Government's New Credit Approach: Does the End Justify the Means?

With much fanfare this week, Congress and the Administration began a series of actions designed to protect over-leveraged consumers from the high fees imposed by credit card lenders. As with most other initiatives devised by government, this policy will create a host of unintended consequences that will undermine the benefit the program hopes to create.

Anyone who carries a credit card knows that billing practices have become much more aggressive, punitive, and seemingly arbitrary over recent years. Sadly, these fees have become one of the only means the companies can use to compensate for the increasing defaults on their unsecured loans.

By mandating that the credit card companies lower their fees, the government will severely hinder their tenuous profitability. In order to avoid bankruptcy, the companies will have to deny credit to marginal borrowers, which would reverse the "easy access" policies that have defined the industry over the last generation. The resulting contraction in consumer credit will run contrary to current Administration efforts to keep Americans spending. The horns of this dilemma are completely missed in Washington.

In better times, when companies could make money from interest charged on a high-performing loan book, companies could perhaps compete on better customer service and transparency. Unfortunately, desperate times have called for desperate measures. And rather than seek to break their reliance on credit through harsh reductions in spending, many Americans have waded into the snake pit despite the costs.

Among other things, Congress objects to credit card issuers raising interest rates and cutting back on lines of credit for those borrowers deemed at heightened risk of default. One practice, called "universal default", in which card issuers take into account a cardholder's total liabilities, not just what is owed on a single card, has drawn particular Congressional fire. In this system, delinquency on one account will often affect rates charged on all accounts, even those where the borrower is still current.

Also under scrutiny is the very concept of lenders raising rates on existing balances to reflect heightened risks, despite the fact that their ability to do so is spelled out in advance. The concept is similar to adjustable rate mortgages, where borrowers initially get lower rates but face the possibility of higher rates should circumstances change. Without the ability to raise rates, lenders will have no choice but to charge much higher rates from the start.

The bottom line is that credit card lending is a very risky business. The debts are unsecured and the probability of default is high, meaning big losses should borrowers choose not to pay. In addition, should a borrower file for bankruptcy, credit card debt is often the first to be discharged. Given the risks, interest rates need to be very high to keep lenders in business.

One way to keep a lid on rates for those who do pay is for lenders to weed out those most likely to default. This can be accomplished through higher rates. Not only does this discourage riskier borrowers from taking on more debt, but it gives lenders a bigger cushion to absorb losses. However, by interfering with card issuers' attempts to better price risk and limit losses, the government will reduce credit availability.

The securitization process, infamously associated with mortgage debt, has also been utilized extensively with credit card debt and has greatly spurred the growth of consumer credit. As a result of securitization, lenders were able to immediately offload their loans to Wall Street, which repackaged and sold them to investors around the world. In this way, credit card issuers became more concerned with loan volume and less concerned with loan risk. However, now that huge losses in credit card-backed bonds have reduced investor demand (despite recent multi-billion dollar Fed purchases), card issuers need to hold loans on their own books. Greater prudence is resulting.

Ironically, this is the one potential silver lining to this cloud. By making credit card lending even riskier, this bill will actually make it harder for consumers to get credit. Since excess consumer credit is part of the problem, restricting that credit is part of the solution. However, while I approve of the ends, it is certainly not justified by the means.

It would be preferable to simply allow markets to function. Higher losses among credit card lenders and higher rates for credit card users would greatly diminish both the availability and desirability of consumer credit. Fear of losses and the absence of a secondary market to unload risk would force lenders to more judiciously extend credit. Simultaneously, higher rates would reduce the appeal of credit card debt, causing fewer Americans to partake.

These mechanisms would begin the painful process of weaning the nation from its addiction to credit. Ironically, this is what President Obama has said is necessary.

Of course, there is also a good chance that this silver lining will prove a mirage. When the banks attempt to restrict credit as a result of their business concerns, the government will most likely funnel more taxpayer "bailout" money to banks to entice them to keep lending. In typical government fashion, rather than letting market forces work, our government will force bad decisions on companies and then subsidize resulting losses. Isn't this starting to sound familiar?

Comments

[capitalisth...:]

There are no bad risks just premiums that are too low. Basically, that means you can make money lending to anyone (in the aggregate) as long as you can charge a high enough interest rate. If you take away the CC companies' ability to charge high interests rates then you take away their ability to loan to poor people. When I hear, about the credit bill of rights I wonder how much it's going to cost me. Not giving poor people credit cards is unacceptable to the bleeding hearts therefore it will be me, the taxpayer, who is going to have to subsidize the CC companies to compel them loan to the non creditworthy. Just put it on the tab, I guess.

Apr 26 04:56 AM

[nobby73:]

The credit card market in the US is an accident that has been waiting to happen for many years now. It doesn't matter what the rates are, there are too many people who've been using their cards to meet the income shortfall for years, who are now maxed out. The banks know they can't ever hope to repay the principal and they know that when the default comes, the courts will most likely wipe the debts. Therefore, they are trying to extract that last of the juice out of their clients before this happens.

