Opinion

Felix Salmon

The economics of credit card debt

By Felix Salmon
December 1, 2009

You’re a bank, and one of your customers owes you $2,000 on her credit card. You have two choices:

(a) You cut off her credit, convert the $2,000 to a loan, and she pays it off with 6% interest over four years.

(b) You keep the credit card open, she struggles to pay back the balance at 30%, and eventually declares bankruptcy with a principal balance of $1,205 outstanding, which you never collect a penny on.

Which of the two options do you choose? Mike Konczal has run the numbers, and it turns out that option (b) — driving the poor customer into bankruptcy — is actually more the more profitable of the two.

What’s more, the option value of option (b) is enormous: if she doesn’t declare bankruptcy you can make more money still, and of course if she keeps on spending on her credit card, that’s even more debt on which you can make predatory and usurious profits.

This is a prime example of what Ronald Mann calls the “sweat box” of credit card debt:

Debt-based issuers focus on debt servicing revenues… the most profitable customers are sometimes the least likely to ever repay their debts in full…

As the credit card borrower spirals downward, with the monthly balances growing to amounts that equal, or even surpass, the borrower’s annual income, the issuer begins to earn large monthly profits on the relationship.

This syndrome, Konczal explains, is the reason why Jackie Ramos was encouraged by Bank of America to deny people the ability to convert their credit-card debt into an easier-to-repay loan. Just don’t expect the banks to ever admit as much.

Comments
16 comments so far | RSS Comments RSS

Yes, they can continue to suck the juice out of our brains forever because we keep giving them juicy new brains. (I always wondered why the parasite would want to kill the host… it’s because it doesn’t matter… there are infinite hosts)

 

While I don’t doubt this is true, I have to wonder whether the bank isn’t still more impacted by bankruptcy as their expectation was they would earn 30% on it forever.

Posted by Lord | Report as abusive
 

At what interest rate does A overtake B? Because 6% is untenably low. 6% is a rate you charge on a secured loan like a house or car, no consumer gets that kind of rate on unsecured credit. Mr. Konczal makes the unsubstantiated assertion that 6% is “enough” to make a profit but empirically that’s false, else we would observe such rates.

Posted by Noah Yetter | Report as abusive
 

“Mr. Konczal makes the unsubstantiated assertion that 6% is “enough” to make a profit but empirically that’s false, else we would observe such rates.”Er, no. It might be high enough to be profitable, but not profitable *enough* to satisfy the lenders.

Posted by Jon H | Report as abusive
 

In terms of admitting perferences, there’s an interesting opportunity in an upcoming congressional hearing. Bank executive says, “We are always focused on what’s best for the customer” (e.g. the exec suggest they want people to be in the fix-pay program, as opposed to staying with 30% interest + penalty fees)This provides a great opening for a shareholder lawsuit: why isn’t the bank exec working in the best interests of the shareholders? (And there’s an admission of this fact under oath.) I’m not sure how far the lawsuit would go, but I’m sure discovery would be interesting.

Posted by Mark | Report as abusive
 

Is there any demographic data comparing people who pay off their credit cards every month with people who don’t? I’d be somewhat surprised if there was, since that sort of data probably qualifies as proprietary– if not very proprietary– but I have a suspicion that it would be interesting.

Posted by MattF | Report as abusive
 

Here in Britain we have the same credit culture as the US. It is a well known fact that the customers who are never able to clear their entire balances make the lenders the most money. Since the credit crunch good customers, those who don’t make the banks any money, have actually found their credit services being withdrawn by the banks.Another parallel between Britain and the US is the soaring personal bankruptcy rates. Our bankruptcy laws have become very attractive, you wipe out all of your debt and are released from bankruptcy in less than one year. I am one of these people:http://iwentbankrupt.wordpress.co m

 

(Caution, long post, but the short ones are based on no data).The analysis is flawed. Among other finer points, it ignores:- That there is still some chance that the 6% loan will charge-off, reducing the value of that option.- It ignores the expense difference (or expenses at all, frankly) between servicing a 6% fixed term loan (small $) versus servicing a defaulting loan requiring collections work (very expensive… unless you don’t try to collect, which seems to be what some are implicitly suggesting).As a rough guide, the average credit card rate is about 13% these days (and yes, some of us do have the data). About 85% of receivables accrue interest in any given portfolio, so the effective yield is about 11% (commence the rounding!). Large banks are paying maybe 3% cost of funds when regulatorily required equity levels are factored in (Smaller instititions cost of funds can be lower… which is one reason credit unions can support lower rate cards, their cost of funds is coming in not much more than 1% these days). This leaves a margin of 8%. Fees, after over limit fees will be eliminated in February, MAY get you another 2% (on the average portfolio). And interchange another 4%….so gross revenue are, say, 14% (after funding costs).Subtract from that:- Charge-offs, now at 12% for the entire industry.- Expenses at a low end benchmark of $100 per year per account in use for all underwriting, servicing, statementing, collections, etc functions (industry standard for envelope math, NOT including marketing costs). This is 5% on a $2000 balance.So: Revenues = 14%. Charge-offs = 12%. Expenses = 5%.Sanctimony about the risks others take is easy, I guess, but on average this is why very nearly all credit card issuers a losing gobs of money. A negative ROA of -3% in this data-based example.. The model worked when charge-offs were 5%, leaving a pretax bottom ROA of 4% (after tax of about 2.5%… start a credit card bank if that’s worth the risk to you).Despite all the sturm-und-drang about cards, it is rarely the card payment that is the due-or-die element taking someone to bankruptcy. In the most charitable example, someone may have had a life problem (e.g. medical emergency with job loss resulting) that caused them to use cards to fund for some brief period what was going to crash any way. Less sympathetic scenarios are legion. Conflating the card payment with the cause of their problems is sloppy populism. Don’t get me wrong, many issuers get no sympathy from me, but when sloppy analysis like this is held up as conclusive it diminishes any ability to be rational about the solutions (but we’re pretty much past this anyway).A big part of the truth is that too many people are too financially illiterate, optimistic and/or short-term focused to make smart decisions about cards (or mortgages, or auto purchases, or…). That is not an indictment of specific individuals so much as part of the human psyche; and we’re tipping toward believing we can cover that weakness in ways that won’t have other, too-limiting consequences. Only time will tell, though limiting the mistakes others are allowed make (e.g. CFPA) is something we are all comfortable with every day (can’t pick your own drugs for whatever ails you, can’t design any old car you want to build, ….).

