Yves Smith: Banks returning to the Faucet – Credit Card Junkies

13 Dec

Banks Desperate for Profits Seek Out Risky Credit Card Customers

by Yves Smith

Banks, having trashed their once-sound model for the credit card business, are back trolling to find credit junkies, albeit of a somewhat safer type than the ones that blew up on them in the credit crisis.

Back in the 1980, the credit card industry, despite being more fragmented than now, had what looked a lot like oligopolistic pricing. Card issuers all charged annual fees as well as interest on the order of 19% on card balances. The use of annual fees meant that every type of user was profitable: the sporadic user, the person who paid in full every month, the consumer who ran occasional balances (anything from the occasional late payment to working off Christmas spending). I recall having an argument with an investor in the 1980s who insisted that banks would never shift from this pricing scheme, it was far too attractive to them.

But of course they did. The introduction of no-annual-fee cards meant that the sporadic user and the “pay off my card monthly” types were no longer attractive: the real juice lay in interest charges and fees. So over time, banks became more eager to lend to weak borrowers, which in turn led to perverse outcomes like the passage of the 2005 bankruptcy reform act, in which banks who had decided to lend to weak borrowers claimed these borrowers were so badly abusing credit that it was necessary to change the rules of the game. This is awfully reminiscent of someone who has shot their parents asking for sympathy because they are an orphan.

The 2005 legislation, among other things enabled banks to extract more from credit card borrowers when they hit the wall (a bankruptcy lawyer told me that MBNA, which was one of the moving forces behind the bill, estimated it would make $100 per month more on every customer that went bankrupt, which would increase its profits by $85 million a year). But that was not enough to save them from sizeable losses when the crisis hit (an irony here, most credit card receivables are securitized, but banks found it necessary to support entities with large losses, out of fear of tainting the market).

So per an article in the New York Times, the banks are back trying to build up their credit card businesses, which had become a major source of bank profits. Unfortunately, have trained a whole generation of customers to expect no-fee cards, they’ve made it well nigh impossible for themselves to go back to a more prudent pricing model.

But never fear. The card issuers claim to be wiser and thus better able to make more discerning choices among risky borrowers, such as “strategic defaulters” versus “first time defaulters” versus “sloppy payers”. But how reliable can these credit score and payment history analyses be? We’ve only had two years or so of the “new normal”. The subprime crisis illustrates the perils of extrapolating from unduly short time frames.

Now admittedly, the banks are building in more protection for themselves in the form of annual fees and high interest rates. But the flip side is, independent of the terms the banks put in place is that uptake on its new card offers are very likely to be subject to adverse selection. Yes, some users will be sound, like small businesses owners who use credit seasonally (many entrepreneurs are too small to qualify for regular business loans, and credit cards have long been a major source of credit for them), or people who lost a job or suffered a cutback in hours and are back to working at a decent income again. But in this environment, most consumers are hunkering down and keen to reduce debt levels. Many who take up these offers are likely to be unduly optimistic and/or less disciplined than their credit-stay-away peers.

From the New York Times:

Credit card offers are surging again after a three-year slowdown, as banks seek to revive a business that brought them huge profits before the financial crisis wrecked the credit scores of so many Americans…..But this time, in contrast to the boom years, when banks “preapproved” seemingly everyone, lenders are choosing their prospects more carefully and setting stricter terms to guard against another wave of losses….

Lenders have taken $189 billion in credit card losses since 2007, according to Oliver Wyman Group, a financial consultancy. That was a significant part of the $2 trillion or so that banks are estimated to have lost since the crisis began, and a contributor to the government bailout of the banking system.

To stem losses, lenders halted new card offers to all but their most affluent customers. At the same time, more than eight million consumers stopped using their credit cards, in a sign of the nationwide belt-tightening, according to TransUnion, the credit bureau. Millions more borrowers who still have cards have been compelled to pay down their balances, or are more often choosing to use cash.

That has had a big impact on lenders’ bottom lines. Credit cards once gave the banking industry as much as a quarter of its profits; today those profits have all but vanished and lenders are seeking ways to replace them…..

HSBC mailed more than 16 million card offers to this group in the third quarter of this year, Citigroup 14 million and Discover 10 million, all roughly tenfold increases over the same period last year, according to Synovate Mail Monitor, a market research firm. Capital One’s rate rose fiftyfold, to 22 million..

The response to the card campaigns has been strong, with roughly 4 percent of these riskier borrowers submitting applications. That is about 10 times the typical response rate for the group, though that may be partly explained by the absence of offers over the last two years….

ince the mass marketing of credit cards began decades ago, lenders have waited for years to extend credit to borrowers…..who have fallen on hard times — a process sometimes called “rehabilitating the customer.” But these days, rehab is happening faster because the lenders cannot afford to wait.

This sort of impatience (”we need the profits now, damn the need to have better data”) is tantamount to undue risk-taking. It might work out OK for the banks in the end, but if so, it will be due to dumb luck rather than sound decision-making.


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