Three quick follow up points.
Tony presents a member with his rewards gift
Soprano Credit
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?
Rortybomb 
Pingback: Credit Card Reform: Does my credit card’s interest rate mean anything? « Rortybomb
As a finance geek, I’ll take your invitation to answer the question, “What does [the negative expected value of the option to revolve credit] say for financial theory at the consumer level, and behavioral economics more generally?”
The implication here is that borrowing money on a revolving credit line with a credit card is costly. It’s an option that’s never optimal to exercise, more like a potential pitfall, a trap you might carelessly fall into rather than a potential benefit. Think of it like an option to play Russian Roulette!
It seems to me that if financial theory suggests that the option to revolve credit on a credit card is in fact a cost and not a benefit, then that financial theory is pretty sound. The interfluidity post you link to highlights the double-edged sword of revolving credit, and in my opinion there’s almost never a situation where borrowing money at an 8+% interest rate that could increase at any time with no notice is a good idea. Interfluidity points out a few good alternatives like a secured loan.
So appending that feature to a transactional credit card, from a consumer perspective, makes it something dangerous.
I think this is actually a situation where we should celebrate financial theory for revealing something that’s hidden in those no-annual fee come-hither offers, what we all intuit anyway—if the offer looks too good to be true, it probably is. Given that consumers don’t always behave rationally or simply make mistakes (e.g. pay a bill 2 days late), there’s a risk associated with owning the compound card. That’s precisely why it’s priced so cheaply!
I think this option idea is getting us somewhere. Except we should think of it as an option owned by the bank, for which it is paying $100 per year.
Let’s start with a puzzle: This “subsidy” idea makes no sense as a business strategy. Why would banks want to extend credit to transactors if they’re not making (much) money off of them? They could do better by limiting themselves to the revolvers and diverting the funds that they would otherwise extend to transactors to other, higher NPV projects.
Here’s where the option kicks in. Out of a pool of thousands of transactors, the bank knows that some are going to become revolvers, most likely because of an income or liability shock (such as a lost job or a medical bill). But the bank can’t predict which ones, so it carries a portfolio of such accounts under the assumption that some will turn into profitable customers down the line. Meanwhile, it tips the odds in its favor by offering “rewards” that only vest when the cardholder spends money–that is, when he pushes himself closer to the point where a solitary financial shock will draw him into extended indebtedness.
This explanation is consistent what we know about how the business works. Banks make a lot of money on interest, but another source of substantial profits comes from penalties and fees. In fact, over the past 10-20 years their business in general has to a greater and greater extent conformed with a “gotcha” model. They offer services for free (checking, etc.) but make money on situations that most people believe ex ante that they will never face (such as overdrafts).
Great comments.
Another Mike – remember by ownership I mean the right to exercise. The credit card company can’t force anyone to revolve a balance. In general we shouldn’t expect a rational consumer to exercise an option with a negative present value, unless they are risk-seeking (concave risk preferences) or horribly constrained in inter-temporal substitution.
“But the bank can’t predict which ones, so it carries a portfolio of such accounts under the assumption that some will turn into profitable customers down the line.”
These points made something occur to me – the credit card company’s business model is the exact OPPOSITE of an insurance model. Instead of making a small profit on each consumer, with a giant loss on a handful, netting a profit on average, it takes a small loss on each consumer, with a giant gain on a handful netting a (big) profit.
Or if you are thinking in trader terms, it’s the equivalent of buying a large number of out-of-the-money puts on American consumers. “I’m short the American working-class.” Ghastly.
First, I loved how “complex models that include dozens of variables” was reduced to Tony Soprano punching you in the face. Life is less sophisticated and more simple than we think. If Tony Soprano was working in a bank, he could use the models to calculate the optimal punch and justify it as a fair reaction against the risk of default. Anyway, I like the “gotcha” model from Another Mike, and as he said in other comment, “banks are behaving in a way that is individually rational but socially suboptimal”. Of course consumers are not innocents, since they are not forced to enter in this madness, but it is surreal to think that everyone acts in fact as super homo economicus. Crises show us that rationality is also an economic good for being scarce. With banks falling apart, it should be obvious that new rules are necessary. The biggest risk is to keep business as usual. People should move from the typical Shakespearean intervention-or-not-intervention discussion to the more important what-kind-of-intervention discussion.
