Credit cards: An exchange

By Felix Salmon
May 24, 2009

I got a very smart email from Zoltan, one of my readers, yesterday, on the subject of credit cards:

In the recent past, I worked as a management consultant for some major credit card issuers. I can tell you that internally, these companies have a common term for customers who pay off their entire balance every month: “freeloaders”.

These “freeloaders” aren’t necessarily unprofitable; some are, most aren’t, on average the group is mildly profitable, but not nearly as profitable as those who carry a balance. If you’re wondering how a “freeloading” customer can be unprofitable, there are several factors. For one, about 0.8% of the 2%-3% interchange fee goes to rewards, but a diligent customer can push that to 1.5% or more by optimizing the collection and redemption of rewards points. Beyond that, the credit card issuer finances everything the “freeloader” buys on the card for 15 to 45 days. Finally, there are the various expenses a customer costs: printing and mailing cards and statements, call center service, various card benefits, etc.

The result is that roughly 20% of a credit card issuer’s customers are unprofitable (this can vary tremendously, depending on the company and calculation – for instance, allocation of fixed costs). This isn’t particularly remarkable, I suspect the number might be similar for Safeway or Best Buy. But this legislation is going to increase that percentage, by either increasing the number of unprofitable customers (the numerator) or decreasing the total number of customers (the denominator).

The legislation changes credit card economics fundamentally, making it less profitable. The issuers will try to restore some of the lost revenue by playing with their pricing, rewards, and servicing. A pricing structure built on a revenue model of 30% fees, 40% interest, and 30% interchange, will have to change when the revenue model is shifted overnight to 25% fees, 35% interest, and 40% interchange (these numbers are just theoretical examples).

One company may just raise the basic interest rate. Others might raise annual fees or reduce rewards. Many will do a combination of things. But the point is that some companies will make changes that will definitely disadvantage customers who don’t carry a balance (i.e., “freeloaders”), while other changes will be neutral. Eventually the issuers will settle at a competitive equilibrium or develop their respective niches. However, as someone who knows how these decisions are made, I can’t think of any fruitful changes they could make that would improve things for “freeloaders”. So on average “freeloaders” will lose out. Will they lose out as badly as the industry implies? No way, but they will still lose out.

I responded:

I guess where I don’t follow you is where you talk about when “the issuers will try to restore some of the lost revenue” — aren’t they trying to maximize their revenue already? Aren’t they basically trying to maximize the profitability of the freeloaders in the face of known competition?

The analogy I have in mind is health care reform, where people ask how the health insurers will be able to make as much money as they do today — the answer is that they won’t. And the same with credit cards — why can’t they simply become less profitable, like, I dunno, video rental stores?

It strikes me that if freeloaders, as a group, are profitable right now, then at least some credit card companies will be content to continue to make money off them as they do right now. And if other credit card companies start raising fees etc, those customers will just defect to those companies which don’t, no?

And I got this back from Zoltan:

Yeah, that “restore lost revenue” part wasn’t as clear as it could have been. What I meant is that the current pricing and service structure has been optimized (or ostensibly optimized) for a certain type and level of revenue. Once that revenue changes, they will reconfigure things to maximize profitability under the new conditions. The profit-maximizing pricing structure of January 2009 won’t be the same in July 2009. I can’t conceive of any way that the new profit-maximizing pricing structure will have lower prices for anything. I can’t say it’s impossible, but I don’t see it.

I think health care is a great example. Of course, insurers will make less money if there is health reform. But they will also change the structure of their plans (beyond merely what’s required by legislation) to adjust to the new reality. Certain types of policies or benefits will become less profitable, even unprofitable, and be phased out. Others will be more profitable and be pushed. Many (mostly well off) people will be worse off than they are now, in that they’ll have to pay more (through premiums or taxes), or have less benefits. The idea that some have that the entire cost can be borne by the insurers is a fantasy. Even if it weren’t, the idea that everyone will be better of, as opposed to, say, 80% being better off and 20% being worse off, is also wrong. (I’m Canadian, so I don’t really have skin in the U.S. health care game, although I think the U.S. status quo maximizes our sizable free rider benefits).

There are tradeoffs for everything. If hotels were banned from charging $8 for a minibar beer and $2/minute for phone calls and $25 for breakfast, the hotel chains would have to reevaluate their pricing structure. The result would probably be higher room rates and some closed hotels. If airlines had a price limit put on their business class seats, you can bet coach tickets would go up in price and the number of flights would go down.

