Posted on 05/28/2009 9:10:17 AM PDT by library user
Credit-card companies are getting a lot of grief in the blogosphere (not to mention Congress) lately. Most of these critiques are just a bunch of shaggy dog stories, but the very smart Rortybomb has an extremely numerate post in which he points out that when the interest rate on your plastic goes from 8% to 28% because you’re two days late on a payment, it’s highly unlikely that this is a pure reflection of a change in your probability of default. His analysis indicates that the way this price (i.e., interest rate) change is determined is not by the change in creditworthiness that is indicated by the new piece of information, but instead by the price sensitivity that is indicated by this new piece of information:
One model is that the credit card companies are lying to you – they think of you less as an individual to have a dynamic risk factor dynamically assigned to you, and instead as part of a portfolio to have a specific rate of return extracted from. So they have statisticians and psychologists not to create a credit risk, but instead to figure out who is likely to pay what when, and use that to keep their returns very high. Quants to study how much they can squeeze from someone – not too much, but not too little. So it is less about the awesome part of markets, the price information and the convergence and feedback, and something more feudal.
His conclusion is that credit-card companies are, morally speaking, “scumbags.”
In my experience, and very broadly speaking, he is correct about the logic by which price changes (including interest rates, fees, and other contract terms) are determined. The credit-card company is making decisions with the intent of maximizing their shareholder value, consistent with the law. In other words, this is a normal consumer market in which the guy selling you something is not looking out for you, but is trying to make money for himself. This is just like a car company, search engine provider or private university. Why is the guy who sells you a credit contract responsible if you are later unhappy about the decisions that you made?
In the specific example that Rortybomb cites, a reasonably prudent person should be aware that he or she has just signed a contract that gives the counterparty the right to increase the interest rate on a debt contract from 8% to 28%, or to the so-called penalty rate, if you miss a payment. If you have a credit card, go to your cardholder agreement and search for “penalty rate.” In any normal such agreement, you will almost certainly find a specification of the penalty rate, and the conditions under which this rate may be invoked. Expecting that your counterparty will not act to serve their own interests under a contract is the attitude of a child. If you didn’t want this deal, you shouldn’t have signed the contract.
Now, fraud is generally forbidden in these markets, and is for credit cards as well. There can get to be a gray area — what amount and type of disclosure is required and so on. Second, there is normally some kind of (speaking non-technically, and without a specific legal meaning to the term) implied warranty. Even if my purchase agreement with GM doesn’t say “this car will not explode in a ball of flame if you tap the accelerator twice and then hit the brakes,” they are subject to legal action if this occurs.
What we are really debating is where to draw the line on these two questions. That is, to what degree does the issuer have to emphasize risks, what degree of complexity should be allowed in the contract and so forth?
The Center for American Progress is typical of current sophisticated liberal thought in emphasizing this:
Credit cards are convenient, but difficult to use responsibly. Credit cardholder agreements are written in language that is above the level at which about 50 percent of U.S. adults read, and information within them is poorly organized. Moreover, issuers appear to “price” the cost of using credit cards by taking advantage of cardholders’ behavior biases. For example, credit card issuers take advantage of the fact that cardholders underestimate the probability of paying late or going over the credit limit, and punish this behavior with fees and increases in the penalty rate.
The right information at the right moment can help cardholders make better decisions. A text-messaging system by itself would not prevent issuers from continuing to price credit cards however they like, but it would orient cardholders toward the best outcomes, such as paying on time and not going over their credit limit. This approach recognizes that most individuals don’t behave like homo economicus—the “economic man” of economic textbooks who maximizes every financial decision and has perfect information to do so. Most cardholders could benefit from a “nudge” toward a more beneficial choice.
But why is it the credit-card company’s job to “nudge” you to “more beneficial choices”?
It is an unfortunate reality that there are many people who are not equipped to get along in a capitalist system. They lack some combination of (rarely) the basic intelligence and (much more frequently) the emotional maturity and self-discipline required to make their way in a world in which others are not looking out for them. Much of the rationale for traditional notions of child-raising, education, and social organization is to prepare people to live in such a world. That is, to produce actual adults. To the extent that we can count on people to act responsibly, we can have a less regulated economy that will tend to produce greater freedom and growth. But the problem of how to deal with the semi-incompetent is a real problem that will never go away entirely.
One practical effect of proposed credit-card legislation would be to make it illegal for party A to voluntarily engage in a credit contract with party B that has some specific elements that might be abused by an irresponsible person. Why should this freedom of contract be restricted for responsible people? Because the guy who lives down the street might use the same contract to drive himself into personal bankruptcy with Cheetos, beer, and big-screen TVs?
Maybe, actually. If (i) the abuse problem were severe enough, (ii) the productive uses of such credit extremely rare, and (iii) there were no other practical remedies, this could be a theoretically poor, but practically-workable, compromise. But I don’t think any of these assumptions holds. First, the vast majority of people who use credit cards don’t default, and second, they continue to voluntarily use this source of credit.