Terry
I think Another Mike’s got it down pretty well.
I would only add that all fees and penalties are in fact interest – they result from not remitting the required payment on time. So when you see rates of 25% – 30% remember that the people who will be at those rates will most likely incur fees. Their actual interest rate is probably closer to 40%. And this isn’t the corner payroll loan shark store, but “respectable” banks.
“In general we shouldn’t expect a rational consumer to exercise an option with a negative present value, unless they are … horribly constrained in inter-temporal substitution.”
Bingo! In other words, people believe that although they may have a financial imbalance right now, they expect (or wishfully think) that something good will happen in the future (for example, a raise) that will bail them out.
Paige Skiba and Jeremy Tobacman are working on this issue in the payday loan market [example: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1319751%5D. They come to a similar conclusion (many borrowers exhibit behavior “most consistent with partially naive quasi-hyperbolic discounting.”) The math can go over my head at times, but from what I do understand, it sounds like good stuff.
Mike,
Your argument seems to essentially say, “The option to revolve debt has a positive value for the rights-holder (since they will never excercise non-positive NPV option etc), therefore it should cost more than a mere transactional card since it is an added benefit. However, the two cost the same ($0), so therefore the option having a negative price is the only value that makes sense.
I think this is faulty logic through oversimplification.
Card issuers have three kinds of customers, and only make money on one of them.
1. Customers who carry the card in lieu of cash. Use it for transactional purposes, run up a balance, then at the end of the month pay off their statement balance and incur no fees. The card is basically a free convenience for them. The bank loses money due to the short duration loan it extends that is payed back at zero interest, but makes up a certain amount of it in transactional fees.
2. Revolvers. Customers who take out a card, run up a balance, and then pay a certain amount each month – the bank makes money on the interest rate on the balance, which is borderline usurious (but accurately reflects the cost of unsecured credit). This group is the main driver of card issuer revenue. Unfortunately, the bank loses money when the revolvers turn in to..
3. Deadbeats. Customers who may have been revolvers, or maybe not. They default on their balance and, the credit being unsecured, the bank loses a large portion of the individual portfolio. The issuer will lose money here.
I think my main point is that you can’t price that option has a negative price unless you assume that most people are willing to pay for the transactional card, which I think is incorrect. Goods purveryors do reflect the cost of transactional credit in their prices (ever been charged an extra .25 for credit card purchases under $5?), implicitly or explicitly. Why would I be willing to pay $8 a month when i’m already paying the merchant for the privilege?
Awake, take a look at the Interfluidity post if you haven’t already. The first group of customers, those who pay balances in full and use a card only for transactional benefits, is actually quite profitable for the card issuer. The interchange fees are on the order of 2-3%, while the rewards and value of interest-free short-term loans returned to the consumer are significantly less than that in aggregate.
As for annual fees, $100 is not unreasonable for a certain class of consumer. There are many people that pay up, largely in order to access rewards programs or because of some perceived prestige (e.g. American Express Black Card). For example, suppose a card pays 2% in rebates—the $100 annual fee is recouped after the first $5000 in purchases, so it might make sense for a big spender. And while some merchants increase prices for credit transactions, that is by no means the norm. Since even many rewards cards have no annual fees, it’s debatable how worthwhile the fees actually are, but there does appear to be demand for them.
This is probably an argument that we should be having on SRW’s page, but i think my disagreement was solely around this portion of the post:
“Transaction Card + Option to Revolving 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"
I would be interested in hearing that fleshed out more. Without including the benefit to the issuer of the cardholder swiping their card, that is kind of like saying "writing a call option is always a losing bet because you are infinitely exposed to the upside" without mentioning the part where you charge a premium for taking the risk.
