In the past two weeks I’ve received 11 offers to open up a
line of credit at almost all of the big banks in the country. Each one offering similar benefits including
low initial APR, high credit limit ($5k plus), and no annual fee. Very flattering yes, but why would I be
offered a combine $50-75k in credit in two weeks? If I were interested in committing financial
genocide, I would fill out those applications, mail them in, and be a proud
owner of 11 new lines of credit in less than a week. I would then go out and buy an ungodly amount
of stuff. Not necessities, just
stuff. Necessities are affordable, but
it’s just “stuff” that puts us in debt.
And then at the end of the month, I would not be able to pay the
balance, probably not even the minimum payment, and ignore the problem. With that decision, I’ve executed the unofficial
goal of all of these letters. I’ve now
violated the initial terms and will be subjected to high amounts of interest
payments to each bank, each month, until I declare bankruptcy. A business plan formulated by the banks to
maximize profits.
Good news everyone, I’m just going to throw away all of
these offers. This is troubling
though. What possibly qualifies me for
all of this credit? I’m 25 years old and
have student loans. I make a good living
for myself, but I’m well aware of my financial limits and how much I can and cannot
spend. So the question is, what’s the
thought process for issuing credit to consumers? What is the consumer’s incentive to
borrow? What is the bank’s incentive to
lend? And are these incentives properly
aligned?
Let’s tackle each question at a time.
What is the
consumer’s incentive to borrow?
What do we borrow money for? Houses, cars, and tuition are the big ticket
items. You borrow to buy a house because
of the understood benefit of owning a home.
It’s assumed that there is value there and that rate of return on the
appreciation of the home will surpass the cost of borrow the funds to acquire
the home. A car is a necessity, you do
what you have to do to purchase one. How
much you spend on it, should be based on your income and what you can afford. Student loans are a byproduct of course from
going to college. Tuition increases
every year, and you borrow to go to school in hopes of attaining a job after
you graduate.
Regardless of the item that you are purchasing on credit,
the incentive is that there is a demand to purchase that item. Without credit, your demand can not be
realized.
What is the bank’s incentive to lend?
The bank’s incentive is simple, to make money. Fundamentally banking institutions are pretty
simple to understand. They make money
off of the spread. The spread is the
difference between the rate they charge on their loans and the rate they pay
out on their investments.
So not only is the bank’s incentive to make money, but the
real incentive is to maximize profits.
Maximize profits by maximizing the spread. Maximize the spread, by increasing the rate
they lend at.
Are these incentives properly aligned?
Well, let’s look at this.
The consumer’s incentive is to borrow so you can consume. The bank’s incentive is to maximize profits
through the spread. So, the bank is
willing to lend assuming the consumer is willing to continue borrowing. You are not going to buy a house every day,
or a car, or go to school over and over again.
But you will borrow for day to day consumption. So the day to day consumption is what the
banks will focus on to maximize their spread.
This better explains why I have 11 offers to open a line of credit.
Income inequality is at an all time high, yet consumption is
increasing. The only reason this is
occurring is through an increase in debt.
Wages are not increasing, yet businesses are willing to lend more to
people. This structural flaw is leading
to the destruction of the lower and middle class and a market failure that
could lead to the fall of capitalism in modern society.
Which avenue leads to a solution?
This is a tough question, because it forces you to consider
two very disturbing questions. Are
consumers too dumb to know what is best for them? Or are banks too greedy to change?
Legislation would have to tailor to one of the two, but not
both. I’m a firm believer that banks are
only as greedy or unethical as they are allowed to be. There are more checks and balances for banks
to operate in than we think. There is a
lot of regulation geared at keeping the banks operating w/in their constraints. Tightening the constraints would mean they
could not partake in a majority of the business that they are engaged in currently.
So are consumers too dumb to change? Most importantly, are we willing to let the
negligence of the few effect the prosperity of all? This is where we have failed. We give the consumer too many opportunities
to make bad decisions. Bad decisions
with some pretty terrible consequences.
People will succumb to temptation eventually.
