Simple Math

I just read an article in Harper’s Magazine by Thomas Geoghegan (Infinite Debt: How unlimited interest rates destroyed the economy) about uncontrolled interest rates and how they got us into the present financial crisis. Part of the thesis is tied to a principle of investment – return is linked to risk. Traditionally this is interpreted to mean that investors demand greater return from investments that have greater risk of failure. Thus, corporate bonds pay more than your federally insured savings account. It works the other way as well. Greater return promotes greater risk taking.

I did some simple math.

Imagine you have a bank and you issue ten credit cards with a 10% interest rate. Customers carry an average of $1,000 on their account. None of them defaults. You make $1,000 x 10 x 10% = $1,000.

Now imagine that you pull the usual credit card company sleaziness (shortening the grace period, for instance, or penalizing for a late payment on a different account) and nail all your customers with a 25% penalty rate. One of your customers can’t manage it and defaults. In this scenario you make interest on nine customers ($1000 x 9 x 25% = $2,250) and lose the $1,000 from your defaulter. Your total take is $1,250. You have a 10% default rate and you are making 25% more money. This pushes the practice of banking towards the same gambling ethos of venture capital investing. The rule of thumb for venture capitalists is that three out of five investments will go bust, one will hold its own, and one will gush enough profits to make up for the three failures. For banks, the short term income from penalty rates and fees more than makes up for the defaults, inspiring them to issue cards to anybody with a pulse. Damn the credit ratings, full speed ahead.

Of course, not all credit card holders are paying penalty rates, and a 10% default rate would be disastrous if it applied to all customers. In fact, default rates among credit card holders is climbing past 5%. Here is Geoghegan’s premise displayed perfectly. In the short run the credit card companies made out like bandits (which, in fact, they are). In the longer term they are experiencing a financial “tragedy of the commons” as consumers crumple under multiple credit pressures.

I’d like to revive a proposal from Anthony Pollina’s campaign for Governor of Vermont. The citizens of this small state pay out roughly $250 million a year in credit card interest payments. Some unfortunate people are paying those punitive rates. At the same time we are trying to deal with a state budget shortfall in the tens of millions. We should have a State of Vermont credit card, with the profits going into the general fund. Even if we charge a humane 10% it would still mean something like $100 million into the state coffers. Why should we make an interest payment to an out of state credit card company and then turn around and write another check to the state tax department? We could write both checks in one.

It would be a multiple win. Vermonters would save money on the combination of debt and taxes. Many would be spared those rapacious fees and interest rates. The budget gap would close and then some. The money would have a chance to stay in state.

I know, I know: politics. There will be a group of conservatives, and not-so-conservatives, screaming about socialism and big government, and letting private industry do its thing. Because private banks have been so smart and good, right? You love your 26% interest rate and huge penalty fees for being a day late. This is one of those situations where ideology trumps common sense and the common good. Our Republican governor would veto such a proposal. He seems to regard government as a publicly funded organization for serving big business.

I still think the idea has legs. The combination of tax and debt relief could have even the most ardent ideologue going over credit card bills with a thoughtful look. Political principle could yield, as it generally does, to the bottom line.

Comments

[robby]

Two points, Hilton:
You're right, but here is another thing that is happening.. Credit card companies realize that a credit card bust is coming and so they are pulling lines of credit. The quickest way for them to do this is by zip code, so when they have a lot of defaults in a particular area as defined by zip code, they pull all lines of credit in that area including from perfectly credit worthy customers. They know that as credit lines get pulled people are consolidating their credit card debt and no company wants to be that last card issuer holding the debt. The result is terrible for the economy because it means that even people who are good credit risks have less credit available to them.

Second point, the greater reward for greater risk concept is what got us into this mess. Risk is often measured by volatility and volatility is not a good predictor of long term gains or losses. Risk is also measured by past history, ie. house prices have never gone down and therefore they never can, and this is not a great predictor either. As Warren Buffett points out, when farmland goes from $4000 an acre to $2000, people say that it is a very risky investment because the price just got cut in half, when, in fact, you are buying land for $2000 an acre, how much cheaper is it really likely to get? The real value and hence the real risk depends on what you can do with whatever it is you are buying.