that part of the industry, and force it to reoptimize accordingly.
Revolving Credit as Embedded Option
Last thought, a bit wonky. Interfluidity, in a post you’ve hopefully already read, splits credit cards into two items – a transaction card and a revolving card. I’ve been thinking of embedded and real options lately for work and a post coming up, so I want to phrase that line differently: your credit card is a transaction card with the embedded option to revolve the debt.
Transaction Card + Option to Revolving Transactional Debt = Credit Card
Now lots of things can be thought of as options. Car insurance is the option to having someone pay for your car repair if you are in an accident. Now in almost all cases (what are exceptions?) the option has value to the person who can choose to exercise it. Wouldn’t it be really weird if someone paid you to get car insurance? No, you have to pay to get that option, because according to economic theory you’ll only exercise it when it is optimal for you. If you have the right to exercise an option, you are going to have to pay something for it.
Now interfluidity points out that people are willing to pay a yearly fee for a transaction card – let’s say $100. Now if you are a business and get a revolving line of debt, you are going to have to pay significant fees to keep it. And since the “revolving debt” option of a credit card is an option you choose to exercise, a credit card should cost more to have than a transaction card. Checking my mailbox, there are a lot of credit card offers with no yearly fees. In fact, they are incredibly rare. So:
Transaction Card + Option to Revolve Transactional Debt = Credit Card
($100) + ($?) <= 0
So the option to revolve the debt, counter-intuitive to classical economic and financial theory, has a negative expected value. So being given the option to revolve debt is actually a losing prospective for the consumer. At least in the aggregate. What does that say for financial theory at the consumer level, and behavioral economics more generally? For the finance geeks, isn't that twisted?