Hey awake. Yes, I am assuming for that example that having a transactional card is a net worth to the consumer, and a net loss to the provider, and that consumers would be willing to pay for them. I would, to avoid traveler’s checks and to be able to buy things over the internet, etc. I’d pay a penny at least! I would not expect to get paid to do this, because I exercise the option to use it, and getting paid to taking out a short-term commercial paper loan is akin to a negative interest rate.
Whether or not I’d pay $100/year or 1 penny a year is kind of incidental, though I imagine people would be willing to pay. It’s the direction of the expectation of the payment stream that I’m interested in.
This was fleshed out by interfluidity. Obvious if you don’t agree on that part then the rest doesn’t make sense to talk about.
“1. Customers who carry the card in lieu of cash. Use it for transactional purposes, run up a balance, then at the end of the month pay off their statement balance and incur no fees. The card is basically a free convenience for them. The bank loses money due to the short duration loan it extends that is payed back at zero interest, but makes up a certain amount of it in transactional fees.”
You are mistaken, they make money off the transaction only customers…
Ask yourself what the APR is for a loan where you receive 2% for a 30 day loan (and that’s a worst case scenario, try 3% for a 10 day loan).
Ask yourself why the banks would work so hard to recruit these people who pay off every month if they aren’t making money off them, the rewards programs are designed to get them to do more transactions, because the transaction fees are profitable.
Now clearly not as profitable as a revolver that they can trick into some kind of default through cutesy moves like changing due dates, and then raise the rates to extreme levels and nail with numerous fees, those are where the business model goes from pedestrian to spectacular. It’s no surprise, there has always been more money to be made by playing dirty than by playing straight, 3% per transaction is good money… 30% and $30 late fees is GREAT money. That’s where $300mil bonuses come from, you don’t make that kind of scratch charging reasonable rates. Great work if you can get it, it’s like being loan shark without the violence or the threat of going to jail… all win from the banks perspective.
I posted over on Interfluidity – someone mentioned that those who pay their balances off every month were “deadbeats”. Maybe they aren’t the most profitable customers – but the banks make very decent money with interchange and having low risk loans (paid every month).
But we live in a world where those who pay our debts are deadbeats and those that run up unsustainable debt get on the dole.
typo: “Checking my mailbox, there are a lot of credit card offers with no yearly fees. In fact, they are incredibly rare.” i’m pretty sure a “not” got dropped somewhere.
@Aaron Davies: No, only an ambiguous pronoun. “They” in the second quoted sentence refers to the fees, not the offers of fee-less cards.
@Mike: You seem to be assuming rational behavior by consumers. I suggest that credit-card companies are pragmatic behavioral economists who offer the option to their customers precisely in the expectation that some of them will irrationally exercise it to their own detriment (and the profit of the CC companies) – and the profitability of the credit card companies is testament to the fact that their model is more accurate than homo economicus.
Maybe your anti-insurance metaphor is better – if you look at awake’s three categories of consumers, it’s clear that the main profit event in the current CC business model is customers moving from transactor to revolver. No customers expect *themselves* to do so, but the companies know that given enough customers, some will, and the resulting business model is profitable. The chance to fall into the revolver group has negative value, which is why it is appended to the transaction card at a negative price.
The fact that the transaction part of the card is paid after the fact rather than before makes it easier to fall into the revolving trap. (And also more likely; you can see your debit card balance instantly at any ATM, but how many credit card companies will give you an instant projected next bill in the middle of the month?) A debit card is safer because you can’t spend more than you have – which is why no-fee debit cards are generally quietly attached to accounts with subpar return to the depositor.
I’ve wondered about the formulation that the “loser” cardholders who are paying exorbitant fees and usurious interest are “subsidizing” the cardholders who use it purely as a transactional card and pay off their balance in full each month for no interest charges and, as Mike points out, in all likelihood no fees either.
And after paying no interest charges or fees these customers accrue rewards and it seems clear: the card companies make money off the backs of the poor unfortunates who cannot pay off their full balance and use it to give little gifts to the people who can.
