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.
The credit card companies surrendered to their own prurient naked greed.
not to split hairs, but...
Anyway, you might want to read up on "ambiguity."
If you can’t read a simple credit card contract and understand it you are stupid.
Go hire someone to explain it to you.
Yep.
While I firmly agree that people are responsible for themselves and their own debts, these companies are the modern equivalent of the "Company Store" system that kept people in debt bondage.
They encourage debt. They encourage paying forever and never retiring the debt while at the same time changing the rules and rates to make it harder to pay off the debt.
jw
There is no place in Capitalism for the lust of greed. Working for one's self-interest yes, but not lusting after greediness. The Bible warns of these two deadly sins to the individual and society.
For the banks, lusting after their greed, actually harms themselves in the long-term.
For the consumer, lusting after their greed, again actually harms them in the short-term.
Constructive self-interest has been replaced with first jealousy, then lust, and now blatant greed.
You’ve just articulated Rand’s Contradiction.
Detroit has a 25% graduation rate, and what fine graduates those are. Commonly, urban HS have rates around 50%.
( I suspect the rates are even worse, but long story )
These kids would learn more math on the streets, borrowing from leg breakers than the Public Skools.
The kids are victims. Victims of the unions, the administrators and the politicians.
Yeah, “the parents”. The problem is the parents went through the same ‘skools’. So now the system is bullet proof and self sustaining.
The parents you are thinking of, died out generations ago.
The idea the credit card companies have to raise rates from 7% to 30% overnight, just because a person is a day or two late with their payment, is ludicrous.
Take a look at your bills folks. If you’re one hour late paying your bill, you will be charged a “late”, “penalty”, or some other version of a fee, related to your tardy status. Generally that’s a $25 to $35 dollar fee.
The credit card company doesn’t have to hire more staff to have this facilitated. It’s computers do the task for it.
If you’re paying 7% interest and you’re a day or two late, the $35 fee more than makes up for any loss. One could say yes, but that’s just for one account. They loose gazillions if everyone is late. Yes, and they gain gazillions by charging everyone $35 because they are late.
If you pay your card late, you also pay interest on a higher amount that you would have. And so the repayment schedule is pushed on out one month, and the credit card company makes more money as a result. If this happens across the board, another words if say 100,000 accounts go 24 hours, the credit card company stands to make a significant increased profit due to this small individual increase in interest rate paid.
These credit care companies plead that their business model is destroyed if people pay even one hour late. Like hell it is. That’s not true.
The public is getting jobbed by these exhorbitant interest rates folks.
You can make all your payments on time all year, and be paying off less than 20% of the sum total of the money you sent in.
I figured it out recently. It could take you 30 years to pay off a loan making your minimum payment, if the interest rate is 30%. That is flat out abusive, and should be a criminal act.
There’s no call for that under any circumstances.
Fine. Don't like it, cut up the cards. A market-based solution that doesn't need to government to get involved. But people are too damned lazy to take matters into their own hands, so they call on Uncle Sugar.
too bad you’re a lawyer. you seem like good people.
What? A is A?
“Greed is Good.”
Same company just did the same to us. I’ve never been late or missed a payment. Luckily we don’t have a very large balance and good credit so when the next good offer came I jumped on it and transfered the balance at a free transfer, 5.99% until it is completely paid off and a 1.9% for the first year. Go look up what HSBC is offering right now and see if you can do the same. :)
When the credit card companies simply raise the rates to 30% arbitrarily, it is wrong. If you can’t grasp that, don’t talk to me on the issue.
The government already regulates these industries. It’s an abdication of oversight to allow this to continue.
These rates are userous. There’s no other term for it. It’s surpases the level of loan sharking.
I can’t believe you would defend this, and yet your come back is, well cut up your credit card. And then pay out for thirty years under these terms? Are you nuts?
Something needs to be done about this.
Classy. I bet you work for one of the CC companies don't you.
And I agree, so cancel the cards, and tell all of your friends not to do business with the credit card company. That's the way the market works. If the people abdicate their responsibilities as good consumers, you get a Nanny State.
Great post! Thank you!
Nope, you missed it then.
Greed is not good. Greed functions against a persons own best self-interest.
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