Just In Time Lending

There is something not right about credit cards.

Have you ever sat down and really thought about how they work?

A credit card is a loan. It is linked to a piece of plastic that facilitates loan draw downs in most retail outlets and businesses world wide when you spend.

Unlike a traditional loan, a credit card loan does not require fixed repayments of either interest or principle. Instead, the customer is required to make minimum payments.   Lets assume for example that the minimum payment requirement is 2. 5% of the outstanding card balance per month.

The interest rates on credit cards, due to their unsecured nature, are usually between 10% and 25%.

The fundamental flaw with credit cards is that they enable a consumer to live beyond their means, and to avoid paying any interest until either years or decades down the track when they max out the card. Even worse, the actual maxing out is determined not by when the consumer reaches their original limit on their first card, but rather when the consumer maxes out their total position and is unable to access new funds via any new cards, balance transfers, etc.

Credit cards are the ultimate enabling device for debt addiction. I have sympathy for all addicts, because whether you want to blame the addict, the enabler, or the regulator, one way or the other all addictions result in destruction for the addict, enabler and regulator (society!). Everyone loses.

Take alcohol. If liquor-land issued credit accounts to alcoholics, what are the chances they would recoup their ‘investment’? And in actual fact, if regulators allowed this, society as a whole would pick up the costs via the cost to the health, policing, courts, social security and other systems. This is why we regulate markets – we can’t always leave it up to a free market company to decide what is right and wrong, and we as a society end up picking up the tab (consider James Hardy and asbestos). In fact free market companies often do not act in their own self interest! Consider sub-prime lending.

Credit cards are enabling debt addicts to live beyond their means without having to make any interest repayments or face reality.

If you crunch the numbers you can see that even the ideal scenario for a credit card issuing institution is disturbing and socially undesirable.

Step 1 – Maxing your first card

How much credit can you handle?

Imagine that I want to spend $2000 a month but I only earn $1000 a month. Lets assume that I put my $1000 a month net pay on my credit card. This will cover via the 2. 5% credit card standard minimum payments on a limit of up to $40,000.

You can see that under this ratio, if you put all your income onto the card and then spend from there, you can fulfill the minimum payment requirements for a card that is 3. 3 times your annual net income.

When do you pay the interest?

I have no doubt that the bank would book the interest on a credit card as income the minute they print the interest charges on the statement. However, there is no requirement for the customer to pay the interest until at the card is maxed out. And further, the bank has only made profit equal to the interest if in the future they are able to get the card completely paid out. If the consumer goes bankrupt, the bank didn’t really get the interest.

Imagine for a month, the interest is $1000 and the client has at least $1000 in available credit, and makes a $1000 payment onto the card. The customer then spends $1000 on the card. The interest has not been paid by the customer. As long as you have available credit, the interest simply accrues on the card and as long as you keep depositing money and spending, you don’t have to pay any interest until you are out of credit.

This can go on for years, depending on how much your spending exceeds your income by.

When will you max out?

Assume that the bank will give you a credit limit based on your ability to meet the minimum repayments. If you put your whole net pay on the card, maxing out even with one card is an ugly affair. But it won’t happen for quickly. The music will play for quite a long time before it stops and you have to look for a chair to sit down on.

If you ignore interest then someone who is putting $1000 per month on a card but spending $2000 per month will max out in 40 months.

If interest rates are 10% it will take 35 months.

If interest rates are 20% it will take 31 months.

This example is for someone who is spending double their income. If you had a card with 10% interest, and only spent 50% more than you earned via the card, you would last 62 months before you max out.

Remember – you don’t pay the interest out of your own money until you max out.

How bad is maxing out, really?

Maxing out is seriously bad, if the bank will lend to you based on your ability to make the minimum payment.

If you have been able to borrow 3. 3 years net income on your card, then at a rate of 10%, you will eventually have to pay 33% of your income in interest.

Now ask yourself. What is the chance of someone who has been spending 150% of their income for the last 5 years, adjusting their spending to now live on 67% of their income?

It is even worse the higher the interest rate! If you have to pay 20% interest, then 66% of your income is going to be interest payments. What do you think is the chance of getting someone who has been spending 150% of their income to now spend 34% of their income?