But this doesn’t seem to jibe well with the check-card industry. For example, my bank gave me a transactional card (check-card), heck they more than gave it to me, you have to go significantly out of your way to get an ATM card that is not a transactional card. The card also comes with a modest rewards program.
On the money-making side for the bank, I pay no fees when I use it and incur no interest charges, as I am drawing down a pre-existing balance. The only way the bank makes money from me is if I overdraft the account but since I could also overdraft the account with a regular check, the benefit to the bank from supplying the card would only be my additional liklihood to overdraft. And, of course, they make money on transactional fees paid by the stores I frequent.
It seems unlikely to me that the additional chance of overdraft is so much higher that the bank finds it profitable to provide transactional cards for free to all of its customers so that it can then ride on the backs of the few who will use it to overdraft. And, even if they did have that policy, it would seem odd for a bank to have as its business model trying to get more and more of its customers to have negative balances. But I’m not a banker, so maybe that is the model. Clearly, the bankers of late have come up with some truly bad ideas.
What seems more likely is that the transactional fees generated by the card more than pay for the card. So then tagging on a small rewards program (especially if you have to sign-up for it separately, as you do with my bank) probably makes the card look even more “valuable” to the customer while not completely wiping out the profits from those transactional fees.
In short (I know, I know: too late), it seems to me that the model of credit card companies subsidizing the payers with the ill-gotten proceeds of the insolvent doesn’t seem plausible given that there is an entire industry (check-cards) that seems to find it profitable to give away transactional cards. Clearly the credit card companies are making money on their “bad” customers, but I think it’s likely they are also making money on their “good” customers (the pay-it-off-every-month crowd) through transactional fees, yes even counting rewards program costs.
It seems to me that if you make it harder for the companies to gouge the “bad” customers, rather than having the company continue to supply cards to “good” and “bad” alike and merely alter the “subsidization” process, you are far more likely to find companies attempting to not give any credit to “bad” customers and instead create books of business of “good” customers and just live on the transactional income. Basically have the industry turn into “check-cards without a bank account”.
Good, informative article. I agree it is being generous to the CC companies to excuse interest rate spikes as carefully-formulated protections of slim profits.
Nevertheless, I still don’t see where CC companies have acted dishonestly or illegally. Every credit card agreement I’ve seen has made clear that interest rates are subject to change and many even mention conditions, such as missed payments, that might trigger such a change. The inclusion of this clause, as well as high fees, are the two reasons why new credit card offers I receive go in the garbage.
To me, the product most CC companies are selling is a revolving, unsecured credit line with 23.9 or 24.9% or 27.9% interest. That’s the product. If you read CC agreements, you will understand that is the product.
The fact that the product is pitched to you with a “teaser” rate of 8.99% or 9.99% doesn’t mean the CC companies are scheming bastards. It just means that if you’re really, really careful about your finances, you might get a helluva bargain on your unsecured loan. It also probably indicates the CC companies are counting on you blowing it and getting stuck with the typical, high-twenties interest rate.
These are some good points, and I don’t see why they are “too late.”
I did some Googling and found a figure: Banks made $25 billion on “overdraft-related fees” in 2006 [http://www.nytimes.com/2008/11/09/magazine/09nix-t.html?_r=1&scp=1&sq=overdraft%20penalties&st=cse&pagewanted=all]. I’m not sure what that means (especially the “related” part–finance charges, perhaps?), nor do I know whether this takes into account losses from customers who just default, but it at least sounds like a pretty big number.
I agree, though, that banks probably aren’t losing money on net from transactors. My guess is that they are eager to hand out debit cards because they believe that customers will use them instead of writing checks, which will lower costs for them, rather than raising their revenue.
Some credit-card customers intend to become revolvers right away. It’s easier to get a credit card than it is to get an unsecured personal loan from a bank. If there’s something expensive you want to buy, and you don’t have the ready cash, getting a credit card is the easiest way to do it. If you have a decent credit rating and actually make your payments on time, the rate is competitive with the rate you’d get from an unsecured personal loan. (The fees and penalties for late payments may not be significantly worse on a credit card, either.)
