02/12/2009
CQ Congressional Testimony

Statement of Lawrence M. Ausubel Professor of Economics (Behavioral & Social Sciences) University of Maryland

Good morning, Chairman Dodd, Ranking Member Shelby, and members of the Committee, and thank you for inviting me here. My name is Lawrence Ausubel, and I am a Professor of Economics at the University of Maryland.

One of the main issues we are discussing today concerns what consumer advocates call "penalty interest rates," but the industry refers to as "risk-based pricing." Consumer advocates assert that when the typical issuer raises the credit card interest rate by 12 to 15% following a late payment, this is penalty pricing intended to take revenues from their most vulnerable customers. However, industry representatives respond that consumers who miss payments are the most likely to eventually default, and all they are doing is requiring the riskiest consumers to shoulder their true cost. As the author of the most-cited article on credit cards in the economics literature, I have been eager to determine which characterization is more accurate. The consumer view would justify legislation such as the Dodd bill; while the industry view would suggest that such rules are misplaced. Unfortunately, the data necessary to answer this question is typically kept confidential within the confines of the largest issuers. However, the industry recently produced a report which, I suspect inadvertently, enables the researcher to obtain answers which are nearly definitive.

In October 2008, Morrison & Foerster LLP issued a data study in response to the then proposed rulemaking by the Federal Reserve Board to amend Regulation Z with respect to credit cards. Their data study purports to collect proprietary account-level data representing 70% of the credit-card industry's outstanding balances. It considers various delinquency events, for example, going 16-30 days past due, or going 3-or-more-days past due on two separate occasions; and it reports the percentage of these consumers who ultimately go 90 days past due or bankrupt. Using their reported numbers, I was able to perform simple back-of-the- envelope calculations that enable me to reach the conclusion that the increases in interest rates bear no reasonable relation to default risk, i.e. these are penalty interest rates that demand regulation.

Two Sample Calculations

First, consider the May 2006 cohort of accounts in the MoFo (2008) study.1 9.3% of the accounts that were current in May 2006 went 90 days past due or bankrupt in the following 22 months. By comparison, 20.7% of the accounts that were 16-30 days late in May 2006 went 90 days past due or bankrupt in the following 22 months. Converting these loss rates into annual rates2 of net credit losses,3 we find that the increased probability of loss per year is: (12 / 22) - (20.7% - 11.3%) / 1.39 = 4.47% An overly literal interpretation of risk-based pricing (but see below) would say that these consumers merited an increase in their interest rate of 4.47%. By way of contrast, the standard repricing in the market today is a 12% to 15% increase in interest rate. By any standards, these are penalties, not risk- based pricing.

Second, consider the April 2007 cohort of accounts. 4.5% of the accounts that were current in April 2007 went 90 days past due or bankrupt in the following 11 months. By comparison, 11.5% of the accounts that went 3-or-more-days past due on two separate occasions subsequently went 90 days past due or bankrupt in the same period. Converting these loss rates into annual rates4 of net credit losses,5 we find that the increased probability of loss per year is: (12 / 11) (11.5% - 4.5%) / 1.39 = 5.5% An overly literal interpretation of risk-based pricing (again see below) would say that these consumers merited an increase in their interest rate of 5.5%. By way of contrast, the standard repricing in the market today is a 12% to 15% increase in interest rate. By any standards, these are penalties, not risk- based pricing.

What we have just seen quite clearly is that the penalties imposed on consumers are at least double or triple the enhanced credit losses attributable to these consumers. Moreover, the calculations that I have just performed are overly generous to the industry, in several respects: (1) To be more than fair, I selected 16-30 days late as my selection criterion. Many banks use a short trigger, and using a shorter trigger such as 5 days late would obviously produce more lopsided and egregious results. (2) My calculations ignored late fees, which are typically $39 today and with availability of data would clearly be included. Inclusion of late fees would obviously produce more lopsided and egregious results. (3) It is unclear whether Morrison & Foerster is using the relevant selection criterion. Morrison & Foerster looks at "account 16-30 days late." One can argue reasonably persuasively that it would be more relevant to condition on "account 16-30 days late but account becomes current before day 31." After all, if the cardholder fails to become current before day 31, the lender would still be able to increase the rate under a 30-day rule. Since becoming current is good news, this must imply lower loss rates.

At the end of the day, the economic conclusion is inescapable that these are penalty interest rates, based not on the cost to the banks but on demand factors. Observe that the demand of consumers who face penalty rates is rather inelastic; they are often borrowed up, distressed, and have diminished alternative borrowing opportunities. Thus, setting penalties according to demand factors means charging what the market will bear which, in the absence of regulation, apparently is a 12 to 15% penalty rate, applied retroactively.

Current Economic Crisis

It is important to emphasize that a retroactive rate increase for distressed consumers is precisely the opposite policy prescription that we apply in other areas of lending. For example, there is a growing consensus today that, in the mortgage area, loan modifications are needed (i.e. reductions in principal and/or the interest rate). Why do credit card issuers unilaterally adjust interest rates upward, when lenders as a group might benefit from downward adjustment? This occurs because credit-card lenders face a common-pool problem, a prisoner's dilemma problem. While lower interest rates by the group of lenders would reduce the likelihood of bankruptcy and increase eventual collections, each lender individually has the incentive to grab as much money as possible prior to bankruptcy. Professor Amanda Dawsey, of the University of Montana, and I have research showing that a consumer with debts of $5,000 to each of four lenders is more likely to default than a consumer with a debt of $20,000 to a single lender. The current legality of "universal default" and "any time, any reason" clauses exacerbates the prisoner's dilemma problem.

In short, economic analysis of recent data supports stricter regulation of the credit card industry, particularly with respect to penalty interest rates imposed on existing balances. Regretably, the Fed has taken some action in this area, but the effective date of the new regulations is July 1, 2010. The current economic crisis makes it all the more urgent that Congress adopt the Dodd bill sooner.