This Is Why Credit Card Interest Rates Are So High

23:26I remember talking to Lending Club about this back when they were a thing. They were spending so much money on mail advertisements. And I just don't get why that's the primary acquisition channel and why it seems to be so important to the business model? It's a really interesting question. Maybe the answer would be like, people listening to this would be like, oh, I knew that, which is the reason you do it because it works, which means, which by wish, I mean, this goes back to Joe's question. I think you can see, we do this analysis there, that if you spend more on operating expenses, which I think largely means additional marketing, because the actual operational side of this apparently is very expensive, but there's big differences across these guys in operating expenses.

24:08And I don't think it's because their systems are like much more. And we actually see no relation between that and default. So it's once you control for FICO. So it's not about screening people for better borrowers. But what it is, it's an effective, apparently at the margin, customer acquisition strategy. So think the following thought process. You could say, well, why don't somebody just cut all this marketing out and just charge a lower rate and that'll get people. Yeah, that's your acquisition advertising, right? But apparently it doesn't work. So people are not rate sensitive, which is a recurring theme I'm starting to learn when we talk about banks and bank deposit rates.

24:44People are not completely insensitive, obviously, but they're not that sensitive to the rates they get paid and they're not that sensitive to the rates they get charged on this. So there are actually, this is a surprising thing, the CFPB has a spreadsheet. Well, when there are people still working there, they used to have a spreadsheet that they updated with essentially every single card there is. and what the rate on it. And all the cheapest cards are credit unions. And they're significantly cheaper, much cheaper than your average credit card. But I'm sure almost nobody except their customers have heard about them.

25:14And that's because they don't advertise much. And so you say, well, if their rates are so cheap, why don't people go there? It's like they haven't heard about them and they don't care that much about the rate is my inference from this. So the more you pay for marketing and operating expenses in the data, the higher is the average amount you're able to charge people. Yeah, that's really funny. Does some of this stuff repel the brain of the academic economist? No, for real. Like this idea that the borrower wouldn't be rate sensitive, the idea that we're actually paying more to be advertised to, et cetera, because this is their cost.

25:46The idea that there are lower cost options out there and all we have to do is search for them and they're available. Like, well, also for macroeconomists specifically, right, because we talk about benchmark rates and the importance of how those feed into the economy. And here we are talking about the credit card rate, which is actually potentially more. Yeah. Like, I'm serious, though, like rates are high because to some extent consumers just aren't paying attention to them, etc. Do you encounter people who think no, there must be something there must be some variable you're missing because we're rational and we would seek out the lower rate?

26:18I want to talk to people like you're saying. I haven't really had the chance because, you know, when you pitch this to a finance audience, not macro people. and I am a finance president, then they're more open. I mean, credit cards is the thing in finance. People like credit cards. But I think the interaction with macro and monetary is really interesting. So it doesn't bother me because I think it's interesting. I mean, I think it's kind of bad that a lot of people who are usually not in the best shape are essentially adding 6 % rate to their credit card because they're paying for the advertising that they responded to.

26:49But, you know, that's, you know, you could get it if you didn't respond to the advertising responded to the rate, they would do that instead, but they don't. So, you know, think about, you know, you guys often talk about the Fed lowering or hiking rates. At the risk of sounding heretical here, I am not a huge believer that consumers at all are very sensitive to these changes in the policy rate and the Fed funds rate, even though the standard model works through their intertemporal consumption savings decision. I think most of the evidence is very weak that they care about that. And then the credit card, I think, on top of that really makes this clear, because if you're paying 23%, and you are the kind of person that wants to borrow, I mean, obviously, because you've borrowed, how much is a half a percent going to matter to you if the Fed hikes?

27:34Plus, you could have been getting a much cheaper rate anyway, and that didn't compel you to go looking for it. So I think it kind of puts a big question mark over whether that's really the channel, which is a lot of people have said that, but it's still kind of the main way we talk about those things. Can we talk a little bit more about competition? And why doesn't someone just come in with a lower rate and disrupt the entire business? Let's give you another example, personal lines of credit. These were all new things to me. I find this, I think where you've put retail people with the financial sector, you actually get a lot of explosions.

28:07They're like weird stuff. So that's the place where sort of academics should go looking and many do, but it's not the place where I kind of having worked at like hedge fund market maker ever thought about these things. You don't think about like the fancy people, like the people who are sophisticated, do all the math, but they kind of cancel each other out. Where the real fireworks are is when you get into the retail sector. And if you look at personal lines of credit from the same companies at the same FICO, they're substantially cheaper. Plus you get all the money up front. There's something I, it's still very puzzling that there is almost no marketing there.

