With much fanfare this week,
Congress and the Administration began a series of actions designed to protect
over-leveraged consumers from the high fees imposed by credit card lenders. As
with most other initiatives devised by government, this policy will create a
host of unintended consequences that will undermine the benefit the program
hopes to create.
Anyone who carries a credit card
knows that billing practices have become much more aggressive, punitive, and
seemingly arbitrary over recent years. Sadly, these fees have become one of
the only means the companies can use to compensate for the increasing
defaults on their unsecured loans.
By mandating that the credit card
companies lower their fees, the government will severely hinder their tenuous
profitability. In order to avoid bankruptcy, the companies will have to deny
credit to marginal borrowers, which would reverse the "easy access"
policies that have defined the industry over the last generation. The
resulting contraction in consumer credit will run contrary to current
Administration efforts to keep Americans spending. The horns of this dilemma
are completely missed in Washington.
In better times, when companies
could make money from interest charged on a high-performing loan book,
companies could perhaps compete on better customer service and transparency. Unfortunately,
desperate times have called for desperate measures. And rather than seek to
break their reliance on credit through harsh reductions in spending, many
Americans have waded into the snake pit despite the costs.
Among other things, Congress
objects to credit card issuers raising interest rates and cutting back on
lines of credit for those borrowers deemed at heightened risk of default. One
practice, called "universal default", in which card issuers take
into account a cardholder's total liabilities, not just what is owed on a
single card, has drawn particular Congressional fire. In this system,
delinquency on one account will often affect rates charged on all accounts,
even those where the borrower is still current.
Also under scrutiny is the very
concept of lenders raising rates on existing balances to reflect heightened
risks, despite the fact that their ability to do so is spelled out in
advance. The concept is similar to adjustable rate mortgages, where borrowers
initially get lower rates but face the possibility of higher rates should
circumstances change. Without the ability to raise rates, lenders will have
no choice but to charge much higher rates from the start.
The bottom line is that credit
card lending is a very risky business. The debts are unsecured and the
probability of default is high, meaning big losses should borrowers choose
not to pay. In addition, should a borrower file for bankruptcy, credit card
debt is often the first to be discharged. Given the risks, interest rates
need to be very high to keep lenders in business.
One way to keep a lid on rates for
those who do pay is for lenders to weed out those most likely to default. This
can be accomplished through higher rates. Not only does this discourage
riskier borrowers from taking on more debt, but it gives lenders a bigger
cushion to absorb losses. However, by interfering with card issuers' attempts
to better price risk and limit losses, the government will reduce credit
The securitization process,
infamously associated with mortgage debt, has also been utilized extensively
with credit card debt and has greatly spurred the growth of consumer credit. As
a result of securitization, lenders were able to immediately offload their
loans to Wall Street, which repackaged and sold them to investors around the
world. In this way, credit card issuers became more concerned with loan volume
and less concerned with loan risk. However, now that huge losses in credit
card-backed bonds have reduced investor demand (despite recent multi-billion
dollar Fed purchases), card issuers need to hold loans on their own books. Greater
prudence is resulting.
Ironically, this is the one
potential silver lining to this cloud. By making credit card lending even
riskier, this bill will actually make it harder for consumers to get credit. Since
excess consumer credit is part of the problem, restricting that credit is
part of the solution. However, while I approve of the ends, it is certainly
not justified by the means.
It would be preferable to simply
allow markets to function. Higher losses among credit card lenders and higher
rates for credit card users would greatly diminish both the availability and
desirability of consumer credit. Fear of losses and the absence of a
secondary market to unload risk would force lenders to more judiciously
extend credit. Simultaneously, higher rates would reduce the appeal of credit
card debt, causing fewer Americans to partake.
These mechanisms would begin the
painful process of weaning the nation from its addiction to credit. Ironically,
this is what President Obama has said is necessary.
Of course, there is also a good
chance that this silver lining will prove a mirage. When the banks attempt to
restrict credit as a result of their business concerns, the government will
most likely funnel more taxpayer "bailout" money to banks to entice
them to keep lending. In typical government fashion, rather than letting
market forces work, our government will force bad decisions on companies and
then subsidize resulting losses. Isn't this
starting to sound familiar?
Peter D. Schiff
20271 Acacia Street, #200 Newport
Beach, CA 92660
/ Direct: 203-972-9300 Fax: 949-863-7100
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