 

One of my tenants, a guy who has nothing beyond what he makes each month, was working on a payment plan for a credit card. After he’d paid more than the original debt, he owed about what he’d paid – meaning the debt had effectively doubled. If he’d kept on the same plan, he’d have paid forever without gaining ground. My advice was to tell the vampires they had a choice: either write the debt off or he’d declare bankruptcy and it would be gone anyway. He decided to do bankruptcy because he didn’t feel comfortable trying to confront a bank.One lesson: many people pay and pay because they don’t know they can stop. Another lesson: many people can’t deal with authorities well and so are taken advantage of. Third lesson: it’s like the Smashing Pumpkins song, “The world is a vampire / set to drain.”

Posted by jonathan | Report as abusive
 

One reason why banks might be disinclined to be lenient and restructure their non performing loans and reduce the interest rates on them is because such an activity would immediately increase the number of non performing loans. Why would anyone pay 30% on any loan if by not paying you could get a reduction to 6%?

Posted by bar | Report as abusive
 

You’re a customer, and you owe the bank $2,000 on your credit card. You have two choices:(a) You cut up your credit card, convert the $2,000 to a loan, and pay it off with 6% interest over four years.(b) You keep the credit card open, struggle to pay back the balance at 30%, and eventually declare bankruptcy with a principal balance of $1,205 outstanding, which your bank never collects a penny on.Which of the two options do you choose?Slight change in viewpoint, and suddenly the story changes from “evil usury” to “customer making bad choices”. Leaving aside for a minute the question of whether it’s wise to borrow $2,000 that you can’t pay back, why is it the bank’s fault if a customer makes a series of poor financial decisions?

Posted by Geoff L | Report as abusive
 

Yes, Geoff L, customers make bad choices. Your average teenager makes bad choices. That’s why we don’t let your average teenager drink or vote.I’m all for the free market and caveat emptor when the choices are made by informed consumers. Those not so bright folks are under the mistaken impression that people like you, Geoff L, won’t steal them blind at the first chance you get. They’ve been told that customer service is the goal of every business and they believe it. Sadly, they’ve been lied to. Maybe they should know that their bankers are slime, but for some silly reason they think that nice man at the bank is looking out for them.So tell me again why our “christian” nation is so adept at exploiting the weak and why this is an acceptable and moral business model.The social contract is broken. People like Geoff and his fellow Ayn Rand lovers are… not nice people.

Posted by Neil D | Report as abusive
 

Consumers are not stupid either. They are using cash for Christmas shopping.If this trend continues, I wonder how credit card companies are going to do deal with consumers who either do not use credit card or pay in full every month.

 

How often do people declare bankruptcy over $2000?I don’t have the time to crunch the numbers at the moment, but there’s a critical point where the debt is high enough the loss due to bankruptcy is higher than the profit prior to it. That depends, of course, on how soon after the offer to switch it to a loan the bankruptcy is filed.

 

Let’s remember that 3 companies who do some banking along with lots of other stuff issue about 80% of the credit cards. Look at yours — probably from Chase, Bank of America or Citibank. There are thousands of smaller banks who keep getting lumped in with these conglomerates just because the giants use the word bank in their names. Bank with the little guys who are actually real banks and not financial conglomerates who do ‘banking’ as a way to lure people into their other financial stuff.

Posted by jeaniemac | Report as abusive
 

The model worked when charge-offs were 5%, leaving a pretax bottom ROA of 4% (after tax of about 2.5%… start a credit card bank if that’s worth the risk to you).Despite all the sturm-und-drang about cards, it is rarely the card payment that is the due-or-die element taking someone to bankruptcy. In the most charitable example, someone may have had a life problem (e.g. medical emergency with job loss resulting) that caused them to use cards to fund for some brief period what was going to crash any way.
http://www.mastercreditcard.net

Posted by louisprudent | Report as abusive
 

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