Secret History of the Credit Card
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interviews: andrew kahr
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In the credit card industry, financial services consultant Andrew Kahr is recognized as an innovative thinker whose creative ideas and tactics have helped shape how the business works -- from zero percent teaser rates and the two percent minimum monthly payment, to cash rebates, "by invitation only" solicitations and the concept of universal default. In this interview, Kahr discusses the thinking behind the strategies that he devised, the criticism surrounding some of them, the misunderstandings that exist about how people use credit cards, and his observations on human financial behavior and the economics involved. He also offers his views on the issue of fully disclosing to the cardholder any unusual or new terms on an account and whether disclosure actually has an impact on the cardholder's behavior. This interview was conducted on Oct. 10, 2004.

What's unique about credit cards?

I think there's a lot that's unique. The credit card, of course, has a dual function. First of all, it's a transaction vehicle for purchases or for obtaining cash, generally a cash loan, and it's a substitute for either cash or a check, as a general rule. Secondly, it's a way of borrowing money without security, so it substitutes for other forms of unsecured lending, which generally involve having to go to a finance office or a bank branch, sit down, fill out a form, wait for an answer and so forth. This is a much lower-cost operation in terms of what needs to be done in order to create the loan, and because it's open-ended and you can partially pay it back or completely take more money again, it offers convenience. And obviously it's appealing to the consumer in both of those ways. It takes a higher fraction of the transaction activity at retail and for cash transactions, and it also accounts for a dominant portion now of the unsecured lending that consumers do; that is to say, apart from mortgage and auto, this is the main form of consumer debt.

I am happy with what I have done in card and what the results have been. But I recognize that it's always going to be more emotional, more subject to concerns and recriminations than most other businesses are. It's become a convenience that's in many ways a catalyst in our consumer economy.

It certainly facilitates the creation and the maintenance of consumer debt in a way that probably causes more people to borrow more money than would have been the case if it were much less convenient, if it cost a lot more to do, and so forth.

The credit card is a key thing that makes everything easier.

That's easy for you and me to say. But we're not representative of the U.S. consumer population, of whom probably over half don't have the opportunity to obtain the kinds of cards you're talking about; namely, Visa, MasterCard, a line of credit of $1,000 or more, no annual fee for the card. That's not open to them. They either have to put up a cash deposit in order to get a card, [or] they have to use a debit card, which draws against a deposit account, [or] they have to take a card with a small credit line and a high annual fee, something we call a subprime card. So it's far from universal in its availability and in its dominance in the consumer transaction and borrowing space.

Subprime card? What do you mean by that?

Subprime card has emerged in the last five to 10 years as a way of providing a bank card, Visa or MasterCard, to people whose riskiness precluded establishing a card relationship on the terms that had become conventional and were effectively universal at that time; for instance, no annual fee and a substantial credit line, something in the four figures.

So the subprime card is generally a card with a significant fee to initiate the account, plus a substantial annual fee -- $49, $80, whatever; very limited line of credit [of] a few hundred dollars; and it tends to have late penalties and so forth, like the prime cards. So it's a different line of business, recognized as such both by the regulators and by the issuers. And not every issuer has chosen to get into subprime cards. And because the subprime card business is young, it hasn't been seasoned. Not as much has been learned about how to handle it safely and effectively.

This is lending money to people who are lower-income or less likely to pay their bills?

Less likely to pay on the card as agreed, for whatever reason. The reason often relates to lack of stability of income.

And you can make money on these cards? It's profitable?

Well, some people have made money; some have lost money. And it can be profitable. If you're lending $400, you have $50 to open the account, a $50 annual fee. You're going to collect, on average for this population, two or three late charges of $30 in the course of the year. That's going to dwarf the interest you can make on it, even if it's 20 percent of the $400. So it's a different pricing structure, which has proven to be very profitable for those who have developed a way to select people for these cards and to operate the accounts.

You're known in the business as a financial innovator, a guy who thinks creatively and comes up with new ideas. Give us a list, if you will, of the ideas that you developed.

I can mention a few of them. I was the inventor of the design for the Cash Management Account [CMA] at Merrill Lynch [and] the Schwab One account, which basically use a card, Visa or MasterCard, not as either a credit card or a debit card, but as a means of access to money on deposit in a brokerage account or to borrowing margin debt. That has been extremely successful. Hundreds of billions of dollars have moved through those accounts.

I thought one of your tactical innovations was understanding that if you lowered the minimum payment, the "revolvers" -- those who didn't pay off their balance each month, particularly revolvers at a lower level -- were profitable.

I think what you have in mind is the reduction of minimum payments, which we did in California. They had been 5 percent. I was able to convince one of the major issuers to reduce it to 2 percent. And at the time, the interest rate was 1.5 percent a month, 18 percent a year. So they were reducing their balances, even if they made the minimum payment. But when you reduce the payment to two-fifths of what it was before, you can have a credit line that's five-halves as high, and the number of dollars to be paid per month as a minimum will stay the same. It's that number of dollars that determines whether the cardholder can pay. So by making possible higher credit lines, it gave the customer more flexibility, and of course the bank has a potentially much more profitable account.

So when you started out, the minimum monthly payment allowable, or conventionally, was 5 percent, but you discovered with your first client that their profits came from the people who were making the lowest payments. Is that correct?

