The Credit Card Bailout

 |  Includes: AXP, BAC, C, COF, DFS, JPM, KBE, MA, V, XLF
by: Linus Wilson

The recent New York Times column by the distinguished Professor Robert Frank of Cornell University reads like one of those obvious fraudulent e-mails that get caught in your spam filter. “Act now because the federal government is going to wipe out your credit card debt!” If you click the link in the e-mail, you get a computer virus. Instead of computer viruses, Dr. Frank is spreading intellectual viruses that could make our children and grandchildren poorer.

There are some ideas that are controversial and there are some ideas that are just wrong. His Sunday, July 4, 2010, column in The New York Times ventures into the latter category. Princeton Professor Paul Krugman, for example, is famous for jumping on one side of controversial ideas in his columns or blogs. I may disagree with him. Yet, I rarely find things that I think could be shown to be false in a classroom or an academic seminar. (Nevertheless, I don’t read his column or blog that much.)

Professor Frank said the following in his Sunday column in the New York Times, which I only came across when listening to the Weekend Business podcast by Jeff Sommer:

For example, it [the federal government] could create a program to restructure consumer debt. Although rates on 10-year Treasury bonds are only about 3 percent, many consumers still carry tens of thousands of dollars of credit card debt at 20 percent or more. This burden has been a continuing drag on spending. The federal government could reduce it by borrowing at 3 percent and lending to consumers at 8 percent under a one-time debt-restructuring plan.

I’m not one to defend the credit card companies. I just think Dr. Frank’s credit card bailout is justified by fuzzy (incorrect) logic.

This is a standard scenario discussed in finance classes. Consider a firm that has a project that is so risky that it has a required market return of 20 percent. This firm could borrow at a rate 3 percent to fund the project. Should the firm borrow at 3 percent to fund the undertaking if that project will return anywhere between 3.00 percent to 19.99 percent? No, it should not. The reason is that the marginal contribution of the project to the firm’s cost of capital is 20 percent. Thus, accepting the project for 19.99 percent annual returns or less will reduce the overall value of the firm.

What Professor Frank proposes is that the U.S. government moves to replace the private sector in consumer lending and to increase the risk of the public balance sheet. At best this is a transfer of wealth from the government to the recipients of these subsidized government funds. (In fact there will also be distortions away from efficiency in terms of incentives, misallocated investment, and the deadweight loss of taxation.) By transferring risk to the government sector, the federal government will find it increasingly more expensive to borrow money. There is no “free lunch” as Professor Frank proposes in his column and his statements on the podcast.

One very popular textbook by Stephen A. Ross (MIT), Randolph W. Westerfield (USC), and Bradford D. Jordan (Kentucky), Fundamentals of Corporate Finance (Alternate Edition), 9th edition, McGraw Hill-Irwin, page 438, says,

The cost of capital depends primarily on the use of funds, not the source. It is a common error to forget this crucial point and fall into the trap of thinking that the cost of capital depends primarily on how and where the capital is raised.

Similar statements can be found in almost all major managerial or corporate finance textbooks. I hope the public and policy makers listen to someone who has read a finance textbook before they endorse a credit card bailout.

Disclosure: I have no positions in the companies mentioned. I only own broad-based index funds. I think the textbook mentioned is a good one, but I do not get any compensation for mentioning it.