In these cases and in the case of credit cards, there is tremendous profitability in one customer segment that, to an extent, essentially subsidizes another segment because it is willing to pay ridiculous prices. The difference is that with airlines and hotels, the people paying the ridiculous prices are corporations and rich people, while in credit cards, it’s the stupid and the poor. That may argue in favour of the legislation.

Even if you don’t buy my arguments, it’s pretty clear that the industry will have less revenue per customer, and higher fixed costs per customer (due to the allocation of fixed costs among fewer customers). Economically speaking, this will cause the supply curve for credit cards to shift leftward, increasing price.

You’re definitely correct that the new equilibrium is card issuers making less money. But that isn’t necessarily a good thing for those (like me) who are currently maximizing the benefits and minimizing the costs of our cards. That said, I think the overall effect on “freeloaders” will probably be minor, maybe a few dollars a year in extra fees, maybe a small depreciation in rewards schemes. I think the bulk of the loss will be shared by the credit card companies and by those who continue to carry a balance, in the form of increased interest rates and increases in whatever fees can still be increased and assessed.

Your last paragraph about issuers trying to keep making money off freeloaders is essentially correct. American Express’ charge card (as opposed to credit card) business, for example, is made up entirely of freeloaders, and is very profitable. But they are an exception. Most companies can’t cordon off their freeloaders and charge them a specific pricing structure that makes them profitable (although they do try). They’re often stuck in the same ABC Bank Gold Rewards card as the people who carry a balance. So if they change the pricing for that card, everyone gets hit.

As for your point about “freeloaders” defecting from companies that raise fees, that will definitely occur, but I still believe the eventual equilibrium will be higher pricing.

This is pretty convincing stuff. Yes, those of us who pay our credit-card bills off in full each month might be worse off as a result of this legislation, but probably only by a few dollars a year. On the other hand, all of us will be better off in that we will no longer run the risk, however small, of being egregiously shafted by the credit-card companies.

Think of the credit card legislation as an insurance premium: it might cost a few bucks a year, but it might end up saving you a huge amount of money and hassle. Meanwhile, it’ll certainly help out millions of cardholders who are less assiduous in paying their cards off in full each month. So net-net, the new regulations are a very good thing — unless you, like John Hempton, think that it’s a great public good that banks make enormous profits each year.

Update: Another reader adds:

I have worked for five years in the credit card industry for two major issuers, actually running and developing the financial models (NPV etc) on which the decisions were made to solicit and approve consumers. I am now in b-school, but can shed some light on the consequences of this legislation, in light of your below article. In my five years in the two companies, I have been intimately involved in decisions to lend more than $100B to US consumers through credit card. So, I am talking form reality here, not conjectures.

Credit card industry works on a bar-bell business model. All the profits (mainly through fees and very very high interest stretching into 30% or more) are made form people below 650 FICO, all the assets (loans or balances) are from people from above 700 FICO. The industry is just a giant wealth transfer mechanism from poor people to wealthly people. The profits from below (subprime) serve to subsidize the interest rate and rewards cost of people in the ‘super prime’ category. You can bet that that will disappear soon. The discussion about ‘transactors’ (thats the industry term, not freeloaders) is a side distraction, not relevant at all. At best, transactors are mildly profitable, at worst they breakeven. The interchange rate is 1.87%, not 2 or 3%.

The subprime people need to be saved from themselves, no doubt about that. I couldn’t myself stomach the usurious 35% interest rate charged on them by my companies on a $500 credit line, in addition to the varying forms of fees, while a superprime customer had a $30K line at 5% interest rate.

I ran multiple simulations last fall in my previous company on behalf of the CFO in anticipation of these new laws and I can tell you that we were deeply unprofitable in every scenario. Considering my knowledge of the business model of other card issuers, I wouldn’t be surprised if they are in the same position too.

Welcome to the new age of credit cards, when they will actually be used as a convenience service, rather than as an ATM. This can only be a good thing.


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Interesting insight. I think you will be fine, maybe a few dollars more each year like you said but not more, if at all. I can’t really assess this accurately cause I don’t know what most ppl pay for their credit card in the us. However, I think anyone who has lived in a country where credit cards aren’t as commonplace as in the us (hell not even debitcards) would agree this legislation is probably a good thing. This (credit cards not being so widely in circulation) also leads to many much more “freeloaders” i think. (though this is not backed up by data, only subjective experience) Still somehow with say, a mastercard for 12 € a year, credit card companies make due … so yours will manage too ^^.

Posted by flo | Report as abusive

Revenues earned by predatory lending practices are revenues that never should have been earned.

I’m sure usurers everywhere lent out a collective groan when Jesus Christ drove those lenders out of the temple, but thems the breaks.