Yes, these rates are clearly usurous, but the lending practices of the banks has been negligent in the extreme for years.

Now, by identifying the bad credits, they can weed them out and transfer these assets to the Treasury.

There is no solution - when you have been living beyond your means for many years, a day of reckoning will eventually come and it won't simply be the debtors who suffer.

Apr 26 05:48 AM

[Alonzo66228:]

The concept that credit card companies need higher fees and rates to weed out people that may default in the future is a bogus argument. Card companies indiscriminately send out bulk mailings for credit cards without regard to the recipient, and they come in the mail as pre-approvals. They tease with low rates and thenjack up the rates and fees after the initial period and in somw cases that period is shortened dramatically from a year to a few months.
Thsi problem began when usury rates were eliminated with the complicity of our Congress, whose members received huge political donations for their troubles.

Apr 26 08:35 AM

[fireball:]

the statists (corporate fascists) never waste a good crises when there is more control to gain.
if you step back and look it is the wealthy parent paying the debt of the spoiled, foolish, extravagent child. in return the 25 year old must submit like a 2 year old. the difference is the govt. benefactor has not got the citizen baby's best interest at heart. the proper course would be to let the kid suffer and learn.

Apr 26 09:20 AM

[DONE_SONZ:]

Sounds like a ploy to get people to use their credit more,even if they should or shouldnt.The credit card companies will have to focus on quanity over quality.Print and borrow continues.

Apr 26 09:32 AM

[ferguson:]

Peter Schiff's argument only makes sense if one ignores the predatory practices of credit card companies in the pursuit of profit at the expense of responsible lending and borrowing. The rapacious onslaught of commercial forces on the pocketbooks of ordinary Americans has precipitated a catastrophe which, in retrospect, can be seen to have been both inevitable and necessary. The out-of-control consumption machine has been derailed. Perhaps we need to consider a return to living within our means and in harmony with the natural world which we call home. In case anyone doubts the compelling seriousness of the issue, they chould consult the third edition of "Earth From Above," by Yann Arthus Bertrand.

Apr 26 09:57 AM

[thinker70:]

Anybody who believes the pronouncements of bankers and politicians deserves what they get! They do not serve the common people, they serve themselves and their cronies in high places.

People like Peter Schiff and Congressman Ron Paul are realists who are not afraid to tell it like it is and let the chips fall where they may.

The simple truth is that our whole financial system is broken and is not being fixed because this Ponzi scheme is simply too lucrative for the 5% at the top of the pyramid and they will keep milking it for as long as they can get away with fleecing the masses.

Someday in the not too distant future the masses will begin to realize that the fractional reserve banking system using fiat currencies is a TOTAL FAILURE that has destroyed the savings and future security of the average working family.

Apr 26 10:30 AM

[Gregman2:]

very few have asked of the deeper, underlying implication of credit card debt to begin with: why has routine borrowing become a basic necessity for so many? Is it because outsourcing, in part, has been causing a decline in real wages here for the past 25 years? Isn't the rise of credit card debt proportional to the decline in real domsetic production of goods and services? This phenomenon points to the need for an industrial policy here at home.

Apr 26 01:09 PM

[henarl:]

It would appear that destruction of an overreaching credit card industry is inevitable. Either the government will destroy the industry thru limiting their interest and fee income or the industry will destroy itself by charging amounts nobody can afford and creating an avalanche of defaults.
In either event, a retrenchment of credit cards is probably a good thing as society can no longer continue to live beyond it's means much longer.

Apr 26 02:15 PM

[Rumpole:]

Since the secondary market has dried up and credit card companies have to keep the loans on their books, could someone please tell me why they can't secure them against a card holder's real estate or personal property using personal property security legislation? Granted, it's not a perfect solution, but the companies could at least do that much. but your larger point is correct, too much credit was issued on very loose terms and it's been abused by many of the people to whom it's been issued. Pain will ensue, it's inevitable.

Apr 26 03:03 PM

[ron_paulite:]

peter, u hit the nail on the head again.

run for the senate, peter.
and then for president in 2016.
obama is too popular.

Apr 26 03:53 PM

[nobby73:]

The basic trick of the credit card is it plays on individual optimism. People have believed that things would get better (politicians and advertisers would say nothing else), so they assume this will feed down to them, they can buy things today and pay for them in the future when they hope to be richer.

Add to that consumption has been the way to participate in the American dream - the equation is you buy something to make yourself happier but you pay for it on a credit card, which defers the cost.

As to why using credit has become a necessity, I believe this only became a necessity because of the financial commitments and that the snowball effect of how much income is now committed to covering the interest on the outstanding balance. I know the UK market better, and there on average 5% of your post tax income covers the interest on the balance. As this is on average, it means that for those on a lower income this is a much higher percentage, which is a frightening indicator of the snowball effect.

On Apr 26 01:09 PM Gregman2 wrote:

> very few have asked of the deeper, underlying implication of credit
> card debt to begin with: why has routine borrowing become a basic
> necessity for so many? Is it because outsourcing, in part, has been
> causing a decline in real wages here for the past 25 years? Isn't
> the rise of credit card debt proportional to the decline in real
> domsetic production of goods and services? This phenomenon points
> to the need for an industrial policy here at home.

