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.
That’s been one of my biggest peeves about this, the idea that decent people could be caught in this snare. I’ll be honest. I can’t believe this isn’t a criminal act.
I’m glad you can get out from under it. I am very sorry for the folks who can’t.
It certainly seems criminal. The terms of the contract are that the terms can change at any time. That doesn’t seem much like a contract to me.
The absurdity of it is this. If they can quadruple the rate on a whim, why shouldn’t you be able to cut the amount owed by three quarters on a whim?
Both sides should be required to follow the rules of common decency. There’s no way in hell 30% interest rates are reasoned or amount to something akin to common decency.
I have nothing to gain by seeing credit companies go under. We need them. They need us. I think they suck people in, get them to borrow money, then push the rates up to 30% to consummate the “cash cow” model.
That is wrong. There’s no question it’s wrong. It is not unreasonable to seek to get that sort of thing eliminated.
Greed has gotten millions of people into trouble with their credit card debt...again...how did their greed benefit their self interest. It didn't and the greed of the CC company didn't create wealth either. They both lose, again.
Greed has not, has not, created wealth. It has created corruption of the capitalist system. Essentially everyone around has no wealth, they may have stuff and pieces of paper claiming wealth...but they have no wealth.
In a few short weeks we may very well see the depths of our debt system of greed. The dollar in your pocket will not buy the loaf of bread to feed your family, it represents the debt and greed of the nation.
Greed works against the capitalist system. Self-interest works within the system to preserve, protect, and create prosperity that leads to wealth. One must ask why a greedy person would do something against their own self-interest? Like purchases they don't need, can't afford, etc. And why a business would support such actions, which work against their own profits? If you can't see the difference, then perhaps it is you who doesn't understand the capitalist system.
So, if you don't like it, don't sign the contract.
call me crazy but it would never occur for this fraudulent occupation of the WH to question the practices of Experien,TransUnion and the other one(can’t remember the name) those are the BIG GUYS , the Credit Card Co’s answer to them , am I not right on this one?
Kinda sorta think this might be appropriate to our discussion: http://usabig.com/autonomist/moneyspeech.html
It's not necessarily that simple. For one thing, if you need a mortgage to buy a house to live in, your credit rating is a huge factor in determining how much interest you pay. If you close all your credit cards, your credit rating goes down, way down. In addition, insurance companies and employers rely on credit ratings.
I am not saying that everyone who works for a credit card company is evil. Some credit card users are also irresponsible. Dave Ramsey said, While I think it would be unfair to think of the people employed in credit card companies as "snakes", I think that consumers would do well to think of credit cards as something that can bite them.
It’s safe to say the credit card companies are out of control, and those who abuse the system from the other end are also out of control.
I will say that some people who get into trouble do so without realize they are doing so. They experience a divorce or some other negative event, and have little choice but to pay off loans in a very slow manner, or simply declare bankruptcy.
If people are trying, I respect that.
I agree that it isn’t as simple as cutting up credit cards either. Like you say, you do need credit accounts open to achieve a credit history.
Did you notice that Biden was absent when Obama signed the credit card bill? Hmmmm... Delaware....credit cards....
Too bad, he might have made one of his precious remarks.
How does ole Dave suggest people establish credit, so they can purchase a car or finance a home later on?
And the way they calculate your score is based on your available credit. So even if you have a good credit score, if they start charging a yearly fee on all your cards, or try to scam you in some way, and you cancel them, guess what?
LOL...
Biden and for that matter Obama too, personify the Dan Quayle, George Bush, et al, dumb people (according to the left) that the Democrats always said they were afraid of.
And they’re happy as pigs in mud right now. Go figure...
Agreed.
I thought Ramsey's "snakes" comment was appropriate in a way, but I am not claiming that everything he says is practical for everyone. For a mortgage, he says, "Since you aren’t “building your credit” you will need to find a mortgage company that does actual underwriting. That means they are professional enough to process the details of your life instead of using only a Beacon score (lending for dummies)." That actually may turn out to be very good advice if the whole credit system goes ape in the future.
For buying a car, I would guess he would say go to your credit union (which may not work, because they pull your credit score too), or pay cash. I believe Ramsey's advice will work for some, but not all folks.
Ramsey has some good ideas. One thing I like is when somebody asks him how he is doing, he replies, "Better than I deserve!"
I didn’t mean to trash him overall. I’m just not sure how practical his advise there was. I try to listen to what people say, because you can learn some things from just about anyone. Still some folks do try your patience, as I’m sure I try others. ;-)
I appreciate the interesting response. Thanks.
I think the irony was quite lost on you.
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