Posted by Kinkistyle | Report as abusive

One also has to consider the effect of economic changes. In good times freeloaders probably are subsidized by those carrying balances, but only very minimally, due to heavy competition between issuers, while in the times like these they will likely end up subsidizing those who default to a far greater extent than they ever benefited during the good times, due to reduced competition and competition to increase revenue. If you think only bad credit risks pay for their losses you would be mistaken; the increase in merchant fees is passed along to freeloaders as much as everyone else. They subsidize defaults far more than they are subsidized over an economic cycle.

Posted by Lord | Report as abusive

Lord’s post implies that the changes to Rewards plans, and maybe even the return to a fee each year (as with those “the first year’s free, the second one you have to pay for” offers).

But most consumers see those changes all the time anyway. (No more $100-off from Marriott for spending $40K a year? I think I’ll survive.)

To do a variation on the theme: A difference that makes no difference to the consumer is no difference, even when it’s a difference to the firm.

I agree with your conclusions. Note that the credit card issuers don’t attempt to deny that they are shafting the poor and/or ignorant, and would continue to find new and ‘better’ ways of doing so if they were allowed to. The only argument the card-issuers make against stopping their abusive policies is that it would lower their profits. The social costs of the policies– which are borne by the rest of us– are just written off as ‘in the nature of things’…

Posted by MattF | Report as abusive

It’s good to see the veil pulled back by someone who understands how the credit card system actually works.

I think it’s obscene that we allow credit card interest rates of 30% or more, and then don’t allow credit card debt to be released in bankruptcy. The new bill doesn’t go nearly far enough.

Posted by hmpierson | Report as abusive

“The result is that roughly 20% of a credit card issuer’s customers are unprofitable (this can vary tremendously, depending on the company and calculation – for instance, allocation of fixed costs). This isn’t particularly remarkable, I suspect the number might be similar for Safeway or Best Buy”

There’s something about this business model that strikes me as peculiar. Shouldn’t there be a credit card company that attempts to lower fees for the “profitable people”, and hence siphon off the subsidizers. Isn’t that what people claim happens with health care? I’m reading in these comments that the subsidizers/profitable CC users are held hostage, allowing the CC companies to make money off of unprofitable people. Maybe I missed something.

Nothing happens in a vacuum. From one perspective, you are a ‘freeloader.’ From another, you’re a ‘good customer.’ From yet another perspective, you’re a ‘subsidizer.’ At any given point, something unforeseen and unanticipated could warp those perspectives to alter your status.

Given the trillions of new federal debt cheer-lead by President Obama, today’s freeloader may be tomorrow’s good customer. Last time I recall an annual fee, it was $75, back in the 1990s. So now they may come back at $125 per annum. And if you slip off the ‘subsidized’ pedestal that grates so many raw you’ll have that annual fee to pay on top of your ‘good rate’ interest-accumulating balance. Perhaps that possibility is what columnists like Michelle Singletary at the Washington Post secretly treasure.

A more-complete story on this matter would involve delving into the federal and state tax situations of those good customers. Are they receiving no-waste tax credits, such as EIC? I’d much rather not need the EIC than receive it, but if one does receive it, there’s a subsidy that offsets the cost of a good customer’s lifestyle.

Other tax subsidies include those that reward Prius purchases (a Prius ad just flashed on this website), sales tax deductions for 2009 new car purchases, and no-waste tax credits for buying a home before the end of the year. If you’re not doing any of those government-approved things, you’re helping to subsidize them. As of today. Tomorrow, who knows? If the carrot approach doesn’t work as well as anticipated, maybe the stick approach will evolve, and you could lose your standard deduction or personal exemption for not doing a government-approved thing.

Above all else though, I’m glad I’m not one of every four taxpayers selected at random by the Treasury to selectively shoulder the entire cost of bailing out AIG’s $20 billion point-spread marker to Goldman Sachs and European banks over derivatives insurance. I got my notice in the mail of that status last Friday, what a relief! If you didn’t, oh well, when the *special* bill comes in the mail, you’ll have the satisfaction of knowing you are a good sport about subsidizing AIG. I’m hoping I’ll also not be one of every four taxpayers selected at random by the Treasury to selectively shoulder the entire taxpayer cost of Geithner’s upcoming 50%-of-all-the-profits/almost-none-of-th e-losses toxic-asset party. But getting lucky twice in a row may be pushing it.