28:37You don't get marketed a lot on personal lines of credit. And the people who discover them do use them to consolidate these debts and pay them off in one shot at a lower interest. It's a very, I think, very logical thing to do that people don't do. But I mean, just to get back to, I think we see over and over, and you're talking about BNPL and stuff, this idea of how do you acquire customers and what role the rate actually has there is, I just keep seeing it. It's like a movie. I've seen this before. It's more effective at the margin than lowering the rates. And it explains a lot, I think, of how the finance sector interacts with retail, which is not just like canceling out.

29:15So that's the issue. It's like, oh, well, they spend 5 % of assets on marketing, then they add 5 % to the cost. I guess there's no harm in that. Well, not really, because what people have done is paid the 5 % in order to get the marketing. So if you really like the commercials, you should be really happy, but I don't think most people would sign up for that.

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31:57Maybe I should be looking at it. On the disruption front, You mentioned BNPL, and we've done at least one episode on it. We should probably do more at some point. Is that the big disruptor? You know, if they're plugged into websites and some of them are getting rewarded for being plugged into those websites by retailers, then they bypass the high acquisition costs and presumably can still acquire customers because you see them everywhere online. So I do think that has a lot to do with what their angle is, is it gets in front of you in that way. I listened to a recent episode of yours. I think you guys were talking about BNPL.

32:35I assume I wasn't going back into a much earlier episode. But I don't think the economics of the BNPL beyond that aspect of it are that different from the credit cards. And there still is a very high operating and acquisition cost. If you look at BNPL companies, first, most of them don't really make money. And so I think they're still in that stage where they're building up to it. And you mentioned Lending Club. Lending Club didn't make money. No, no, it did not. It didn't. So because I think you want to grab these juicy customers, but they respond to the marketing. And just to go even back to that.

33:07So Amex is one of it's really hard to find aggregate marketing numbers across companies. But from lists I've seen, Amex might even be it's definitely, I think, a top 10 marketer in the whole country. It might even be in top five. I'm not sure. Along with some of the it spends over six billion dollars a year on marketing. And this is not including the lounges and all this which there's been like articles about how everybody's like investing like millions of dollars in these lines that's that's a separate category and capital one spends over four billion dollars a year so i looked it up and amex is bigger than nike and coke and marketing and you think of like those being the ones that are got to be like the gigantic ones and capital one's about as big wait uh a personal line of credit yeah that's just a good classic what is that product?

33:51I've never looked into one of those. Is that an unsecured loan from a bank? It's an unsecured loan. But this is just like classic bank borrowing. I go to the bank, I say, can I borrow some money? Surprisingly, you can look it up even like, it's so easy to look it up. It's a relatively large amount compared to a credit card. And you put in your FICO, they give you a rate. The rate's almost for sure always lower than the credit card. I don't get it either. But, you know, I, you know. And one could use these to pay off involving. That's mostly what people do, which they should. I had a journalist ask me about this and I was like, this is a great idea.

34:28Like, I should look this up and talk about this. I mean, there's no, you know, how do you explain this spread? I mean, I think largely it's got a lot of this, less of this retail focus to it. But yeah, it's the same companies too. If you go to Amex, you can Amex line of credit. Discover offers a Discover line of credit. Capital One, Capital One line of credit. It's the same thing. It's so strange. This whole conversation, it edges into some, frankly, like slightly uncomfortable territory, in my opinion, because you, right, because especially when you characterize something as like, you're kind of end up paying a lot for them to advertise to you.

35:02And you apparently like the advertisement because that's you responded to it, etc. Like you edge into this territory where it's like, these are not like it must be not the most sophisticated base. Right. It's like, why do Nigerian email scams have all kinds of typos, et cetera? And the theory is because they want to select for people who will be foolish enough to respond to them. Because if you go down the chain, they don't want you to be too savvy in asking questions. So let's just get all the savvy customers out of the way who would instantly recognize a scam email. And then you get there. Are you saying that the Nigerian princes don't pay you?

35:40I think I might be in trouble. It seems like there's a filtration process going on where you end up with the base of revolvers where all this money is made, who are just clearly not that financially savvy because otherwise they would be doing the personal line of credit or not doing these things or looking for that credit union credit card. Well, I'll say something about marketing. I mean, we all do respond. I know you guys are very not elitist here, very anti-elitist. So marketing is just a huge industry. is as a finance person, I'm like, we do have a marketing department at the business school.

