Thursday, July 29, 2010

Elizabeth Warren and Credit Crunches

Mike Konczal takes exception to my post over at e21 on the impact of 2009 credit card reform. There, I tried to argue that restrictions on credit hurt consumers in several ways, and this will be worth bearing in mind as we get a new Consumer Protection Agency (potentially headed by Elizabeth Warren).

Konczal makes a number of points:

1) The law was going into effect anyway. He argues from a Reuters piece that the new law merely enforces changes that the Fed had already planned on.

This goes against everything I’ve read on the bill so far, and I can’t seem to find any other corroborating evidence. It looks like the Democrats made a previous attempt to pass the bill in the House, and succeeded, but it took until after the election to get legislation through both houses.

Certainly, this seems to be the general assumption among both liberals and conservatives at the time—that this is a sizable change to the status quo, and will affect credit cards (either in a good or bad way). For instance, the Reuters article goes on to tell us:
Banks have repeatedly warned higher interest rates are likely to result because it will be more difficult to set rates based on the risk that customers pose. The higher rates mean less credit available for consumers, they say…

Banks may also reduce credit limits, or make it harder to obtain card-affiliated rewards, Arnold said. And others may return to charging an annual fee, now charged by only one in five cards, he said.
All sorts of other media reports (for instance, see here and here) have argued this is an ongoing issue. None of this proves that the bill is to blame, of course. But everyone seems to regard the passage of the bill as a new thing, and plenty of people seem to think that banks did change their behavior afterwards in response to the bill’s passage. Even if the bill did nothing new--people only became aware of the consequences afterwards, that's when you expect to see a change.

2) Credit card rates aren’t rationally set anyway. The big piece of evidence here seems to be that credit card rates tend to rise quickly after you miss a payment (the bill really tackled this issue by making it much more difficult for companies to raise your rates arbitrarily).

I think commentor “Mike” raised a good point on this, that Mike (Konczal) also mentions in his initial post. One reason that companies are so quick to raise rates on delinquent card-owners is because it sends a strong signal about the future ability of borrowers to make payments. Perhaps I’ve hit a shock, or who knows what else. The easy thing to go is to call in that payment right away. Credit card companies don’t really have a chance to burrow into the full aspects of a consumer’s finances, and payment choices are the big piece of information they have to go on.

I think there are several parallels in other parts of finance. For instance, suppose I’m an Investment Bank with plenty of repos outstanding. The moment I hit a little bit of a rough patch—my creditors immediately come knocking and take away my funding (potentially making a crisis more likely). Gary Gorton has referred to this a transition when loans change from being information-insensitive to being information-sensitive—and I think there are some parallels here.

You can say that relying on short-term funding if you’re a bank (or credit cards if you’re a household) is a horrible idea, because it involves taking on credit that can withdraw so quickly. Generally, I would agree. But while banks have the option of opting for longer-term credit (and choose not to take it), often these sorts of unsecured loans are the only way people have to cope with unexpected shocks (including medical charges, as Mike refers us to).

Now, it’s perhaps true that the degree of price hiking is greater than a simple model would predict. This no doubt reflects some degree of borrower inattention combined with creditor market power. But it’s consistent with credit card companies adopting a broadly rational pricing structure, which will respond within broader legal constraints. A monopolist may charge outrageous prices to begin with, but will still raise them when taxes rise.

So think of what it does for a simple credit card financing model. In the past, companies could tell apart good and bad risk individuals, based on their pattern of delinquencies, and charge higher rates to the high risk folks. Now, they have to charge rates uniformly across the pools. It doesn’t take extreme rationality assumptions to think that banks will now raise rates on both groups, to recoup the lost profits from discrimination. This is, again, what news report after news report argues to be the case.

Now, if Konczal wants to argue that a more egalitarian approach to credit risk is preferable, and the impacts of the law are good—I think that’s a perfectly defensible position to take. Though I’m inclined to favor Matt Yglesias’ point that it’s better to let competitive businesses charge as they like and make up for distributional effects through the tax code. The particular timing of the law—taking effect as it did in the middle of a huge downturn—is potentially another large concern. Given the importance of revolving credit for the payments system, the bill plausibly had a contractionary effect by discouraging spending in general. This really was the point I was trying to make: not that the law was "bad" (though I think that is the case); but that it involved a set of tradeoffs that people didn't quite realize.

3) Other things are to blame. I’ll be the first to agree that many things are going on here (of course, if one believes that higher credit card defaults result in higher rates, you probably believe that rates are being set in some sort of reasonable fashion). What drew my eye here was the fact that rates were completely flat before the law, and only took off after the bill passed, while presumably card delinquencies were rising throughout the period. Auto loans probably had a spike in defaults as well, and also did not receive any assistance from the Fed, while seeing stagnant rates. Of course, this graph is merely suggestive rather than causal in nature.
But I also mentioned other evidence Konczal doesn’t touch. From the mouth of JP Morgan’s CEO:
In the future, we no longer will be offering credit cards to approximately 15% of the customers to whom we currently offer them. This is mostly because we deem them too risky in light of new regulations restricting our ability to make adjustments over time as the client’s risk profile changes.

We reduced limits on credit lines, and we canceled credit cards for customers who had not done business with us over an extended period.

In fact, the industry as a whole reduced limits from a peak of $4.7 trillion to $3.3 trillion. While we believe this was proper action to protect both consumers and card issuers, doing so in the midst of a recession did reduce a source of liquidity for some people.
I don't put too much stock on the self-serving arguments of executives, especially ones that work for JP Morgan, but it's certainly suggestive. And though I did not post on this, there is certainly information out there backing up the idea that credit limits plunged during this time period—again, with a pattern around the date of the bill’s passage.

Figuring out the effects of law changes is tough. Warren suggests how we can do so without being ideologues:
I finally filled in the blanks, suggesting some empirical tests–ticket prices for companies that do/don’t use such clauses, changes in pricing before/after such clauses are used, evaulation of whether cost is large enough to be reflected in price, etc.
I think my analysis so far has focused on exactly these sorts of tests, noting that I have limited information and other things are going on. Konczal, of course, has responded with little new data of his own.

1 comment:

Chris Powers said...

Arpit, just wanted to let you know that I was reading the Rortybomb blog and saw him give you a shout out. Pretty Cool. Hope all is well.

From the land of MaiDangLao,

Chris Powers