Sarcasm aside, the biggest disappointment to me in theory, principle, and practicality with the recent credit card bill is that those at the extremes weren’t recognized. Cash-paying customers won’t get a 2% discount at the register to recoup the subsidized interchange fee and more importantly, a national usury rate wasn’t set to limit how much interest a revolver could be gouged. As such it seems the jellyfish was punched in the middle, and it can still sting from both sides — one side way more than the other.

And as Don the Libertarian succinctly pointed out, something is missing. Why isn’t there a bidding war over the good customers? That is a very, good, question.

The overall disdain for any measure of personal success and thrift that would make previous generations proud just keeps growing on a case-by-case basis. It doesn’t matter what the law is concerning credit card debt, I’ll still avoid it like the plague. I hope that all the good customers as of now will be able to use provisions in the new credit card bill to climb out of the personal debt trap — and join the rest of us freeloaders. As a nation we’ll need all the help we can get to pay for Iraqipakighanistan — on top of everything else.

Posted by dom youngross | Report as abusive

Whether or not the freeloaders have to pay more (I am one of them) is irrelevant to the issue of should banks be allowed to continue to operate like loan sharks. There will no doubt be side effects of new laws that reduce the number of sub-prime credit card customers, but that shouldn’t be a factor in legislating these needed changes. If the net result is higher costs (or no reward programs) for zero-balance customers, or less people qualifying for cards, so be it.

What’s worse than the sub-prime customers subsidizing people who pay their balances off each month is their offsetting of other stupid things the banks do. 30% interest rates $35 late and over limit fees have masked a lot of sins by the incompetent parasites who are referred to as “management” of the banking industry.

Posted by KenG | Report as abusive

Health care is an apt comparison. Like health insurance, revolving credit is a real, useful service. Like health insurance in the US, revolving credit in the US is provided by organizations nobody likes, most hate, that would not be missed were they to vanish tomorrow.

Bring on national health care and some well-targeted usuary laws.

Good riddance, bad rubbish.

Full disclosure: I am a perfect-payment-history ‘transactor’.

Truly an excellent use of the media here – I am financially sophisticated but have never seen the credit card industry income/revenue model explained so well.

I am a free loader myself but several times over the past few years had to deal with unrequested transferred balances and similar tricks that I assume attempeted to push me into the profitable category with carry-overs and assocaited fees.

One of these was AMEX where I am a 30++ year cardholder and I viewed what they did as totally sleazy. It took e acouple of hours on the phone getting back to the simple monthly charge and pay model.

I am a capitalist but I have no sympathy for the credit card cos – they crossed the line just like the cigarette companies and became a blight on the system.

Posted by tim | Report as abusive

I am trying to figure out how 1.5% monthly gross turnover (18% annualized) makes me a “freeloader”. If their cost of funds to finance my purchase is 8% (that is being generous), they aren’t doing too bad on a very low risk (payment every month) loan.

I have a feeling that “unprofitable” customers are purged pretty quickly.

Posted by pebird | Report as abusive

“Transactors” is generally the official name of the customer segment, the one used in Powerpoint presentations and Excel models. “Freeloaders” is a colloquialism used among people in the industry.

The interchange rates vary according to the network (Visa, MC, Amex), the country, and the type of merchant. They range from 1% to 3%, so the bank’s overall interchange rate will depend on the mix of spending. The companies I worked for were generally in the 2% to 2.5% range.

For actual Visa interchange rates, see: pril-2009-visa-usa-interchange-rate-shee t.pdf

Posted by Zoltan | Report as abusive

Perhaps I missed this in the post and/or comments, but I’m a bit torn here.

I worked for a CC company pushing cards onto otherwise unsuspecting customers while I was in college, and have been screwed over by them several times since in my personal matters. However, despite my general disdain for many of the Industry’s practices, I almost (key word) understand the “usurious”rates charged to many “non-prime” borrowers. As the Administration has made painfully clear, their goal is to maintain/extend credit to all borrowers to keep the economy from going to hell. At the same time, they’ve criticized the CC firms for “predatory” and “unfair” practices. Sure, there’s alot of sleazy fees, but mmore generally, why are we surprised?

The CC firms have to be compensated for the risk they’re taking-on, in the form of annoying fees and seemingly ridiculous interest rates. Does the Gov’t plan on limiting the CC companies returns like they do with public utilities? I’m sure that’d really work out well (sarcasm alert).

Now, excuse my rambling stream-of-consciousness, but I’ve wondered – and if anyone has data on this I’d appreciate it – to what degree, if any, does jacking interest rates actually contribute to consumer delinquency and/or default?



