Washington Should Let Credit Card Issuers Do Their Job

Ok, Washington crowd, here is a quick lesson on how credit card rates should work. Looking at rates and knowing the Fed Target Rate is not merely an oversimplification, it ignores the reality of the business. Sure there are villains to be exposed, incarcerated or fined. Unfortunately, our elected officials are once again leaning towards throwing the baby out with the bath water.

Step one is factoring the cost of money which is quite low right now. Step two is calculating a fair profit (yes, I will come back to this topic). Step three is the administration of lending. This includes the time value of money paid to merchants until the credit card company collects. Step four is client acquisition costs such as advertising, mailings etc and maintenance such as statements and customer service. You get the picture.

Best practices for everything above have been published by Visa (NYSE: V) and MasterCard (NYSE: MA), plus American Express (NYSE: AXP) and Discover (NYSE: DFS).

The next and most important factor is risk. In fact risk and a fair profit are the only two real variables which happen to be intertwined. Selling and G&A expenses are pretty well defined.

Risk is something that those of us on any side of Wall Street work with daily. The basic premise is that the more risk a firm takes on, the higher the potential reward. One risk is late payment. This is handled by the assumption that money is either being borrowed, or that the credit card holder is having trouble meeting the obligation. In the old days, American Express only issued charge cards, meaning there was no credit. The card holder was expected to pay in full upon receipt. There was gold in those hills of issuing credit, and AXP joined the banks in providing credit to its customers.

Let’s get back to risk. Investors provide financial institutions money to put to work/ invest for them. If we are talking about JP Morgan (NYSE: JPM) or Citibank (NYSE: C), there are many ways of putting money to work. Specifically with credit card issuance, risk measurement is a key factor in calculating the appropriate interest rate charged and should have no correlation to Fed Fund Rate or LIBOR.

Now banks are not in the business of communicating risk in their presentations to customers. The reality of the situation is that banks do communicate risk to their customers really well. They speak loudly and clearly through the interest rate offered each customer, individuals, small businesses or other entities. Banks make an assessment of every potential customer classifying each person into one of many buckets. Each bucket is parsed by income, total liabilities and payment history. From there a risk level is assigned and an interest rate is ultimately presented.

No one is making people sign up, use the cards or not pay their bills on time. Firms that charge erroneous and egregious fees should be prosecuted. The card issuers doing their job, making a living and returning money to shareholders should not be vilified or prohibited from providing an essential global service. I am hoping this does not further restrain consumer spending.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is currently long MA, DFS and JPM.

Comments

[nprfreak:]

Hmmm. Seems to me Chase (JPM) is adding risk by assuming their better customers can take whatever arbitrary abuse they can dish out.

Nov 05 08:20 AM

[Tom S.:]

Andrew, I agree wholeheartedly. The lender should have every right to charge whatever interest rate (within reason) they wish. The rate should take into account their risk of not recovering the loaned funds and a fair rate of return. It's up to the borrower to decide whether or not to take the offer (interest rate and payment terms), and then it's the borrower's responsibility, not the lender's, to repay the loan within the terms of the agreement. Government getting involved in this process will, as we've seen with everything else, only serve to reduce the effectiveness of the process. It's worked well until now. Let's let businesses conduct business and keep the government out of it.

Nov 05 08:45 AM

[john s. gordon:]

'let credit card corporations do their job' means let them charge everybody 29%.
> jack

Nov 05 08:57 AM

[lennywon:]

The author's argument is a stark, oversimplification of credit logic as if the transactions had been contemplated by both parties in an astute fashion. Anyone who has been on a college campus knows full well that banks prey on unsuspecting students to sign up for credit cards with free offers of a tee shirt or other trinket. This is a well documented event and occurs all over this country.
Now the thing is, there is no credit check, no review of asset holdings and not even a required cosign from the parents. So what level of professional banker do we have here? Whoops, we goofed so lets charge more for the good clients, who pay their bills? You cannot defend a toad by calling it a prince.

Nov 05 09:03 AM

[SeanMcC:]

This is the problem with America today: there is no sense of parental responsibility anymore. I'm 26; when I was an impressionable 18 year old freshman, I certainly knew what a credit card was and how much money it could cost me if I left a balance on one. I knew this because of a simple conversation with my parents.

The US Government should not try to take over the role of parent in every little instance, because that is how power consolidates for a few, at the expense of the many. People should be able to think for themselves, we're supposed to be evolving here!

If you get accepted to an institution of higher learning, you should be able to understand what an interest rate is.

The card issuers have rightly all raced to increase their rates before the deadline. This increase in borrowing costs for the consumer is the economic cost of the government regulating inefficiently instead of parents teaching life lessons.


On Nov 05 09:03 AM lennywon wrote:

> The author's argument is a stark, oversimplification of credit logic
> as if the transactions had been contemplated by both parties in an
> astute fashion. Anyone who has been on a college campus knows full
> well that banks prey on unsuspecting students to sign up for credit
> cards with free offers of a tee shirt or other trinket. This is a
> well documented event and occurs all over this country.
> Now the thing is, there is no credit check, no review of asset holdings
> and not even a required cosign from the parents. So what level of
> professional banker do we have here? Whoops, we goofed so lets charge
> more for the good clients, who pay their bills? You cannot defend
> a toad by calling it a prince.

Nov 05 02:27 PM