Further and most importantly, I think there is a different and better approach. I don’t think our basic strategy should be to forbid contracts that are only suitable for actual grown-ups, but instead to provide safe havens for the less competent. This could, in theory, include things like requirements for a “simple card” alternative and so on. I’ve tried to describe such an overall approach to financial regulation as “walls, not brakes.” It would not eliminate the problem of some sympathetic people getting over their heads in credit-card debt, but should reduce it, while not giving up on the dynamism enabled by freedom of contract.
LOL.
This is extremely well put.
The problem with this article is that the credit card companies raise rates not just for penalties, but also unilaterally. That is, for the “economic conditions.” Thus many are punished even if they did not violate the terms of the original contract. The credit card companies simply amend them at will.
They aren’t inherently evil, but bad things can happen when you rely on them too much. And the credit card companies are shooting themselves in the foot right now. They are going to have a great many more defaults as a result of the interest surges, and good luck to them collecting all of that.
Credit Card companies are thieving scum which thrive on fraud and collusion.
And there you have it. In one nice and tidy paragraph we see the reason liberals exist.
I kind of agree that there is financial mental violence going on, where very very bright people construct these cards and other schemes like socialism, and then dupe, sell them to those that by and large don’t fully understand what they are getting into.
In a phrase, they are having retards sign contracts and holding them to it.
I got a friend, perfect credit. Even better uses cards and pays them off and makes them money.
Anyways, he had a balance on one of 12K. Next statement rate goes to 30%. He pays off the balance immediately, and they call asking why. He tells them, they apologize, offer to return to the old rate( 14% ). He says no thanks, don’t like the way you do business, keep the card.
He knows that they were fishing, thinking he didn’t have the balance. Then when they knew they were losing the vig, they circled back to make up.
I hear what you are saying and agree with your sentiment, but technically credit card companies do not violate the terms of the original contract as the signed contract states they reserve the right to change interest rates at whim, or ay least with some minimal amount of notice.
Good article but in a world of bailouts the government has a obligation to reduce risk to taxpayers which means limiting credit. 25 years ago there was no easy credit. My grandmother owned a house and had savings but could only get a store credit card because she didnt have a job.
Saturday on FNC someone from FNBusiness was on and was asked if those like me that “pay their entire balance every month” will be hit with new fees to pay for those that carry balances. She said exactly what I said, “those that pay off balances have all the power. We dont need them, they need us.” Those that carry balances are at the CC’s companies mercy, they need the CC credit.
I know what you mean, it’s just unfortunate that boilerplate like that is enforceable. Capital One just raised my rate to a near-usurious amount and when I called to complain they admitted I was never late or anything, and always paid early, but that they raised them due to economic conditions.
I have been making every effort to pay them down but it’s been tough—dating back to when I was underemployed and my wife lost her job. Now she’s going to massage therapy school and once she gets done there I think we’ll be okay. Until then, I just have to stay afloat.
I am mad at the credit card companies, but I am also mad at myself for finding myself so deep in debt. But that’s life I guess.
the credit biz is in a state of mass confusion. B of A just raised my rates and Wells Fargo just lowered them and doubled my credit line
Worshipping the great FICO ping.
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Keep your chin up. Most of us who are honest have been there. Why do you think there is such a vengence of dislike for credit card companies. Just remember who stuck it to you in hard times (and for no reason) and totally wash your hands of them when the financial sun comes out shining again.
“Credit cardholder agreements are written in language that is above the level at which about 50 percent of U.S. adults read”
People that stupid should obtain help exp[laining the terms before sifning the agreement.
Anyone that signs a contract that they haven’t read or understand deserves to be taken for everything that they have!!!!!!
Thanks, I will. :)
Excellent way to put this problem! The biggest obstacle to reversing this trend is finding people who will do the same thing in the opposite direction. Talk radio is old technology, and until we get more people like Beck to put a face to the argument, we're going to continue to spiral into the maelstrom.
Great tagline.
Most people don't have a personal attorney to interpret the gobbledygook for them. They couldn't, by your maxim, sign on for a library card.
You are correct. That is the typical statement on the contract, but, and I add this at fear of the torch throwers, there is supposed to be a certain amount of reasonable trust between parties if any capitalist system is to function properly.
Can they raise rates on a whim, sure. Is it in their own financial best interest, not always. Especially if it is being done willy-nilly on good customers, then they have broken the contract of basic trust between the two parties. At which point they begin to lose customers or should begin to lose customers.
As long as there is no viable virtue of trust between the card holder and the issuer, we will need regulation. Good customers don't and shouldn't expect to be punished. And there was even a time that being late once or twice wasn't considered a major event, but waived as part of normal human behavior.
Much has changed since I worked at the banks. Before I left they started taking away the Branch Manager's ability to review the nightly overdraft reports. The manager used to be able to waive those O/D fees, make calls to the customer to let them know or get authorization to transfer funds for them. They took that ability away before I left. The banks often worked on the individual level to help consumers learn to stay in check. Now they are in it to just collect the fee.
There are a lot of reasons people hate credit card companies, banks, mortgage people...they've gone from being part of the community to a necessary evil in the community. And they did it all pretty much of their own free choice. A choice to stop serving the customer. It will cost them dearly as time goes on.
To hell with stupid people!
I’ve never seen a contract that any reasonably inteligent person couldn’t understand if they took the time to read it.
As for credit card contracts, they are really very simple even if they are very long in verbage.
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