Ok Washington
crowd, here is a quick lesson on how credit card rates should work. Looking at
rates and knowing the Fed Target Rate is not merely an oversimplification, it
ignores the reality of the business. Sure there are villains to be exposed,
incarcerated or fined. Unfortunately, our elected officials are once again leaning
towards throwing the baby out with the bath water.
Step one is factoring
the cost of money which is quite low right now. Step two is calculating a fair
profit (yes I will come back to this topic). Step three is the administration of
lending. This includes the time value of money paid to merchants until the
credit card company collects. Step four is client acquisition costs such as
advertising, mailings etc and maintenance such as statements and customer
service. You get the picture.
Best
practices for everything above have been published by Visa (NYSE: V) and
MasterCard (NYSE: MA) plus American Express (NYSE: AXP) and Discover (NYSE:
DFS).
The next and
most important factor is risk. In fact risk and a fair profit are the only two
real variables which happen to be intertwined. Selling and G&A expenses are
pretty well defined.
Risk is
something that those of us on any side of Wall Street work with daily. The
basic premise is that the more risk a firm takes on, the higher the potential
reward. One risk is late payment. This
is handled by the assumption that money is either being borrowed, or that the
credit card holder is having trouble meeting the obligation. In the old days,
American Express only issued charge cards, meaning there was no credit. The
card holder was expected to pay in full upon receipt. There was gold in those
hills of issuing credit, and AXP joined the banks in providing credit to its
customers.
Let’s get
back to risk. Investors provide financial institutions money to put to work / invest
for them. If we are talking about JP Morgan (NYSE: JPM) or Citibank (NYSE: C),
there are many ways of putting money to work. Specifically with credit card
issuance, risk measurement is a key factor in calculating the appropriate interest
rate charged and should have no correlation to Fed Fund Rate or LIBOR.
Now banks are
not in the business of communicating risk in their presentations to customers.
The reality of the situation is that banks do communicate risk to their
customers really well. They speak loudly and clearly through the interest rate
offered each customer, individuals, small businesses or other entities. Banks
make an assessment of every potential customer classifying each person into one
of many buckets. Each bucket is parsed by income, total liabilities and payment
history. From there a risk level is assigned and an interest rate is ultimately
presented.
No one is
making people sign up, use the cards or not pay their bills on time. Firms that
charge erroneous and egregious fees should be prosecuted. The card issuers
doing their job, making a living and returning money to shareholders should not
be vilified or prohibited from providing an essential global service. I am
hoping this does not further restrain consumer spending.
Disclosure:
Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company.
Through various equity strategies under his supervision he is currently long (MA),
(DFS) and (JPM).
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