NOT BLOODY LIKELY!!

Now, some readers will object to my assumption above that the bank will lend you 3. 3 years income on one card.

Firstly, the exact numbers don’t matter – the point of the exercise is to examine how a credit card works and to predict whether they will lead in the future to banking profits or losses.

Secondly, this becomes a lot easier to imagine when you consider achieving those numbers via multiple cards.

And finally, 3. 3 years income on one card is not a magic number. Having one years income on one card is still bad, and will still eventually require 20% of your income to go to interest payments.

Step 2 – Beyond Maxing out – introducing multiple cards

The introduction of a competitive market place and multiple cards is the really scary part.

I mentioned before that the banks record the profit on the credit cards when they print the interest charges on your statement – even though you don’t actually have pay it; you can just keep borrowing and spending.

The only reliable way for a bank to record interest charges would be to record them when the card balance is paid to zero – but this doesnt happen in all cases.

The fact is the credit card market is extremely competitive, and every bank wants a slice of the action.

A market correction should be taking place at the point where a customer maxes out their one and only credit card.

This should mean that the customer is forced to stop living beyond their means, and is forced to start repaying the debt and interest.

However, facing reality and cutting spending from 150% of your income to 33% of your income is rarely the second step.

The second step in reality is a choice between

1) Having the bank increase the limit on your card

2) Getting a card with another bank

Both are easy and have the same effect – delay the pain. Delay reality.

As a result of the fact that the banks continue to increase credit limits, and issue cards to people without knowing how much they owe other banks, the day where the customer finally maxes out their card and faces the reality that they are completely stuffed is being pushed further and further into the future.

Do I have any stories either from my own experience or the experience of my clients to back this up? Of course I do. I’m going to leave out discussion of mortgages in this matter, because we are just discussing credit cards. But surely you can see how, if you had a mortgage that you couldn’t afford to pay, you could use credit cards to keep you going backwards without having to face reality about your mortgage and lifestyle for as long as the banks are prepared to keep increasing the limit and issuing other cards.

Due to rampant credit card fraud, which deserves another article in its own right, I won’t name names or put in exact figures. But this really happened.

A real example of credit card madness

A person I know moved to a house. At this house they started receiving mail from one of the world’s largest banks addressed to a person that never lived at the property. They reported this fraud to the bank and the police. Repeatedly.

The next year, the person responded to an online offer to get a credit card balance transfer at 4% for life – to lend to their own business as a loan – since 4% was at the time roughly equal to the rate of inflation, and therefore they considered it free money.

The bank released the balance transfer before identifying the customer. This was to the same address that the bank had been defrauded previously. The amount was large.

A year later, the bank, having just been bailed out by its government, offered to increase the credit limit by 400%, despite the fact the customer had only paid minimum payments which were very small. This new credit limit would be greater than the average Australian take home salary – and was equal to 100% of the net salary of this individual according to their previous tax returns. The customer already owed a lot of money to other banks at the time.

If this customer wanted to spend $500 a month more than they earned, even at a 20% interest rate, it will be five years before this new card was maxed out.

Does anyone really believe that this customer will not be able to get an increased credit limit within that five year window or additional card(s) to delay the day of maxing out even further?

The fact that the banks are tripping over each other to do balance transfers to increase the debt of debt addicts is irrefutable. If you are reading this on articles base. com, there are probably a whole lot of paid commercials on the right hand of your screen encouraging you to do balance transfers to “get out of debt”!

Where this is all heading

1. For addicts

This credit card circus is heading to a massive day of reckoning for both the debt addicts, and their lenders.

The addicts are going to inevitably reach a point where they will have to file for bankruptcy, because the debts will be so big it is impossible to pay them off or service them. Why on earth would someone who has been living beyond their means spend 15 years paying off their loans at 10 or 20% interest rates, when bankruptcy will wipe them out immediately and still enable them to earn enough money to live on?

2. For banks

For banks, it is sub prime all over again. But when will crunch time be? I don’t think that this problem is going to manifest at all in the next few years, unless we take action now to stop it. I think that this problem, will build over another 5-10 years and then cause mass bankruptcy and banking losses, which will get picked up by tax payers.

At this point, when the lenders and investors do their sums on the exposure and loss coming, they will dump bank stocks and stop lending to banks.

