Credit card optimization and inflexibility
I’ve mentioned before the general principle that optimization creates inflexibility — in business, investing, computer programming, law and much else.
The credit card industry’s current travails offer an example. Many have written on this subject recently, many good, but usually with the leftist or moralist subtext that 30% interest rates are somehow inherently wrong, so card issuers are getting what they deserve. I’ll leave the Biblical debates to other writer. This post just talks about the relationship between steady-state profit maximization and brittleness in economic shocks.
Credit card issuers mainly make money from so-called “revolvers” — people who endlessly pay interest on high balances, too high to pay down, but never quite high enough to trigger default. The issuer’s business revolves around revolvers, endlessly optimizing to maximize cash extraction from that particular group. (Conceptually similar to the way casinos make much of their money by catering to and optimizing for “whales,” a gaming industry term for high-stakes compulsive gamblers.)
The 2005 bankruptcy reform, in force since 1/1/06, was intended as yet another credit card industry optimization. By making Chapter 13 harder to qualify for, debtors could not easily write off consumer even in bankruptcy. Instead, they were placed in repayment programs by the bankruptcy court. According to at least one reliable source, issuers responded to this by lending more freely, assuming they would always be able to collect, even in bankruptcy.
This and other optimizations were in a sense too successful: the more effectively the issuer optimizes, the closer it pushes the “revolver” to his absolute theoretical fiscal limit, the more exposed both borrower and issuer become to an economic shock.
Say you are a lender. Would you want most of your customers to be paying you 100% of their EBIT in interest payments? A residential lender would answer no. Corporate bond issuers would say “no way.” Too dangerous, no margin of safety. A one-dollar decrease in the borrower’s income would trigger default. Yet card issuers were actively seeking that 100%. They tried to control losses with higher rates and better collections, but mainly just crossed their fingers on general economic stability. That turned out to be an ill-placed hope.