36:13And I'm like, wow, there's a reason. Because you look at, let's say you look at Alphabet and Meta. Meta's revenues are almost 100 % from marketing. And Google's are like close to 80%. We're talking hundreds of billions of dollars a year and all the very sophisticated stuff. And at the end, it's to sell you advertising. It works, it works. And I've certainly been taken, I get taken in my marketing all the time. I'll just say one other thing is, I think the reason that because the ROAs here are high, when we decompose this at the end, it sort of does most, if you take the alpha of this, think of this as alpha relative to the average bank asset, we get that it's about a percent.

36:51So how do you get down to a percent? So the risk premium here is quite big. We compare it to the risk premium on bonds. You have to compare it to high yield corporate bonds. And it looks similar for all but the lowest FICO bonds versus, let's say, triple C rated bonds, where the lowest FICO seems to have a big chunk, the risk premium over and above the bonds. I'd actually see the bonds look a little low relative to that because it's the risk premium on credit cards that kind of rises linearly and it's the bonds that kind of don't. But for the not so bad credits, it's pretty similar risk premium to high yield bond markets.

37:22So NetSense doesn't look, it's big, but it doesn't look crazy. But I should say, you know, Goldman, I think they, when they got it before they got into credit cards and it did not work out, apparently it is competitive in that sense. I think they were eyeing this and saying, this is a good business. You see the highest ROEs by far of all the, you know, if you go look through the banks, 10Ks, you know, some of them break this out. I think JP Morgan, for example. And you see like that's got the highest ROE by far that it's bigger than the, you know, all the other parts of the bank. So I think they were thinking that and I got into it.

37:50They paid very high operating costs and had higher defaults than other ones. It didn't obviously did not work out because they turned away from it. Do you see any signs of rates eventually coming down? It sounds like it's probably not going to be through competition or new entrance like fintechs, but could it be something like regulation? I have vague memories of the Credit Card Act doing something on this front, but could it be something like that? The Credit Card Act, there were tons of papers on it when it came out, mostly limited your ability to increase rates on existing borrowing. OK. And it sort of put caps on all kinds of fees and charges.

38:25and then people were looking for whether banks would move that to something else. I think in the long run, the answer is yes. I don't know if they moved that or it's just something else. But I mean, so far rates, if you could just plot it on Fred, even though I think it's like a little bit distorted, it's been going up and up. I mean, before it starts going down, it's got to stop going up. So they're in a pretty strong position. But there is this buy now, pay later. They were lending club kind of things, although they largely crashed and burned. and payments in general. I mean, these companies for payments are huge because there is, you know, it's PayPal, these guys, this is just to take off a little bit off the top of this swipe fee.

39:03And then we're going to get to the interest rates on this borrowing. I mean, I think that there is constantly like movement in this space, but it has not been to drive down, I think it's driven up acquisition costs more than just driven down the actual rates. Unrelated macro question. One of the reasons I like your work sort of revisiting some of these like basic questions, which I think is useful. And of course, when we talked to you a couple of years ago, it was like, let's revisit some of what we thought we knew about the 70s and see if that inflation story is a little bit different. Just on the big macro question, these days, rates where they are, inflation sort of persistently warm.

39:43A lot of people are like, oh, talk about our star must be therefore higher than it otherwise would have been. What do you think we've learned? You know, we had this very fast rate hiking cycle, 2021 through 2023, I would say many economists would have expected the unemployment rate to rise a lot more, given that rate hike cycle has. And I don't know, maybe spending to go down or spending to go down, et cetera. But I personally am rarely satisfied by the stories that people tell about how, in fact, those rate hikes translated into lower inflation. Have you yourself sort of learned anything interesting in the last, I don't know, three or four years, five years of this macro experiment that we have post pandemic?

40:20I think this is a great topic and question. My inference was that the cycle, I'm in the group that thought that this was largely a supply shock issue, that COVID disrupted supply chains tremendously. I mean, we saw that. And I think if you look like the New York Fed has this index that they put together on supply disruptions, this predicted the trajectory of inflation with the three-month lead very well. I think we had a period where we saw that there was increased employment and yet output was going down. So usually when we talk about productivity and things, there's all these compositional issues.

40:53Do you fire the least productive people? So productivity goes up for mechanical reasons. But when you have more people being employed and yet outputs going down as it did for several quarters, that can't be the reason. So I took away from it, you know, there's harsh arguments about this, that this was largely supply driven and how it relates to the seventies is our argument there for different reasons was that it was supply driven due to credit crunches and things. So I tend to think that a lot of the business cycle things and the inflations we've seen, like after wars, we're often switching the kind of production that you do, which is a supply thing.