This is where the governments will step in and guarantee everything. Governments allow banks to be free-market in the good times, pay bonuses to executives etc, but they step in and bail out banks at the first sign of trouble. This is because banks are really a public good.

By the way governments don’t have any money. They redistribute money from tax payers. You are paying for all the bail outs we have already had – and you will pay for the credit card bailouts of tomorrow one way or the other.

3. For people with manageable debt

For people who are not in so deep it is a hopeless situation, there is still going to be a decade of deleveraging ahead. During the last decade the majority of people have lived beyond their means. At some point there is going to need to be a decade of repayment – a debt deleveraging decade.

How to stop it

Stopping this problem is not difficult.

My proposal is regulation.

Assuming that banks are imperfect, and that they are a public good where the tax payer picks up the tab when things fail, we should regulate to stop this problem growing.

The problem:

1) There is no restriction on how much credit card debt a bank can issue someone.

2) There is no reliable way for a bank to know how much debt (including credit cards) someone already has

3) There is no reliable way for a bank to know how much income someone really has.

Action Required:

1) Limit the amount the bank can lend

My proposal is to either make it illegal for a bank to issue more than 1 years net income to consumers via any debt instrument except mortgages & car loans, or alternatively, in the event that lending exceeds this amount, require the bank to hold the equivalent amount in Gold as a capital reserve and to forbid the bank from recognising the interest income that is being capitalised against the loan from being reported as profit.

If we don’t do this the bank could currently record unrealised paper profits on credit cards, issue more shares to the public to get more money (or borrow overseas), and then pay big dividends to their shareholders funded by the new shares issued. Everyone would think they are super profitable, and not realise how toxic the whole situation really is. Is this what is currently happening?

2) Create a national debt register via the tax office

The tax office is already setup to collect information from banks via an individuals tax file number. They are using this to report on interest income and to audit tax returns for missing interest income.

This program can, and probably already is, be expanded to report the closing balance of every loan a customer has via the customers tax file number.

The problems banks have, is that they do not have any reliable source to see what a customers real debt position is. They have to ask the customer. This is like liquorland asking an alcoholic if they are an alcoholic before they supply them with alcohol. Self diagnosis doesn’t work, and a person who is desperate to get a new loan will sign anything to get one, including a fraudulent application (remember subprime?).

If the tax office had a record of the debt position for each individual, a national debt register, an electronic system could be created to verify a consumers stated debt position with the real one. Further, the consumer will be able to get a report from the tax office system to give to a bank to show their position, and the banks can verify the report with the tax office to be sure it hasn’t been cooked.

The banks should be required by law to verify their customer’s debt position using a national debt register.

Why the tax office? This information has other uses and I would bet you that the tax office is already moving in this direction for their auditing program. They want to be able to have a computer compare someone’s spending habits against their income, to determine if an audit should take place. This can only be reliable if they know the movement in the persons debt, so they can see if the spending was funded by undeclared income, or if it was debt funded.

3) Income

The banks need to be able to reliably verify someone’s income. But whch measure of income? In reality it is the person’s disposable income that matters.

The banks need to be further regulated and forced to seek additional confirmation as to someone’s income. Filling in a form on a website, or posting a copy of a payslip is not enough.

Banks should be required by law to see someone’s tax office notice of assessment. They should be able to verify with the tax office that the information provided is authentic.

Further, the debt reporting system could potentially include minimum repayment obligations, and help a bank work out what someone’s real disposable income is after meeting their pre-existing payment obligations.

Of course, as discussed, in reality, credit cards would create confusion because in effect, they don’t actually require any repayments until you are so maxed out that no one is prepared to increase your limits or issue new cards. And no one really knows when that point is.

Conclusion

Our credit card system is fundamentally flawed.

In effect, a debt addict does not have to make any repayments until their cards are completely maxed out and they can not get any more limit increases or new cards.

We need to urgently put a cap on how much credit card debt a bank can issue to one person.

We have a chance now to limit the losses that banks are going to incur as a result of the defective product structure and regulatory environment.

The amount of the loss that is coming is increasing every day.

The sooner we take action to end this madness, the smaller the bill that the tax payer is going to pick up.