Crossposted at Taunter Media
Credit cards are in the news today - the White House summit, Carolyn Maloney's Credit Card Bill of Rights, the Dodd/Schumer call for card issuers to freeze rates - and it is understandably a topic of great relevance for most people.
The Maloney bill is a good bill. It focuses on disclosure requirements (cracking down on hidden fees), with some fairly basic regulations (applying payments from the highest rate downwards, instead of the lowest rate upwards). Nothing will ever be good enough for the card issuers, so they can be expected to try to stall in the Senate, but this is some common sense stuff.
However, several members of the Kos community, as well as some advocacy groups, seem to want the government to go beyond focusing on disclosure and impose rate caps or bar universal default. It is an emotionally satisfying position, but it is also wrong.
Rate Caps / Usury Regulations
Rate caps are a popular topic. Pretty much any time the price of a good increases dramatically, you can count on people to start arguing that the price should be capped by government fiat (except houses - curiously, people cheer price increases in real estate). Why don't we cap all prices?
The simple answer, of course, is that capping the price of something leads to shortages as producers exit the market. It would be nice to be able to buy a new car for $100, but if we capped the price of cars at $100, no one could build one profitably and there would no longer be cars sold.
But isn't there something wrong with a credit card company charging 30%?
Perhaps - but what's wrong is an economy where even 30% might not be enough to overcome the risk of default. Let's take a look at Capital One. The smartest guys in the credit card business (and the guys with the most annoying ads on TV) had a charge-off rate of 9.33% in March. And rising; the stress test envisions eventually flushing 20% of credit card debt. That's across all their customer segments, that's before dealing with the prime rate (3.25%), that's before keeping the lights on and the computers running and the caviar in the executive dining room.
What do you think the probability of default is for the worst tenth of COF's customers? Can you imagine why a company would think it needed 30% to compensate for the risk?
If a rate cap were imposed, all that would happen is that the card issuers would cut people off. If there were a 25% cap, for example, it would have no effect on people paying 17%. But someone paying 29% would not see his rate reduced to 25%; he would simply have his card cancelled. How does that help anyone? The borrower preferred 29% interest to no card - he could stop charging on his own if he preferred not to borrow - and now has no card, all so someone else can feel better that no one is paying a "usurious" rate.
By the way, this argument about rate caps applies to payday lending and other subprime financial products (negative amortization mortgages, reverse mortgages, etc). Lenders should absolutely be required to explain in plain English what the charges and fees are for any financial product. However, there is a person for whom that product is the best available product, and it is completely counterproductive to deny access on the grounds that some other person might mishandle it.
Universal Default
Universal default is credit card jargon for raising the rate on a credit card when someone defaults on another card. So you default on your Bank of America card and Capital One raises your rate.
Opponents generally believe it is unfair in some way for a business dealing with Bank of America to interfere with a business dealing with Capital One. But that fundamentally misses the fact that in an unsecured loan, the only thing the bank is lending against is the creditworthiness of the customer. Knowing that someone has defaulted with someone else certainly affects your assessment of his credit; wouldn't you be far less likely to loan money to a friend who has a reputation for not paying people back than someone who is religious about repayment? Well, if it would affect your decision upfront, why wouldn't it affect your decision along the way?
Credit cards are, in almost all cases, open-ended facilities. There needs to be some mechanism to reflect a change in creditworthiness. Why should a credit card company be forced to be blind to external events in someone's credit profile and essentially undercharge a high risk customer? That's just a nicer way of saying that they would need to overcharge a low risk customer, as the opening rate would need to reflect the probability that a customer's credit deteriorates and the issuer can't change price.
Disclosure
Financial literacy is not a strong suit in this country, and the retail financial services industry hasn't exactly bent over backwards to change this. Let's make sure we deal with transparency and disclosure and see where that gets us before we start banning sectors of the market. That only forces people to either do without or deal with people who are not constrained by the law...