Think about when you went to orientation for college. You took a tour, found your dorm room, met
friends, but there were also products being marketed. There was most likely a few stands with
applications for credit cards. Fill out
the app and get a free tee shirt, or a backpack, or a hat. CC companies at that moment are preying on
the uninformed and taking advantage of the fact you just turned 18 and are on
your own. They are banking that you open
up that credit card. Universities get
kick backs for allowing them to operate as well. In some cases, the payout is 8 figures.
So we are being brought up in a system in which
opportunities to make poor financial decisions are all around us. The temptation doesn’t get to everyone, but
it gets to enough. The end result is
before you turn 30, you are buried in debt.
Cars, student loans, credit cards all of this totaled up equaling a six
figure debt amount for most young people.
Right then and there, the middle class is eroding. This is why the rich get richer and the poor
get poorer.
The avenue to a solution has to be tailored around
protecting consumers from themselves by tightening the constraints in which
banks can operate.
Solution
This battle has to be won on two fronts. You have to regulate banks to limit the
capacity in which they can operate and you have to educate our youth on
financial responsibility.
Regulation of banks
Our current system is set up to maximize credit issued to
the public. Retail banks are the face of
this movement, but there are ruling parties behind the scenes that help
facilitate. Retail banks have
constraints they have to abide by. They have
to keep a certain % of their deposits in cash which means they have to keep a
certain % of their loan portfolio in cash.
So a bank cannot just issue endless loans, because they would be
violating that constraint. To get around
this, banks sell off their loan portfolios at a slight margin to 3rd
parties who then bundle up loans and sell to investors. Face value, it seems to work well. It allows the system to work, meaning banks
can continue to issue credit to the public because they are getting the loans
off of their books and then investors get to benefit from the return the
bundled security offers. It seems to
work, right? The truth of the matter is
that it worked too well. There seemed to
be an endless market for these bundled up investments which incentivized the
banks to issue an endless amount of loans.
There lies the issue. Banks
issued loans to whomever, because they knew they could sell the loans and get
them off of their books.
So what needs to happen is this process has to change. Banks must be regulated to ensure that the
only debt they can sell to Wall Street is AAA+ rated. They must keep all of the investments rated at
below AAA+ on their books. They must
bear the risk if they are willing to lend to riskier clients. This will stifle the industry and lead to
stricter scrutiny on who can and cannot get access to credit.
Part two needs to be focused towards credit card
companies. There needs to be a
standardized method of issuing lines of credit to consumers that takes into
account the ability to pay the debt. It
would resemble something similar to your application to obtain a mortgage. The poor and the young cannot be exploited
like they are now. CC companies cannot
market their products on college campuses, and they shouldn’t be mailing a 25
year old offer after offer after offer to sign up for a card.
Education on Financial Responsibility
We all need the tools to make the right decisions. This is hopefully taught at home, but if it
isn’t then it needs to be taught in schools.
Financial Responsibility classes should be taught in all public and
private institutions. Everyone will
benefit from some more info, and chances are you will be preparing future
generations to not repeat the mistakes of the past.
Final Thoughts
This country lives under a fallacy that we are wealthy and a
façade that our house is in order. Our
wealth is temporary and time stamped until the creditor comes knocking on the
door. Credit can allow an economy to flourish
and grow, but too much credit can destroy it.
What we are learning is that all types of credit can be volatile, not
just mortgages.
40-50% of corporate profits are from the financial
sector. We need to cut our losses and
fix the system. In the short term the
economy would suffer, but if anything it would bring us back to earth. We can then look to see where we really are
as a country, and then make necessary changes to ensure long term sustainable
growth. Opening up our eyes and
acknowledging the problem is the only way we can secure prosperity for the
future. Let’s change the constraints in
which we operate, and place the necessary measures to see the income inequality
improve to a sustainable level.
On a side note, I noticed something interesting on two of
the offers. The spelling of my name was
Brian L. Faust and not Brian C. Faust. The
only organization that spelled my name wrong is the University of Pittsburgh. Scary thought that a public institution is
giving away information on its graduates to credit card companies. Just imagine what the payout was for that
info…
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