The leaders of the credit card companies are not the greedy loan sharks described to be in the media or on some of the personal finance blogs. I worked in credit cards and banking — staff groups mostly — for over 20 years (recently laid off) and can tell you that 99% of the people I dealt with were honest and ethical. No one set out to cheat or deceive customers.

That said, the execs with P&L responsibility were under incredible pressure to make the numbers, and the company as a whole felt obligated to beat expectations — making, say, $1.02 a share in Q1 vs consensus forecast of $1.01 (when $1.01 was itself a stretch). The result was an almost constant fixation on “revenue enhancement.”

So, over time many, many incremental and seemingly harmless decisions were made, that individually had little impact on consumers but collectively and over time, added up to, in my opinion, abusive or customer-unfriendly practices.

Examples: Over 10 years the statement mail date / to due date time was gradually reduced from up to 30-days to as little as 14 on some products. (I travelled a lot and I even got slammed with late fees by not being able to mail in payments the day I received the statement). The faster the pay, the better the cash flow and lower the interest expense (for the company.

Late fees went from $10 to $39 and in some cases as high as $49. Again, all in small increments.

FX fees went from 0% to +3% (on top of the existing and invisible buy/sell spreads).

Cut off times for posting incoming mail and internet payments went from 4PM to as early as 10 AM (9 AM at some competitors).

A charge for phone payments was instituted.

Binding arbitration (we chose the arbitrator) was put into the T&C.

We stopped mailing changes to the T&C and slipped them into the statement. (Less call center talk time and postage).

We never did universal default, but other companies did and there was some discussion around using it since the poor risks were being pushed off on to us as our competitors raised rates.

And it was all meticulously, mind-numbingly tested, e.g. revenue enhancement strategy “A” yields marginal revenue of $2MM with only a 1 percent drop in customer satisfaction / recommend-to-others scores, and investment of only $500K (6 mo. payback) which is a better ROI than “B” which, etc etc. Consumers did not seem to care (or did not bother reading the 4 pt type).

I could go on. But no one decision was unethical or could be construed as gouging the consumer. No one was thinking long-term, for why should they? Everyone needed to make their numbers and if they did they were rotated out of their job or promoted within 2 to 3 years. If they did not, then they were “exfoliated.” ( I remember many “rank and yank” sessions just before bonus season).

My take: the regulatory problems the industry faces today are the result of the need to please / meet expectations of security analysts and institutional investors and avoid hostile shareholders / financial media coverage. A systemic problem, not one of character or ethics.

Posted by Alonzo Quijana | Report as abusive

Alonzo, thank you for that honest missive. However, I have to tell you that your explanation and conclusion are highly misplaced. You say that no unethical decision was made, yet almost in the same breath you describe 4-point fonts, you choose the arbitrator, and fees and cutoffs where none were justified except to extract more money from your customers. Your justification seems be that the customer continued to do business with you anyway.

Ethics? I see no ethical behavior in what you describe. Your rationale that it was required by the system, and that anyway your competitors did worse, belies the fact that you and your P&L (perhaps I should say P$L) owners wanted merely to advance their individual careers rather than run a sustainable and growing business that treated all stakeholders with respect.

Posted by Curmudgeon | Report as abusive

Alonzo, that was a great narrative. That said, with all due respect, there is a reason even we perfect-payment ‘freeloader’ commenters despise your industry. It is a blight on the financial-services landscape. When you are a blight on a landscape that includes both super-senior CDOs-squared and penny-stock pump-and-dump, you have sunk awfully low. “Greedy loan shark” is inaccurate only insofar as it is too complimentary.

Dante has a place for the executives who created this monster. The sooner regulation slays it, the better.

this discussion on credit card industry economics has been good so far for a layman like me.
but it has been a bit one-sided. the freeloaders/transactors (like me!) are low profit for a reason. there’s very little chance of a write-off. Whereas the high interest payers might be profitable looked in isolation i.e. ignoring the small percentage of card users who stop paying for whatever reason. It only takes a few hundred write-offs to offset the supposed high profits of others. The card balances/ receivables have to be eventually written off 92-98%. The 2-8% recovery is made only because there are companies like PRAA (yes I’m a small shareholder) who buy portfolios of write-offs for typically 3-5c on a dollar.

Posted by playdumb | Report as abusive

The “high volume transactors” may not be profitable on the issuer side, but they are of vital importance to the health of the network as a whole. Retailers, etc. are only willing to accept the card (and the interchange) because of these high income individuals.

Posted by GD | Report as abusive

Really so insightful stuff! There are so many points which makes your stuff more informative and interesting too.

Posted by ccbuilders | Report as abusive