41:27I'm very much in the supply camp. And I think the reason that employment held up and spending held up, because I don't think that this was happening through decreasing demand and getting people fired and so forth. I think it was products, components could ship again. And so people could be more productive with the labor they had. So to me, I'm sure some people very, very highly disagree. To me, that looked like a pretty clear story. So if you're Jerome Powell and you're worried about inflation going up, and I should just mention we are recording this on October 29th. Yeah. The day of the Fed decision, which is widely expected to be a cut.

42:03Right. But, you know, inflation is still, you know, somewhat warm, as Joe said. If you're worried about it, should you be looking at credit card rates versus, you know, mortgage rates or benchmark rates or things like that. How should policymakers actually think about this problem? Between those, I think mortgage rates that people do seem very much to respond to. It is a much bigger amount. Maybe they're more sophisticated, sensitive. It lasts with you for a long time. I mean, I think that's much more important, the shifts in those spreads for the macro economy than, well, the credit card rates is just not much movement.

42:39I mean, they are literally tacked on top of the Fed funds rate. So that's completely mechanical. Didn't used to be the case 30 years ago, but the spread will move one for one with the Fed funds, except when they expand it by issuing new cards and making rates higher. So I think the mortgage market is much more important for macro kind of stuff. I mean, I don't envy, you know, Powell's job. It's a very hard job now. I'm not sure. Last time I was at the Fed, I was in the elevator when he got in, but I didn't want to bug him. So I didn't say anything to him, but I got to see him in person. Jerome, our star is fake.

43:12So going back to, you know, you're talking about fintech, et cetera. I personally, like, I actually think stable coins are going to be a very big deal. I do not necessarily think they're going to be a big deal for consumer transactions. It's not obvious to me. My guess is that they'll open up new transactions that we aren't thinking of right now, but not for, like, buying coffee or buying, you know, whatever. But from your research, whether into cards, et cetera, how would that inform your or other fintech. How did that inform your thinking about the trajectory of the stablecoin industry? Yeah, stablecoin, it's interesting.

43:47And I've heard you mention this kind of view, which I think is not one I'd considered. I was thinking a lot about consumers. I'll say this. I think for me and some of the people I talked to, my co-authors, stablecoin are, they're like a puzzle in the sense that maybe not all stablecoin, but the ones that have been around are kind of like a money market fund that doesn't pay you interest that's how i would summarize them because and that's why i think these are some like the most profitable companies ever per employee because there's they don't do anything yeah so you give them a bunch of billion dollars they just take the whole interest there's some advertising there too but not a tremendous amount compared to that and people are happy with that i don't really get it but you know now they've like you mentioned, they've started to learn the sort of tricks of the trade.

44:33They're going to do rewards. It's better than paying people actual interest. You give them rewards. So from the point of view of consumers, it is kind of a mystery. I mean, I would love to start a money market fund and not pay anybody any interest. But economically, when you don't pay any interest on a dollar ever, you've taken the whole dollar. That's what the dollar does. It pays you interest. So the net present value of all the interest of a dollar is the dollar. So if they never pay you and you stay there forever. Then if they have$8 billion, they've captured$8 billion. Again, nice business if you can get it.

45:05Yeah, it's a great business. It's weird, but it's a great business. What's your next research project? So I think from this credit card stuff, there's definitely interesting things to think about, how people default and how much this marketing stuff affects them. From another point of view is one of my co-authors in here, a former student of mine, we have a bunch of work on adjustable rate mortgages and why they kind of disappeared. So they used to be a big thing and they've kind of disappeared. And I think we kind of understand why. So that's, you know, there's been a lot of discussion about that for mortgages.

45:37Why is the U.S. in one camp and many other countries in another camp? But the U.S. kind of used to be in the adjustable mortgage rate camp, at least pre-crisis and stuff. I remember when the rate hike, when we started surging, there was this popular theory that monetary policy would have more teeth in countries like Canada, Australia, the UK, because so many more households would be more sensitive to faster resets. Has that actually been borne out? It sounds great. It's like a theory intuitively that makes a lot of sense. I guess Canadian unemployment has trended higher than American, but the inflation trajectories, I think, have been roughly the same in those other Anglophone countries versus the US where they had, I don't know, like how strong effect was that?