A little bit more complicated than that. Somebody who always pays the absolute minimum is probably risky, so if you look at a group of people who show that behavior over the course of a year or two, they won't be the most profitable. But certainly it is the cardholders who revolve, who use the debt, who pay finance charges, who contribute, cover the overhead, provide some profit for the lender. So someone who always pays in full in 30 days, 45 days, doesn't incur any charges of any kind, has the card for free, the bank does get some income from that because of the way the clearing relationship with a MasterCard and Visa is structured. Basically, the stores, the merchants, are paying a little bit to that bank, but it's not enough to cover the costs, or not more than very barely.

So you and I, if we pay our bills off at the end of every month, the bank isn't really making any money on us?

If we always pay them off on time every month, then we're not profitable card customers.

So where's the money?

The profit is made by lending, because it's turned out that consumer pricing preferences run towards accepting a higher rate of interest on the part of those who need to borrow and need to maintain a borrowed balance, and the preference is against paying an annual fee, for example, or paying for each transaction. If you have a brokerage account, you pay every time you buy and sell stock, very easy to understand; it's right there on the transaction slip. If you have a checking account, in days gone by, you could be charged for every check you used.

Customers don't like that kind of pricing, so that's not even done on checking accounts anymore. It has been tried in cards. Maybe it would seem in some abstract sense to be fairer, but you've got more customers, and you get better results if you price primarily on finance charge and on other fees when customers don't observe these terms. ...

You've been known as an innovator in the industry. And you told us about Bank One and your Schwab One account and your CMA account. But what are the tactical changes that you invented in the credit card industry?

You know, some of them might not be considered inventions, but I pioneered the first successful, the first significant cash rebate program -- 1 percent back on everything you buy. That was extremely controversial in its day, because interestingly enough, banks thought, and the card organizations felt, that gee, we've got to have that 1 percent so that there's some hope of at least breaking even on all of the people who don't revolve, [who] pay in full in 30 days. And if we're going to give a lot of that money back to them, then we're making it even more unprofitable.

That was one. The second was the recognition that if you reduce the minimum payments, you can increase the credit lines so that the dollars that need to be paid stay the same.

Many consumers prefer a lower payment simply because it's more convenient?

I think there's sometimes a misunderstanding about those low payments. It's not a matter of make the minimum payment every month and continue paying for a long time for something you bought before. People need to use their cards, so they need to get the balance down, need to pay enough so that they can go out and buy more. Otherwise they don't have a card available to them, at least not from that bank on that account.

So if the customer wants to ... have greater flexibility and be able to owe a total of $5,000 and still pay the same amount in a bad month -- if there are doctors' bills, if this is the annual insurance premium that they need to pay -- then the total that they have to pay on the credit card that month is so much lower. And if the customer had a $2,000 balance, he had to pay 5 percent on that, which is $100 a month; we reduce the minimum payment to 2 percent a month, OK, he only has to pay $40 a month. That means that in a month that is strenuous for him financially, he can make the choice to pay only $40 instead of what would have been the $100 minimum payment.

That's very important, because when people get behind on their payments, unfortunately, it becomes harder and harder to catch up. So it's sort of a declining spiral, and you want to keep that from starting. You want to make the payments affordable.

So you allow them to make the monthly minimum, which you're still making money off of. As long as it continues, at least that much comes in?

Well, it's extremely important to reduce the risk that the consumer is going to get behind, be unable to pay and ultimately get charged off, which would lead to his losing not just the use of that card, but probably not be able to maintain or get another card. So it's very consumer-friendly, I would say, to allow that flexibility.

And you came up with this zero percent. ...

Yes, zero percent was one of my suggestions.

How do you make money off of zero percent?

Well, you can't make money on the balance on which, at the time, no interest is being charged. But ... that's only part of the balance; namely, that's a transferred balance from another account, and the customer can use his card and make purchases, get cash advances, and he will be paying interest on that. Then the account can become profitable faster, but also the zero percent period will end.

So there will be some consumers who, if you offer them six months with zero percent interest, they'll take you up on that, and six months from now, maybe they'll find a greater fool who will offer them a year of zero percent interest, and so they'll switch their whole balance to the new bank. So this is an example of how competitive the industry is, particularly in the prime card sector right now, that banks are willing to make deals with consumers that in some instances they require as long as two or three years to pass before they can get back what they have invested in terms of lending money at no interest and so forth.

How did you come up with this idea of zero percent?

There was a price war, and there was always a number on the envelope in the mailbox -- 13.9 percent, 11.9 percent. And marketers were struggling with trying to stay one step ahead of that process.

And it seemed to me that the result in terms of getting new accounts and ultimately doing better on the new business would be improved by going straight to zero percent. So I advised zero percent. A client went to zero percent, and thereafter others picked up, just as others picked up when I began exploiting interest rates. That is to say, I demonstrated that an institution could charge throughout the country the rates that were permitted in the state from which they were running their card business. Eventually other institutions imitated that innovation, which at first they hadn't understood, hadn't seen how to do it, thought it was illegal or whatever.

Well, that was Marquette [the 1978 Supreme Court decision Marquette National Bank v. First of Omaha Services Corp.] that started that, right?

Well, Marquette was one of a series of legal authorities which made it possible for me to convince the legal counsel of the issuer that business could be done this way. It wasn't obvious to other people, evidently, just as the fact that a bank that could issue cards could be owned by a company that wasn't in the banking business. Likewise, that was inherent in the law. That had been there for quite a while, and yet the other banks, the other issuers, hadn't read the law, hadn't thought it through and didn't do it.

You came up with the idea of a non-bank bank. What do you mean by that?