People get car and house loans all the time, because it’s usually possible to repossess the collateral. How easy is it to get back furniture or appliances? Incidentally, credit cards help sellers of such items get out of the finance and repossession business, and dump the hassle on the banks, which is a gain for the furniture store.
Localcon – “People get car and house loans all the time, because it’s usually possible to repossess the collateral. How easy is it to get back furniture or appliances?”
We modeled zero recovery in the previous entry! Way ahead of ya 🙂
Another Mike – The more I dig down into the fee numbers the sadder I get. It is almost painful at times to realize where the value is getting added; it emphasizes things like poor information and volume of transaction numbers, two of the problems of subprime. I’ve argued elsewhere that (prepayment) fees as income generated a lot of our troubles.
Matt – Welcome! I think at the very least, behavioral nudges to make poorly informed consumers better informed about the decisions they are making would be a good move. I think there becomes a perverse incentive when all your profit is from consumers falling apart to encourage your consumers falling apart. So there is a market mechanism to create an ‘optimal’ amount of consumers, tricks and traps, which our government should push back against.
The fact that the product is pitched to you with a “teaser” rate of 8.99% or 9.99% doesn’t mean the CC companies are scheming bastards.
Yes, it does. Their business model is based on the fact that their customers will think that *is* the product, will not know what they are actually buying until it is too late to change their minds, and will then have no legal recourse because it was in the fine print all along.
The more customers are deceived, the more profit they make. Do you think they don’t know that? Trap contracts are their whole business model. Or to put it more simply, they operate in bad faith every day, as their routine method of doing business.
The whole law of contracts needs to be reformed to eliminate the irrebuttable (!) presumption that all parties understand the contract in the individual vs. corporation context and bring misrepresentation of the contract terms into the area of fraud in the inducement. (Actual negotiation, or proof of actual representation by an attorney, could be a defense; some contracts between individuals and corporations might genuinely be freely negotiated and their terms known to the individual. But the vast majority are not, and it’s past time the law recognized that fact.)
Maybe small businesses too – the number of people who personally guarantee the debts of their small business, stripping themselves of the protections of incorporation and corporate bankruptcy, for no compensation and without even being aware they are doing so is pretty staggering. But, again, it’s right there in paragraph 73, and people starting up small businesses tend to be more optimistic than prudent.
In the meantime, I’ll settle for nibbling around the edges with minor regulation of terms if it’s the best we can politically get.
” 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. ”
I ain’t no financial wiz. All I know is that I have had two children, as babies they flew American Airlines in a car seat to visit grandparents. American knew they were babies, they flew on a child’s fare, they had a car seat. Yet, citi sent them American Airlines credit card offers immediately and has been sending them card offers frequently ever since.
I have a friend who used the name Ted E. Bear for (snail) mail lists. She got a credit offer in Mr. Bear’s name, filled in the form and sent it on a lark. She got a card in the name Ted E. Bear and took her Teddy bear out to dinner. Then woke up in a cold sweat realizing she could spend a lot more time in an orange jump suit than she wanted, paid the bill and tore up the card.
Any system in which the banks offer credit cards to infants on a routine basis and to teddy bears even very rarely, is well beyond understanding with finance 101. I guess its useful to point out that even by banking standards what the banks are doing is NOT banking. But this is a system that is not about rational financial system, this is a system in which consumers have lots of choice in reward but no choice in quality. And the banks, apparently, have no incentive to even glance at credit worthiness. (How can a bank not look? How can they offer credit to a 3 yr old? Where is the due diligence?)
And really will Congress ever do anything to stop this? The only way out it seems to me is for a child to be offered a card, someone steals the card destroying the child’s credit and the guardian sues (for defamation?) on the grounds that the bank didn’t do minimal due diligence. Courts are a tiny bit less likely to be swayed by lobbying dollars. Why hasn’t this happened? I can’t imagine that a child’s credit hasn’t been messed up.