46:23Do you know? I don't know exactly, but I don't get the impression that it was tremendously different. I think it has impacted consumers. One thing I should note though, is there's two senses in which monetary policy can have an effect. One is that it makes people have to spend a lot of money on that. So it's expensive for them. But the other one is that here, and I don't think that's the effect we were going for, but people have just stopped taking out as many mortgages and don't move. It was a negative effect. I'm just not sure it's an anti-inflationary effect. So it's like with you, if you're going to have floating rate stuff, and that's like the case with credit cards and it shouldn't affect the volume of it that much in terms of producing it, but it's kind of people, it's expensive for them.

47:04And then on the fixed rate one, they just stick to the old stuff and we don't, you know, mortgage credits really dried up in a way, but it's not affecting the existing borrowers only to the extent that you don't want to move, which is actually a big deal. Itamar Drexler, thank you so much for coming back on Odd Lot. It's always a treat. And next time you have a new report out, let's talk arms next time. Okay, great. Thank you very much for having me.

47:39Tracy, I found that conversation to be fascinating. I have to admit, like, yeah, like credit cards are the sort of black box to me in many respects. I don't really understand the business because I don't actually use them for revolving purposes or borrowing against them. I don't think I quite realized how crazy the numbers are. And I certainly knew that there was tons of advertising, including direct mail and credit cards. But the idea that this is so substantial that a big part of what people are paying for here is the advertising. That was all very novel to me. It's very surprising. My main takeaway is that people, I guess, are not rational, at least when it comes to credit cards, right?

48:16The marketing seems to work. No, totally. I'm not rational because I don't take advantage of all the points that I could. And I don't, like, optimize the way I could. And when I, like, buy a plane ticket, only part of the time do I think about is this the airline where I accumulate. Well, you could also argue that it's rational to, like, factor in the time you spend on doing this. That's how I justify all of this money left on the table by saying I'm making a rational decision not to allocate. My time is valuable. Yeah, my time is valuable. But, you know, if there are all these other borrowing products out there that are cheaper, etc., it does feel like someone must be able to come along and make a product that is less going to compete on rate or you're going to be able to borrow cheaper.

48:57I don't know. Maybe BNPL will achieve that. I don't know. I'm going to go take out a personal finance loan right now. Go for it. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Jill Weisenthal. You can follow me at The Stalwart. Follow our guest, Itamar Drexler. He's at iDrex. Follow our producers, Carmen Rodriguez at Carmen Armand, Dash O 'Bennett at Dashbot and Kale Brooks at Kale Brooks. For more Odd Lots content, go to bloomberg.com slash oddlots. We have a daily newsletter and all of our episodes.

49:26And you can chat about all of these topics 24-7 in our Discord, discord.gg slash oddlots. And if you enjoy Odd Lots, if you like it when we talk about the very profitable business of credit cards, then please leave us a review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber and you enjoy getting benefits and rewards, then please check out the Bloomberg channel on Apple Podcasts. You could listen to all of our episodes absolutely ad-free. Just find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening. Thank you.

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51:11But today, we're not giving out our usual advice. Our producer Riley says we're giving something else. So what are we doing today, Riley? Today we're playing a little game. Oh, I love games. A game, says the man. How about special gifts for you guys from eBay? Each one picks with one of you in mind. Yeah, Dakota, if you want to guess who that one's for. All right, there is a gift at my feet. Open that thing. And now it is in my hands. Whoa! I feel like it's got to be our resident gamer, Keon. This is the rectangle of childhood. It's a portable game console. I used to have this as a kid. This game console, I used to play all the time.

51:43And you know, when your mom came into the room when you were a kid and you're pretending to sleep? Yeah, yeah, yeah. But Riley, what a thoughtful gift. Yeah, Riley. Thank you so much. Riley, you're crushing it. But we have one more gift. Yeah, we got another one. Let's open it. Let's open it. Boom. Oh, camera. Yeah. An old-timey camera. That's right. The classic. This is awesome. Because you know how I love to take pictures on my travels. Yeah, you're always somewhere. Whether it's in Kyrgyzstan with some nomads or just New York, you know, with a nice little piece of trash or a rat. Nice little picture.

52:14Taking pictures with the birds. So, Riley, you got all this from eBay? Dude, eBay. It was really fun finding it with you guys. I had very specific things for each one of you. Yeah. It was all there. Thanks, Riley, and thank you, eBay. And guys, shop eBay for millions of finds, each with a story. eBay, things people love. Running my small business was like playing basketball five on one, and I was the one. Now, QuickBooks gives me access to a team of AI agents and trusted experts for the assists I need. Nothing but net. Outdo it with Intuit QuickBooks. Feature availability varies by product.