Well, a non-bank bank at the time -- there have been some modifications since then -- is an institution which has a bank charter but which did not come under what was then the definition of a bank in the Bank Holding Company Act, and therefore was not subject to the restrictions of that law, which in effect said that a bank could not be owned by anything other than an entity that was in no other business than banking. So I saw how it was possible to structure a bank's activity in such a manner that it was not subject to the Bank Holding Company Act. Therefore it could be owned by a non-banking entity.

So you created, in some ways, the basis for all of these credit cards that are issued by companies that aren't banks themselves?

Since then, there's been additional levels and layers of legislation, but the effect remains the same; that it is possible to be in the banking business and in other businesses as well, which is not how the situation was perceived before that innovation.

And the monoline banks that developed in the 1980s, what was that all about?

Well, first of all, credit cards in the '80s had a remarkable and consistent pace of growth in the double figures, so it was an attractive business to get into in a selective way. And it was amenable to innovations in marketing, innovations in credit techniques, so it was a massive target for entrepreneurs.

At the same time, securitization and other techniques which reduced the need for enormous amounts of capital were becoming available. And likewise, it was learned that the idea that somehow credit card accounts had to be bedded within a full consumer banking range of services because of cross-sell customer loyalty, it was learned in the '80s that that wasn't true.

That just because you had all these other banking products, that people wouldn't necessarily want to use your credit card, or vice versa?

Right, right. So that opened an opportunity to enter the card business. And the non-bank bank, and the ability to start in a state that didn't regulate rates on cards and other terms of cards and apply what you could do there across the country, all of that made it appealing to start a card business and to not be encumbered with other banking activities which in fact could have brought you under the Bank Holding Company Act.

Well, since we're on monolines, give me a brief description of some of the credit card companies -- MBNA, for instance.

MBNA is an extremely successful company which has entered a number of lines of activity and channels of distribution. But I think their preeminent success has been in dominating the market for what we call affinity cards; that is, MBNA, or occasionally a competitor, entered into an agreement with an organization that has members or customers to offer cards with the logo, with the name of this sponsoring affinity organization, which could be AAA, it could be Cal Alumni, and through that contract, there is an exclusivity, and there's a lot of flexibility granted to the lender, MBNA, and they set the terms. ...

They pay something back to --

They pay a percentage or whatever to the affinity group.

And Capital One is a monoline?

Similarly, Capital One engages in some other businesses to which they have a strong commitment, but their results are primarily dependent on how they do in cards. And their big success has been in cards.

And so the rise of these companies which didn't exist 25 years ago, has that changed the industry?

It's certainly changed the industry in establishing a form of competition and a kind of competition, a source of innovation that otherwise wouldn't be there. So we have the big bank issuers, roughly speaking, and then we have the monolines.

But overall, though, I think the broad numbers -- how big is the industry, how many people have cards -- what is true is the move into subprime was brought about by monolines. And I think in the fullness of time we'll see that that was very important, very constructive, and it expands the access of consumers. Far larger numbers of them will be able to have transactions on cards, will be able to establish their credit, their ability to make regular payments on cards. And I think that that is substantially thanks to the monolines, because there was no great enthusiasm for that that I saw on the part of the big banks.

Now, when you say subprime, you mean making money or credit available to people who generally wouldn't have that credit line available? Critics say that's exploitative, and the proponents say it's the democratization of credit. Which is it?

I believe we should offer choices to consumers that they will find lastingly desirable and comfortable and fulfilling. So if subprime cards were a relationship, a product where you burn through the customer, he goes bad, and you have to go out and find another set of customers, for example, or wait for another generation, then it would be very bad and exploitative.

But if they don't have access to what we've been discussing as quite an efficient form of credit -- there is no sitting down and explaining what you want the money for, no need to come back and say "I want more money," no face to face; a high degree of automation lends itself to a very efficient service -- to do that, we need subprime cards. Otherwise we have things like payday lenders, and we have other forms of debt -- second mortgage on your car, heaven knows what.

So I think in the very early days of what we now call prime cards, in the '60s, all kinds of mistakes were made, all kinds of money was lost, fraud; people didn't understand what they were committing to pay. And we've been through something similar in subprime over the course of the last few years. And there have been institutions that did very badly or put themselves in jeopardy.

But I think subprime is the major area of expansion, and it's profitable, very profitable when done well, largely because it's now understood that you have to have special skills. You have to have different know-how and techniques to run a subprime portfolio; that you can't just assume that because you've been assigning $5,000 credit lines and zero annual fee, zero percent for six months, whatever, that you can do subprime well.

The critics say that subprime means you're offering money to people who really can't afford to make their payments, that you're just trying to squeeze them for more profits, fees and so on. But you're saying it's an opportunity.

If they couldn't make the payments, you'd lose money extending them credit. The great majority of them have to pay; otherwise it's useless. So we can't just burn through people, take some fee from them, take $50, give them $300 and have them not pay. And there have been a variety of misconceptions and hazards in operating it.

But I think this is really a valid point. What if your journalism students said, "Gee, they won't hire me without experience, so how am I ever going to get any experience?" I sympathize with that. And it's the same with credit. If you have somebody who has had credit problems or who has not had credit, then how do you get them started in a reasonable way without asking people like you to subsidize it? To say, "Well, let's charge everybody the same rate; let's make cards available to everybody, and you'll just have to pay more to cover the losses on the very risky people."

So this is a way for them to have a card, be able to buy, be able to establish their credit, and when it's done right, really a low-risk fashion, you give somebody a $400 credit line, the minimum payment is 3 percent or something like that, what the heck? Twelve dollars, you know?