Apr 27 06:54 AM

[Boubou:]

If they manage to bully the banks into extending easy and unwise credit on cards, as they did for mortgage lenders, the banks will run into further trouble.
When they do they will need bailing out again, and they will feel justified in that the unwise actions were spurred by government pressure.
As were the hasty acquisitions under government pressure in late 2008.
And round it goes. Not a lot of wisdom these days.

Apr 27 09:17 AM

[aldousd:]

> "Unregulated free markets got us into
> this mess, and unregulated free markets will get us out."
>

It is delightfully ironic that the only thing that appears to have 'worked' recently apart from commercial paper buys is regulatory forbearance. It's a pity however that it's being applied to such gigantic straw men in the name of capitalism. No doubt this will again turn into a scarlet letter, and capitalism in general will be blamed for the behavior of it's worst actors. ("Never mind the billions of people worldwide over recent history who have been elevated out of poverty, these AIG bastards shouldn't get bonuses when I still have to pump my own gasoline!")

Apr 27 12:17 PM

[LKofScotland:]

So the "cat's out of the bag" and governments want to regulate lower interest rates, eh? And this is news, right? And Cetin's a weenie for complaining about surging equity values. Interesting. More fuel for my roadster, Charles. It looks like another spin in the countryside.

Apr 29 11:00 AM

[Hot Richard:]

Peter rightly draws attention to the credit card issue because, IMO, the state is continuing to pump "credit" when in reality they want you in "debt". The state also believes, like they did with mortgages, they can legislate credit terms in defiance of reality. Everyone with a mortgage and $20K credit cards at 5% and no penalties!

There's a reason a carpenter can get 5x for his time after a hurricane. And it is a good reason.

Yellowhard and some other brothers appear to be giving in to reality. We need to give the people what they are asking for so this puppy can crash hard. Expand the state to explode the state. I know I'm voting for every government increase I can find.

Remember, Hot Richard is just advocating giving you the regulations, wealth distribution/obliterat... high taxation, and anti-capitalism you are asking for. The results are on you, USSA.

@ Scotland: Who the hell is Cetin?

Apr 29 01:19 PM

[Ice:]

We don't need consumption from people who can't afford it - we need healthy consumption from people who can pay their bills. Forcing lower interest on CC will force credit card lenders to be more prudent on who they give credit.
Don't forget that every default on CC is paid by us - the clients who do pay their bills.
So for me the get cheaper credit it is important that credit is given to people who can carried it - not to someone who is juggling more CC-debt than their annual income is high.

The free market has made a mess from the cc system - it is the most expensive payment system around (compared to other alternatives). Effectively it is a sales-tax on every item I buy of 5%. The difference with Europe is that here I pay the sales tax to a bank while in Europe it goes to a government.

Apr 29 11:53 PM

[altaman:]

Time and again we get ourselves into trouble by thinking that having the government play the role of parent (in paris parenti) will protect us from ourselves. Sadly there is no way to keep a fool and his money from separation and the cost to society of fighting this law of nature can be high to the society as a whole particularly when the government watch dogs usually either napping or corrupt and the con men exploit these policies to avoid risk (think Fannie and Freddie, the pension quarantee, FDIC insurance and the credit union collapse).

Apr 30 07:16 PM

[palosverdes...:]

Good point. This is yet another example of "Washington gone Wild"...changing the rules when its convenient. The double standards seem to pad the pockets of the wealthy while draining the pockets of the middle class. Also so much for transparency with "Mark to Fantasy" and spotty Stress Test Results. I'm not sure if this is what Obama is trying to accomplish but I could be wrong.


On Apr 25 05:27 PM Alan Young wrote:

> When taxpayers want to protect their (reluctant) investment in the
> banking system by canceling executive bonuses, we are told that "contracts
> are sacrosanct." But when banks want to protect their profits by
> rewriting the terms of their loans to consumers, we are told it's
> the free market's way of instilling greater prudence.
>
> Aside from the disgusting hypocrisy, this sounds like an unwitting
> paraphrase of Will Rogers: "Unregulated free markets got us into
> this mess, and unregulated free markets will get us out."
>
> Granted, consumers need to borrow with more prudence. But the pivotal
> question remains: how do we instill greater prudence in bank executives'
> behavior?

May 03 02:56 AM

[Mr. Ed, Jr.:]

Cetin, I think I have identified a trend.....

You now have 9175 thumbs down from SA readers....just a couple days ago, it was a mere 8500.

This is actually getting sort of interesting....does the SA thumbs down counter go to 5 figures ? 6 figures ? Will it roll over back to 0 at some point (That would put your thumbs down at 0 and make you SA's top commenter....now, that would be fun)

If the SA thumbs down counter does not roll over, does it just stop ? Could it explode ?

The excitement builds......


On Apr 25 09:27 PM Cetin Hakimoglu wrote:

> Why are all your posts always so negative?

May 03 01:46 PM