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Credit card ticket to high life and deep debt

July 13, 2009, Monday | Print Edition

THE harsh economic downturn that has chastened credit-happy consumers, along with increased scrutiny by regulators, will force card issuers to rethink their business models as the economy begins to recover.

Since bank of America first introduced credit cards in California in 1958, the industry has grown to nearly US$1 trillion in revolving credit outstanding, with more than 700 million US credit card accounts.

During the economic boom that took place between 2005 and 2008, a credit-fueled consumer-spending binge brought the US savings rate, effectively, to zero.

In may, however, that savings rate hit a 15-year high of 6.9 percent, boosted in part by one-time federal stimulus payments made to taxpayers last year.

In 2009, for the first time in the 40 years that the Federal Reserve has tracked the industry, revolving credit is expected to decline.

"even without changes in legislation, credit card companies would be changing lending patterns. They are already tightening credit and raising standards because the risk has gone up," says Wharton finance professor Nicholas Souleles.

Souleles predicts the future of the credit card industry will be shaped in large part by broad macro-economic patterns.

The current drop off in the use of credit by consumers is due in part to a tightening of credit standards by issuers stung by a default rate of up to 8 percent - double the figure for 2006.

At the same time, demand has been cut short as consumers are more reluctant to take on debt when they are uncertain about the value of their home and other assets, as well as the security of their jobs.

Credit card issuers are now in search of new models to account for changing economic realities, according to Wharton statistics professor Robert Stine.

Stine says industry players had developed elaborate credit risk models that were relatively successful until they were hit by the economic crisis and resulting changes in consumer behavior.

For example, mortgage debt was traditionally considered sacred by consumers, who made their payments even under dire financial pressure rather than risk losing their home.

But once consumers began to think of their home more as an investment, rather than a place to live and establish roots in a community, they were more willing to walk away from mortgage debt if the home's value fell near to or less than the amount of their outstanding mortgage.

The economic collapse and change of administration in Washington have led to new curbs on the credit card industry.

In may, US President Barack Obama signed legislation that prohibits issuers from imposing fees on customers who inadvertently exceed their credit allowance, and limits the fees companies can charge for late payments.

In addition, credit card companies will be able to raise rates on existing debt only if consumers have paid their bill more than 60 days late.

The law also limits marketing aimed at those under age 21. The Obama Administration is working with members of Congress to create a Consumer Financial Protection Agency, which will provide federal enforcement of the credit protections for consumers.

Souleles says it is hard to argue against much of the new consumer protection legislation because it requires greater disclosure and puts a threshold on fees.

However, the provisions that limit card companies' ability to set their own rates is trickier, because - in times of higher risk - companies may need to raise rates to remain in business and continue to lend, he adds.

Wharton finance professor David Musto notes a tension in any policy designed to address problems in consumer credit.

Concerns about predatory lending must be balanced against the problem of restricting the flow of credit to low-income people - or people who live in certain neighborhoods - who are able to make their payments and benefit from loans.

Playing games

Wharton marketing professor Stephen J. Hoch says credit card companies and savvy consumers were both playing games that have come largely to a halt with the freeze on credit expansion.

Credit card companies were able to use the fine print in contracts to draw many borrowers into escalating debt, he says.

Meanwhile, customers who paid their bills promptly each month reaped the benefit of free, short-term financing, convenient transactions and other perks, such as airline miles, at the expense of the financial institutions issuing their credit cards.

For the majority of consumers, Hoch says, credit cards are valuable because they allow people to borrow against the future. "As long as the future is brighter than the current time period, it's a rational, normal and appropriate thing to borrow. Unfortunately, people get overly optimistic - or can't do the compounding math."

Inexperienced credit card holders may have been concerned that they would not be able to carry a certain level of debt, Hoch notes. However, if a large financial institution was offering them credit, they assumed "the credit card company must know more than I do."

Credit cards are not going away anytime soon, Hoch adds. Plastic makes transaction processing faster and more convenient.

"but just as people can't use their house as a piggy bank anymore, they can't use credit cards as a piggy bank. The growth period is over, but credit cards are ubiquitous and they are not going away."

(Reproduced with permission from Knowledge@Wharton, www.knowledgeatwharton.com.cn. Trustees of the University of Pennsylvania. All rights reserved. Shanghai Daily condensed the article.)

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