What I hear you saying is that subprime is a way to democratize the marketplace.

I would never say democratize. It's a way of offering more people the opportunity to have a card that they can use to buy things and to get cash while they're borrowing money. If you can select individuals who are really likely to pay, and they can establish their credit, then they become eligible for larger credit lines, for a prime product, they've benefited both in the short and long run.

If you run the business badly and you offer cards to people who are irresponsible, who want to take the money and run, whatever, then you're going to lose money on your subprime, and that's not a lasting activity. And that's not what I've seen in the programs that I've worked with that have gone on for periods of, like, five years, and consistently right through the recession done very well -- gotten more customers, held on to their customers and had a very moderate level of default and loss on subprime, but much higher than you could tolerate on prime.

You discovered that people would have money in their checking account or in a savings account, and they would still be paying the minimum payment on their credit card bill. Why don't they just pay off the credit card?

Well, first of all, let's not get excited about minimum payments. People need to use their cards. It's first of all a transaction vehicle. If someone needs to buy $300 a month on his card, he's going to get to his credit line, and he's going to have to pay $300 each month in order to go on using the card in the way that is essential to his everyday life. But if he's borrowed on one or more cards thousands of dollars, he's got a checking account. He can't run the balance on that checking account down to zero, because we're not tolerant of overdraft in America. Therefore, he has to have enough money in the checking account so that if something unexpected hits that account -- a check he wrote a couple of months ago, an annual insurance premium that he can only pay by check -- the money will be there to cover it.

Therefore, he's used to having a level of comfort in his checking balance. He may have his paycheck going straight into his checking account anyhow. He's not going to pull that right out to create extra transactions to pay down his credit card accounts. So a typical configuration would be $1,500 in the checking account and whatever amount of borrowing he's got on his cards.

Even though he knows that it's costing him more money every month to make payments on those cards when he could just pay it all off?

He can't live with zero dollars in his checking account, so he doesn't really have the option without going to the exquisite inconvenience of keeping track of exactly what's happening in his checking account, what checks he's going to have to write next month and so on and so on. He's paying, as a practical matter, for the convenience of being able to write those checks, not worrying about whether he's overdrawn.

And bear in mind that we have a point of view in this country which is not found throughout the world. The point of view is that if you bounce a check, it's terrible, it's embarrassing, and you can be punished. In the worst case you might go to jail. And you can't expect the bank to take care of you in the case of an overdraft, or if they did, they would make it very expensive -- charge you $20 for every check that had an overdraft, whatever.

Americans have six, seven, eight, nine credit cards. Why? Why are they doing that?

Well, the consumer has a number of reasons. One reason is you get a better offer, you get a zero percent rate, transfer the balance of that card. The other account you're not paying a fee on, which now has zero balance, why on earth would you want to close it? Maybe something will go wrong with your new account. Maybe the card won't work someday.

Furthermore, it gives you additional financial flexibility, not planned by any bank, where each bank thought you were good for $5,000. And your balance may have started at $5,000 total. Now you've got five cards, each for $5,000, let's say. You have access to $25,000, but you don't have the capacity to pay on $25,000, so if the going gets rough and you lose your job, there is a risk, at least for the banks, that you will then draw on the whole $25,000 or more, whatever you can get over the line. And furthermore, there's the cost of running all of those accounts. But every bank, let's say, thinks you're good for $5,000, and they want it to be their $5,000, not the other guy's $5,000. ...

But don't they know through the credit reporting agencies how many cards you've got?

It turns out that the mere existence of other inactive card accounts is not an indicator of credit risk, or at least not a substantial one, so it doesn't affect your credit score, which I think many people somehow know or feel. And oddly enough, if you call a bank and say, "I want to close my account," they'll say, "Why? You're not using it? Why not keep the card? You want to cut up the card, I can't stop you. Go cut up your card." But in fact, they're resistant, for obvious reasons, to ending the account relationship.

Because there's a chance you'll use it and --

Yeah, there's a chance that you'll come back to them. And they want the opportunity to say: "OK, we'll give you zero percent. We'll give you a reward. Come back to us." You can't expect they would just slink away and say: "OK, the other guy's a better mousetrap. We give up."

Do you see why some people say that what you're doing is allowing people to get in over their heads; giving them, in a sense, a license to get in debt over their heads by allowing them to get all these different cards?

Well, we offer adult Americans many opportunities to get in trouble. We build cars that can go 100 miles an hour. But if the speed limit is never higher than 65, why don't we have a law that says you can't build a car that goes faster than 65? The technology will allow that.

So to limit people's choices in credit -- and we let them get mortgages for 125 percent of what their property is worth, and so on. Attempts at regulating credit -- and there is a history of them in this country; in various circumstances, often for economic management, macroeconomic reasons, there have been restrictions on credit -- I don't see why we would apply that kind of limitation and say to one person, "Well, you're good for $10,000," and to another person, "You're only good for $1,000," and another is good for $100,000, or whatever. It seems to me you can't possibly limit everybody to the same amount of credit. And if you're going to begin installing formulas or methods that discriminate in that way, you're going to have an awful lot of consumer unhappiness.

You have to bear in mind that 98 percent of the people who get cards are paying. If you do something that limits their access to credit, even if they're not using it, credit that they still think of as an ace in the hole and which they would intend to use responsibly to get them over a difficult period -- hospital bills, whatever it is -- you are going to be annoying, harming, 98 percent of the people this year, versus 2 percent who can't pay, and who probably couldn't pay if you reduced the amount of credit. They still couldn't pay.

