Why Credit Card Companies Are So Mean

Tuesday, Ryan Avent wrote about credit cards, so I don't want to oversaturate people's interest, but I thought it might be helpful to understand just where credit card companies are coming from. And why those in Congress would really benefit from a class or two in basic economics. I'm talking to you Maxine Waters. Okay, she probably requires more than a class or two.

An example might help to better understand credit card companies.

Let's say you're a kid and have two brothers: Jake and Howard. Jake is unreliable and irresponsible. Howard is reliable and responsible. Each asks you to borrow money. What do you do?

If you understand economics, you'd know that the risk involved in loaning each money is different. There is significantly more risk in loaning Jake money than Howard. That means that if you charge Jake more interest, you are likely to have a lower loss based on that risk. So that's what you do. You charge Jake 20 percent interest, but only charge Howard 5 percent.

The following month, you decide that, for some external reason that has nothing to do with the loan - maybe Jake lost his lawn mowing job or crashed his bike - you are more worried about Jake paying you back than before. You now tell him if he wants to borrow more money, he needs to pay 25 percent interest.

Jake feels persecuted, so he complains to mom. Mom says you are mean and can't take advantage of Jake that way. She says you can't increase his interest rate.

How would you react?

If you said, "Easy, I would choose not to loan Jake any money because I can't be sure that I'll earn a high enough return to get my money back," then congratulations, you understand credit card companies and probably basic economics.

If you said, "Mom is right. He's my brother, so I should treat him more fairly," then congratulations, you might be a member of Congress someday.

The interest rate increases that Congress calls "arbitrary" are anything but. Credit card companies have complex models that include dozens of variables consisting of different customer characteristics. After everything is taken into account, a rigorous, highly tested credit recommendation pops out of their risk management engine. They literally have math and statistics PhDs who are in charge of this stuff. Congress seeks to prevent such complex analysis.

Ironically, denying credit to riskier customers is the only way that credit card companies really can respond. By increasing regulation on how they manage riskier borrowers, Congress is forcing the companies' hand, and they will be forced to tighten credit on the very people Congress intends to help. If they cannot be compensated for the risk they're taking, then they won't take the risk.

Ultimately, Congress must make peace with their presumably unintended proclamation that those with poor credit are better off without credit cards than with credit cards that have aggressive terms and conditions. Right now, those consumers have the freedom to choose, but instead, Congress' "credit card bill of rights," will take that right away when the credit card companies are forced to tighten or deny credit to many of them in the days to come.