Pay Back Time for Credit Card Companies

 |  Includes: AXP, COF, DFS, MA, V
by: Bill Zielinski

The credit card industry has drawn considerable attention in Washington. It’s the kind of attention that the card industry did not want but probably deserves. In an effort to reduce mounting credit losses, the credit card industry has increased interest rates and fees and reduced credit lines. The backlash by consumers has resulted in the House of Representatives passing the “Credit Card Holders’ Bill of Rights”, which will prohibit some of the more dubious practices employed by credit card companies.

The new legislation will prohibit retroactive rate increases and the infamous double cycle billing, require 45 days advance notice of rate increases and require that a borrower be at least 18 years of age.

Prior to passage of the new legislation, lobbyists for the card industry were warning of the adverse impact that new legislation would have.

Congressional action may make credit-card debt less attractive to investors, said the American Bankers Association, the American Securitization Forum, the Financial Services Roundtable, the U.S. Chamber of Commerce and others, in a March 30 letter.

House legislation will “have a negative effect on lenders’ ability to offer reasonably priced credit,” said Kenneth Clayton, senior vice president for card policy at the Washington-based ABA, in a statement.

Card lending is unsecured, meaning the bank doesn’t have any collateral to claim when loans go bad. “The industry is taking massive losses on consumer credit across the board,” Kenneth Lewis, CEO of Bank of America, said on April 8. “Banks in the industry are just trying to protect those assets.”

Weak arguments such as these obviously did little to prevent the new legislation. My advice to the card companies is - make your debt attractive to investors by restricting lending to people who have the ability to pay back their debts. Subprime lending of unsecured money to deadbeat customers regardless of rate will guarantee losses. Responsible lending will allow you to offer “reasonably priced credit”.

Card Companies Victims of Their Own Tactics

The credit card companies have created their own disaster through reckless lending. For years I have observed credit card companies extending ridiculously large credit lines to borrowers with minimal ability to service their debts. It was common to see fixed income retirees or low income wage earners with credit card balances far in excess of their yearly income. Many borrowers, living on the edge, cannot be blamed for accepting the “no questions asked” easy credit and payment terms pushed by the card companies. The lenders are the ones responsible for ensuring sound lending.

The logical question is why would anyone lend money to people who in the end cannot pay you back? The answer is that for decades the scheme worked and resulted in huge profits, as noted in Bloomberg:

Citigroup, Bank of America Corp. and the rest of the top seven U.S. card issuers together raked in more than $27 billion in operating profit from credit cards in 2007, according to Bloomberg data. Now they’re mostly earning customer outrage.

It became routine for borrowers to max out credit card debt and then pay it off through a mortgage refinance (using stated income of course) and then repeat the cycle. This routine produced large profits for the credit card industry until housing went bust. No surprise that suddenly maxed out and over leveraged customers started defaulting en mass on their credit cards. Needless to say, the huge losses were quickly transferred onto the backs of taxpayers via the magic of the TARP program. Logically reckless borrowers walk away from their debts and reckless lenders get reimbursed for losses - does anyone see a problem here?

As delinquencies spiraled out of control, the card companies implemented new harsh policies to cut their losses. The problem that the card companies face is that there is no way for them to accurately forecast who will default and who will pay, since they had previously approved cards without bothering to thoroughly verify the borrower’s financial profile - see Capital One’s Losing Strategy. Not knowing the card holder’s income or asset situation and facing huge losses, the credit card industry had no choice but to raise rates and fees for everyone.

The problem with this new “strategy” is that the borrowers willing to pay 18 to 25% interest rates are probably those most likely to default. No one who has sufficient income and spends prudently would be willing to owe card balances at ridiculously high interest rates. Given these circumstances, the customers owing balances on their cards tend to be the highest risk borrowers, which necessitates higher rates to offset higher losses. Maybe the credit card guys should rethink their basic lending strategy?

Disclosure: No positions in companies mentioned