Because a typical pattern is, people have higher-priority uses for their funds when they encounter financial difficulties. They've got to pay the rent; they've got to pay the mortgage; they've got to pay the doctor, OK? They're going to pay basically zero on whatever their card balance is. Now, if we had regulations which limited the loss on those people, theoretically, fine. They normally borrow $5,000; they get in trouble, they go and borrow $25,000. [If] we said, "No, we're not going to allow them $25,000," the main effect of that is people like you and I would probably be paying slightly less on our cards because we wouldn't be subsidizing these high-risk people. And that's something that the body politic can instruct their representatives to legislate and regulate and enforce. I don't see the demand for that. I don't see the rightness of that.

Universal default: How did you come across this concept, and what is it really?

It's part of a much broader idea. In the early days of the card, when there was only prime card, card was limited to people who were good bank customers, had checking accounts. There was really limited credit bureau information. In those days, everybody paid the same rates. If he was a customer of bank X, bank Y, he'd get bank X's rates. So not very much was known about who was a little more risky or considerably more risky than someone else. The cards were limited to people who were relatively not risky. And they all paid the same rates.

Now, because more has been learned about how to measure credit risk and how to see changes in risk over time, the industry is better able to assign a probability of loss to an account as of a particular date, so they know that some accounts have twice as high a risk as others. And the pricing has followed that observation, that if someone is riskier, he should be paying a higher rate. The same as on a mortgage: If you're a riskier mortgage borrower, for example, because you're borrowing a higher percentage of the value of your house, you're going to pay a higher rate.

I get that. But explain to me how it is that you can miss your payment on your car, for instance, and that results in changing the interest rate in money that I've been paying off regularly, and continue to, after I've used my card to buy a suit. It seems to me one is affecting the other.

Definitely. Because you're riskier. And the card is being used, in general, always for more transactions. You make payments on it, you borrow again on it, but the fact that, let's say, in the extreme case, you've decided to just stiff one of your creditors -- you got mad at that bank; you're not going to pay them anything -- that means you're riskier. The statistics show that if you've had that problem with another bank, you're less likely to pay my bank on time.

But is there any other financial relationship in America that's like that, where my activity over here would change the terms of my agreement with a credit card company?

Yes. I'm going to take your question exactly as stated, OK? Corporate lending, which is, generally speaking, more rational -- there's no emotion in it; there's no pulling the wool over anybody's eyes; you go head to head, and you've got a well-educated individual to make the choice -- corporate lending, small business, whatever you want, millions of businesses, it almost always has a cross-default clause in it which says that we're going to watch all of your debt, and if you go bad on anything, then you have to pay me back right away, or other changes in terms which are far more drastic than merely paying a higher interest rate will apply.

I think that's a model that, as we get closer to it, we're burning off. We're moving past some habits or some points of view that were associated with older forms of lending that were less efficient, less fair, whatever. So I stick to the idea that a bank is wise and fair to insist on risk-based pricing that adjusts according to the overall pattern of financial conduct of the customer.

When did you realize you needed to do this?

In the course of my consulting work and my innovation, my sale of ideas, know-how and so on, I said if we're going to have default kinds of rates, then they should be based on overall riskiness rather than on some event.

Sometimes when you discuss this, someone will say, "Well, look, I had to go to a funeral, and I made the payment late on this account, and look at what they did to me." And my reaction is, it wouldn't matter whether it was this account or some other account; we can't install a system of justice for "Was this really your fault or not?" It would be unduly expensive, and it would wind up being discriminatory.

So we have to select from what is a practical set of alternatives. And if we want to charge riskier people more so that those who are less risky aren't subsidizing those who have become riskier, or those who have started out riskier, then we need something that makes the rate adjust with the risk.

But you understand the reason this has become controversial is that people say, "Well, if I'm making my house payments, and I just choose for one month not to make that payment because I don't have enough cash, and I'll pay the fee the next month when I get some money -- but I wouldn't have done that if I had known it's going to change my interest rate on my credit card."

First of all, what they know or don't know changes with time. And undoubtedly, when these provisions were first put in, they were not widely talked about. I think it's here to stay. I think on the whole it's fairer, and we're getting past the point where anybody is going to be able to say: "How can they possibly do that? I wouldn't have dreamed that this would happen," and so on and so on. So we get a better-educated consumer who better understands that he has to protect the quality of his credit overall.

Now you can turn on the Internet, and you get a solicitation to find out your credit score or to look at your credit report. So we've had a tremendous sensitization and focus on personal credit quality. ...

I think this is extremely healthy. I think it makes consumers more conscious of the fact that they may have five lenders or 10 cards or whatever it is, but they do have, roughly speaking, one number which sums up whether their credit is good, bad or indifferent. And if their credit is going south, they're going to pay for that.

Tell me why it is better that everyone has a credit score, basically.

I think it's very valuable, and it's a big change from 1970 or 1980. And in fact ... the trend in regulation is to give consumers much more access to credit information about themselves, which I think is very healthy. So if we can get consumers to pay attention to the impact of their own actions or inactions -- not paying or running up more debt -- on their creditworthiness, and hence on the terms of their existing debt, we're going to get more responsible consumer behavior, whereas in the world of 20 years ago, they were going to approve you or not approve you.

