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Sunday, July 28, 2013

Why so much credit?


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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