By request (thanks Colleen), my predictions on what new credit card legislation will mean for earning miles and points.

It seems a rather odd time for Congress to be pushing legislation to reign in “excesses” of the credit card industry, certainly the narrative isn’t that banks are taking advantage of poor people and earning too much profit. (If that were the case, they wouldn’t be on the TARP dole.)

Certainly there are industry practices which strike many as ‘egregious’ with respect to changing fee and terms and conditions that customers may not understand.

At the same time much of the alarmism is misplaced.

It’s been a common refrain that if we take revenue away from the credit card companies in one dimension, they’re going to have to make up for it in others — spelling the end of rewards cards as we know them.

But that would seem to misunderstand the economics of rewards cards. Banks offer rewards to their better customers in exchange for charge volume. “Each dollar spent earns a mile.” The mile costs the bank money, shaving their margins on each charge, but each incremental charge earns greater revenue for the issuing bank. These cards are usually offered to individuals that are better credit risks, because assuming no default it’s hugely profitable to offer rewards. These aren’t an expense to pull back on, these are the incentives which generate incremental consumer spend, each dollar of which generates incremental profit. Banks compete for this segment of high spending customer, and ratchet up rewards to do so. If a bank is generating 1.75 cents per dollar and paying out a penny, they’re making the difference (which does involve covering costs as well but the marginal cost of an additional customer and additional charge volume are quite low).

The current credit card legislation doesn’t do anything to change that economics.

The only way it would make sense to believe that making it more costly for a credit card company to offer credit to lower income or poor credit risk customers would have any effect on the rewards offered to generally better credit risk customers is if the former were cross-subsidizing the latter. In other words, if banks were making money on bad credit risk folks paying high fees, and losing money on good credit risk folks paying low fees and earning rewards. But that’s an absurd model, because if it were true banks simply wouldn’t be offering the rewards (at a loss) in the firs place. They could kill of that customer segment and increse profits just by firing their customers. The mere fact that banks offer large bonuses to acquire this segment of customers suggests banks believe that they’re independently profitable. So we can expect banks to continue to compete for this segment of customer, offering rewards to do so.

In other words, little risk to our rewards as a result of credit card legislation.

The real risks are to the lower income or poor credit risk borrowers where the legilsation focuses on industry practices that increase interest rates in the event of detault, push out the period of time in which a customer has to pay their bill, etc. While some credit card practices may seem ham-handed, and there may be better techniques to limit risk or recoup losses (banks do continually innovate along these fronts, e.g. offering incentives and interest-forgiveness for on-time payments with certain cards), the reason these fees end practices exist in the first place is because the poor credit risk segment is a costly one to service. “Charging more interest and higher fees to the poor” isn’t at all unfair, taken in context. If a class of customers has a 15% change of default, the credit card company stands to be left holding the bag with significant unpaid balances. They need to not lose money offering credit to this segment. If they can’t take actions which their data suggests limit or recoup their losses, they can’t service the segment.

The simple expectation would be that limiting credit card practices with respect to lower income or poor credit risk boorrowers would be that credit card issuing banks limit the availability and amoutn of credit offered to these customers.

But that doesn’t limit the need for credit that these customers have. Which means their set of options are limit to other channels, credit cards take the place of payday loans — or of even less above-board and more-costly sources of credit.

The point is made incredibly crisply by an old Onion article, lamenting the way that the credit card industry is driving away customers from traditional loan sharks.

Not so long ago, the loan shark flourished, offering short-term, high-interest loans to desperate people with nowhere else to turn. Today, however, Pistone and countless others like him are being squeezed out by the major credit-card companies, which can offer money to the down-and-out at lower rates of interest and without the threat of bodily harm.

So while I’m not a fan of what Congress is trying to do, because in the end I think it’ll hurt the people it’s intended to help, I don’t fear for rewards cards as a result of this legislation.

On the other hand, rewards are at some risk for some borrowers — if those borrowers are in a customer segment that banks believe carry an increased risk of default. Card issuers are tightening standards, cards are baing cancelled or having their credit lines cut (American Express made some news recently offering to ‘buy out’ customers who were carrying balances if those balances were paid off). That’s because risk of default eats into the slim per-dollar margins on rewards-issuing cards. Awarding miles and points only makes sense when the underlying balances are going to be paid, and the issuer can accept say half of one percent of dollars charged to a card for their service.

So some cardholders’ points-earning will be at risk from the overall economy, but not as much from current legislative proposals.

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