You've just reminded me of an interview we did with the Better Business Bureau here. The gentleman we interviewed said when he borrowed $1,000 with his credit card, he understood that the interest rate would be whatever it was, 11 percent. But because he was late on a payment for his home, the interest rate changed on that balance that he had already accumulated. He didn't see any problem if he were to use the card in the future to borrow money, but why should he have to pay a different interest rate on the money that he had already made a deal to borrow from and had sealed?

Because the deal that he made included giving the bank the right to change the rate. And it wouldn't matter whether he had been late on his house payment; the bank could still change the rates. You won't find very many card contracts that constrain the bank to keep the rate the same no matter what, indefinitely. And we don't keep track of separate elements of the balance.

If you want to imagine a super-complicated system where you buy something this month, you buy something else next month, you're paying off one of those balances, you're paying off the other balance, each balance has a different rate, this gets us into issues of disclosure. There's a tremendous virtue in keeping things relatively simple. And the cardholder has to understand that if he wants a deal that says, "Your rate is 12 percent; you can keep the account forever," which you might like to do if outside this deal, the rates everywhere else are going up like crazy, [and] we have another round of hyperinflation. Or on the other hand, if rates go down to 6 percent, you can pay it off immediately.

Maybe someday some bank will offer an account like that if your friend has enough people like him who want that kind of insurance of rate. But it doesn't work for a card the way it would on a house. Even with a house, it's 30 years, but you're going to make regular payments. Even then, the rate is higher always for a fixed-rate loan, and there will be prepayment penalties and so on and so on.

I'm using your example that he was late on a house payment. People should understand that that's just about the worst thing to be late on, because that's a very high-priority payment. That's the last thing that people want to allow to happen -- have a problem with the mortgage, put their house at risk, and the cost can be enormous.

There seems to be a national policy to encourage flexibility in terms of mortgages to get away from the older form of mortgage, which was here's the rate, here's the payment, that's where you go for 30 years, that's it. And under that structure, incidentally, they could charge you the sun, moon and stars as a prepayment penalty if they elected to do so, and it wouldn't even be called a prepayment penalty. So let's not assume that there's some wonderful, traditional world in which mortgages are conducted in a phenomenally consumer-friendly fashion compared to these terrible things happening on card, because that's not the case.

When you hear people who want to increase the disclosure that's involved with credit cards -- for example, how long it would take you to pay off something with the minimum monthly payment -- what's your reaction?

Amusement, I suppose. I don't think it makes any difference. There's a very wise principle embodied in the Truth in Lending Act, which is that we're going to identify a minimum number of disclosures which there's some hope that the consumer can get to understand and even be encouraged to read. We're going to put those in one place, like in a box, in a separate part of the document, and you'll get used to the idea that you can look at those. And that has had the effect, which is probably pro-consumer, of really sparking the price war we were discussing before, because none of them, scarcely, could tell you what an APR [annual percentage rate] is, but they know an APR is better if it's lower, OK?

The more numbers and the more words that are going to get "disclosed" -- we've already got a complete disclosure statement, the whole contract which gives all kinds of detail, and to say, "Let's add one more number," well, if you add one more number --

So you really don't oppose the idea of disclosing more; you just don't think it will make any difference.

It's not going to make any difference. When the law was passed requiring additional disclosures on cards, I was young and impressionable in those days, so I thought, wow, this is really going to change the business because it's going to be conspicuous; it's going to form a focus of consumer attention. I don't think it changed the competition. I don't think it changed the pricing level. I don't think it changed consumer preference for one kind of deal versus another. I think it [had] a really negligible impact on the industry.

I want to come back to something that I learned from you, which is the issue of disclosure also involves the irrational nature of human beings. Tell me your perspective on this.

Well, you know, one reason why eBay is such a phenomenally successful business is that they can find whatever you want that's for sale on eBay instantly, and that makes it possible for them to sell everything under the sun, to be a dominant market in everything.

Searching for the best credit card deal -- and states and some attorneys general have legislation: "We're going to get the information; we're going to publish a list; everybody will know what the cheapest credit card is." Fantastic. That goes back to the '70s, you know.

Well, somehow or other, it didn't affect anybody's decision as to what credit card to buy. You can say it's a tribute to me, a belief that that shows consumer irrationality. I think it's very rational. Your time has a value. The decision to take a particular credit card is not a life-and-death decision that will necessarily have consequences over a long period of time. So you do what's convenient, and if you have some time later and if you think it's going to come into real money -- "Look, the balance is high now" -- always at no cost and in fact at an advantage, you can shift to one of the zero percent people who give you a front-end deal in order to take the balance away from the bank that you now feel is too expensive, mistreated you or whatever.

And if people operated that way, you would say Consumer Reports would be the biggest magazine or the largest subscription.

Yeah. But I mean, the attorney general's list of credit cards in order of price would be the bible that predicted which cards the population would buy. Yeah, Consumer Reports has a significant circulation. I think they do an outstanding job in terms of objectivity, in terms of insight, and yet I don't think it's a major determinate of what people buy.

And I'll ask you the question again: A number of people that we've interviewed want to add to the disclosure in the credit card statement -- just how long it would take you, for example, to pay off at the minimum payment or other things that they think consumers need to know. You don't think that will work.

I'm not sure what you mean by "will it work." If the idea is that somehow people are going to pick a card with a higher minimum payment because it will take less time to pay it off and thereby they're going to put themselves in a position where, should they have some financial problems, they have less chance of paying and more chance or ruining their credit, no, I don't think we're going to induce that kind of irrational behavior in consumers, which I think would be harmful to the consumer.

