April 24, 2009
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?