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I read this Reuters news item about Democrats Seek to Reform Credit Card Practices. Having real life experiences with credit cards – they are a blessing when you lose your job, and a curse when the unemployed duration gets too long – I think some of this legislation does not go far enough.

We know from the current banking crisis that what is good for the banks is not necessarily good for the consumer-taxpayer. I propose that the reverse is always true, that what is good for the consumer-taxpayer is good for the banks.

Simply put, if the consumer-taxpayer dosen’t get into trouble then neither will banks. But if the banks get into trouble then the consumer-taxpayer will have to bail them out.

My 500-page research thesis for my Masters in Banking & Finance at the University College Dublin, Ireland, was on unsystematic risk. This is the only piece of research on unsystematic risk in the world. I chose this topic because I wanted to understand manufacturing companies better. Fortunately, there were some additional bonuses. In particular I found out that the risk-return relationship is non-linear, and this property is independent of industry.

 

nonlinearriskreward

The risk-reward relationship is basically an ‘S-curve’. That is, the rewards (y-axis) level off as risks (x-axis) gets too great. Also, you don’t get rewards until you have invested some risk. Interesting.

What this graph tells us is that,  if the market processes are pushed to their limits, phenomenal returns are not sustainable, and will soon be accompanied by similar magnitude losses. With this in view, is the Wall St windfall and subsequent collapse a surprise? No.

What this graph does not tells us is, when losses occur? When risk aggressive investors initially lose money, they exit the investment. However, when these investors initially make substantial gains they continue to invest, until of course their investments collapse. This natural selection ensures that successful risk aggressive investors who continue to engage in aggressive risk taking will encounter large losses at some time in the future.  

Aggressive profits come before serious losses.

That is, bubbles form because the risk-reward relationship is non-linear.

Now coming back to credit cards. In a recession with serious unemployment, many credit card debtors will not be able to meet their monthly payment commitments. In so doing the credit card issuers will raise the rates a shade short of 30%. Yes, 30% is the correct number. 

This is a double blow for the consumer-taxpayer. First, the loss of income, and second, steep increase in rates. From the graph, we now know this excessive return is not sustainable. What do we expect follows? We can expect a substantial increase in credit card defaults, and more losses for banks already in a bad situation.

Lesson for the credit card industry: 30% interest rates do not solve your problems, it exacerbates them.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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One Trackback/Pingback

  1. […] I had stated in my Feb/02/09 post Risk-Reward is Non-Linear, increased rates will increase defaults. The unintended consequence of this is that banks that have […]

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