I think that consumers should opt for flexibility, whether they want to make the minimum payment. If you say, "Now, let's put on the statement that if you paid $40 a month it would take you this long to pay it off; if you paid $70 a month, it would take this long to pay it off," and thereby possibly get them to think some more about bringing their balance down, OK, that would make a heck of a lot more sense than making it an initial disclosure which is somehow predicated on imagining that we're going to induce the consumer to do something which for me is plainly contrary to his best interest.

Does disclosure work?

Oh, disclosure works like crazy. Well-designed disclosure is tremendously impactful, and the reason we've had an endless multi-year price war in credit cards, much more serious, much more lasting in its effect on the issuers, the banks, than we find in, let's say, airline price wars, is because the disclosure has been very focused. We have consumers who are super-focused on APR. So zero percent APR -- "Wow, that's what I want." So far be it for me to fly in the face of the obvious evidence that disclosure can be very powerful in its impact on consumer behavior.

The fundamental profitability of the industry is on the revolvers, the people who don't pay in full.

Yes.

And if you pay in full it's very hard for the companies to make money.

Right.

And is there a term that you use in the business to describe the people who, let's say, pay in full and aren't good for very much in terms of profit?

Oh, I've heard various words used. I would call them non-revolvers.

Deadbeats. A deadbeat is somebody who doesn't make their payments. But I'm told that in the credit card industry, or among some groups in the industry, deadbeats are those who actually do pay off their card debt.

I wouldn't get that emotional. I don't get into characterizations.

No, but it's the flipping of the word. That's what I find interesting. The definition flips, if you will.

I think people who don't pay are known as deadbeats. Referring to non-revolvers as deadbeats strikes me as inappropriate. [What] do you call somebody who takes one bank's card with zero percent interest for six months, switches to another bank's card on which he also has zero percent interest for six months, etc.? Now, it may go up to a year, OK? And he makes all of his payments on time. He doesn't close those accounts; he just transfers the balances, all right? He's making other people pay more, so to speak. He's certainly being subsidized, because he's a very, very unprofitable customer. And that's really a better example.

The smart consumer, if you will, is gaming the system.

Yeah. He's optimizing his behavior against the terms of the account. If I were writing the terms of the account and if I were using the data, who was going to be offered the account, I would try and make that very unprevalent. I would try to prevent having that happen, because the effect is unfair. It makes it more expensive for those who do pay. To flatter or to stigmatize someone who does that, call them by one name or another -- you can call them switches or whatever, but he's another kind of customer -- represents a kind of behavior that it would be rational management to try to avoid.

Now tell me, among the other things you did is you founded a credit card bank.

Yeah, I founded the company which at the time was called First Deposit Corp. We got the $3 million investment from what was then the Parker Pen Company, which was the majority owner. I built that up. [It] still remains very small relative to leading companies. And I got out in 1986. It was never our idea to be a monoline. But we did credit card first, and we did other lines of business, such as home equity loans. And we owned both the bank and a savings and loan. So subsequently, afterwards, that became Providian, and that became an independent public company and so forth after I had left.

So you are a founder of Providian Bank.

No, that's really not correct. I'm a founder of a company which after some corporate transformations got spun out. And to say that there's an equivalence there between what I founded and what subsequently became Providian, Providian Financial Corp., whatever it was, is not strictly accurate.

Citibank: What has its role been in the credit card industry?

[Citibank] played a tremendous role, because Citi has always been a tremendous believer in the importance of card. So they were going far outside their market area. They were soliciting enormous numbers of customers on very attractive terms. They were promoting lots of innovation. Of course, just like mine, it can't all be successful, so they were doing new card technology. And Citi, in fact, is really the only meaningful global card issuer, and that goes with the character of their overall banking business, which is concerned with consumer needs across a very wide range of countries. So I've got a lot of respect for what they've done. They've been willing to take chances. They've been willing to settle for modest profit margins on the domestic card business in order to maintain a leading position.

In other words, they have mostly prime customers.

Yes. You see, the prime business is much larger in terms of dollars outstanding than the subprime business can ever be. The prime customer can average out at $2,000 or whatever, can have $5,000, he can have in total $20,000 borrowed, whereas a subprime customer is a few hundred dollars. And although there are a lot of potential subprime customers, and there's a lot of profit in the subprime business, they had such a large prime business actually that subprime can never be in America as important to them as it could be to some of the smaller issuers.

Now, let me see if I've learned something here. So the most profitable customer is not the person who pays off at the end of the month, nor is it the person who pays the minimum payment, because they could be very risky. The most profitable customer is paying some multiple of the minimum and is occasionally late, occasionally misses a payment.

And has a high balance, yes. See, he has a $5,000 balance. His minimum payment may be $100 or $150, but he's paying $500 and charging $500. He can afford it. He's safe, and he's going to pay a lot of finance charges relative to the fixed costs of what we have to incur on every account to provide customer service, cards and so on.

And that's basically -- you're talking about a middle-class or working-class person who is regularly employed, who can make those kind of payments.

I don't find demographics useful. I don't find psychographics useful. I follow financial behavior, so I want to see how he's handling his other financial relationships via the credit report or whatever. But following the percentages, younger people tend to spend ahead of income. They may have tremendous income, but they expect it to rise further, and they're willing, when they're forming a household, when they've got to pay for kids, they're going to borrow and create more debt, and as they get older, they're going to tend to pay it off.

What I've just described is not a guide to how to run a credit card program or how to pick the right customers, but give some insight as to why it simply isn't accurate to say, "Ooh, the person with lower income is the kind of customer who will show the sort of behavior that is predictive of profitability."

We read reports, we interviewed people, and they say: "We're getting solicitations; we're on the verge of bankruptcy. They're still trying to get us to transfer a balance at zero percent or offer another credit line, and we're --"

Yeah, you see, that kind of mistake, first of all, arises from a process called prescreening, which does not commit the lender who sent that solicitation, because after the offer is accepted by the consumer, the data from a full credit report is then laid out against the earlier prescreen. If the situation is different, if there is a worse payment performance, if there's greater debt, if other facts become available, then that account won't be opened.

And unfortunately, prescreening is not an art. It's very mechanical. It's far from flawless, and there still continue to be serious problems in credit card, credit reporting data, many of which you hear a lot of complaints about. And you have to take those to credit bureaus, because there's nothing that any bank can do to avoid those kinds of errors that can occur.

There's a catch-22 in here. I miss my payment on my credit card because I want to pay my mortgage or my car or something that's secure that I really want. A credit card company will have to come last. And the result is the credit card company then charges me a fee, raises my interest and puts more pressure on me basically, even though I don't have more resources. And we hear that, and we've seen that out of this system. Is there any way to adjust that? I mean, it's sort of like throwing stones on a drowning man, basically.

It's impossible to generalize fairly about hundreds of millions of card accounts, thousands of collectors, thousands of issuers and how they handle the kind of situation you're describing.

The concern remains that if he doesn't pay us, then he's going to pay somebody else instead, and [it's] difficult to establish a condition that precludes that. And while we're willing to go along with you -- but then there are these other four, [and] you can't pay them either, and meanwhile they're going to sue them or whatever. There's no neat formula.

The thing to bear in mind is throwing stones on a drowning man, that happens automatically. If you were supposed to pay $50 and you missed that $50, to start with, you're going to have $100 the next time. You're going to have two months' payment. The interest, penalty, whatever it is, is going to be less than that. And the $100 is an irrational effect. Now, a collector will say: "All right, you can't give me two payments now; at least give me one payment, and if you can give me one payment for two or three months, then we'll be able to re-age your account, so we won't treat you as being delinquent anymore." That is a fairly normal form of compromise that can be proposed.

But the creditor, the lender who is hard-nosed and says, "You have to pay," if it's counterproductive, if it causes people to file bankruptcy and so forth, then they've got a self-destructive policy that is bad for the bank, causes more losses. But nobody's got an ideal set of policies. That's why they need consultants or they need other sources of insight from management.

Here is a zero percent offer that I got in the mail the other day. You invented this.

I was the first one to recommend or persuade a client to go into the mail with a zero percent interest rate. Obviously it was limited in time and limited as to the kinds of transactions that it covered, like balance transfers, for instance.

But it's a come-on, basically. It's a way to get people to give you their business.

It's certainly not a come-on. In the extreme, it can be a excessively expensive endgame for the price war that finally the rate got down to zero.

You have been known to use the phrase that you could "see through the Swiss cheese of regulation." You had an insight, if you will -- if I may say, a genius -- at seeing these opportunities or these places that banking could move into.

No. I am willing to read the law. I am willing to read the regulations. I view myself as a businessperson. I am not a lawyer, so unfortunately it takes longer for that to happen in an organization where if the lawyers weren't really profit-oriented and where the businesspeople don't trust themselves or don't have the time to read the law--

So you are a lay banking lawyer?

No, I am not a lawyer. I come up with ideas, and I attempt to find the sound legal basis for them. The ideas are predicated on my reading of what customers want, what they are willing to pay for. And I start with that: What customers do we want? The second step is, what do they want? What are they going to be willing to pay for and to cross the street to get? The third step is, how do we make that profitable and yield a higher return at a reasonable risk? But the fourth step after that is, it's got to square with all of the systems constraints, regulatory constraints. And that's where reading the law comes in.

What's the positive thing that credit cards have done for our society?

Credit cards have replaced what are obviously less consumer-friendly, less flexible and far more expensive forms of transaction, actuation and lending. So previously you had to collect cards from all of the different local stores and wonder how much credit they would give you, because they wouldn't tell you. And previously, if you wanted to borrow cash, you had to go somewhere, bare your soul, tell them what you wanted to use it for, bind yourself to paying a fixed amount every month come hell or high water, and with the expectation that if you needed more money after that was partially paid off or whatever, you had to go back and do the same again.

I travel a bit, and you go to some places where people still use checks. Now, it's really annoying to stand on line at the cashier behind people who are using checks, and you wonder what century you're in. So tremendous advantages to the retailers that used to have to tie up their capital in a business that they weren't really very good at -- lending -- and in doing so, considerably muddy their customer relationships by having to apply collection pressure and so forth. So I think cards have provided a dominantly superior transaction medium and a far more flexible, cheaper, more efficient way of borrowing for the consumer.

Why do you think consumers are attracted to something like zero percent or "by invitation only," or other methods you have used to attract customers? Is that because people aren't really rational?

Well, actually, "by invitation only" was one of my innovations. And it was not a matter of trying to attract people. It was purely and simply the way of avoiding adverse selection; that if you raise your hand and say, "Everybody who wants credit, come here," you are going to get very risky people and bad credit. I wanted to start with people who we had prescreened and not have to face the risk of hoping that I would have the data to eliminate the people who would be preponderantly poor risks. So I take credit for "by invitation only." It was not a marketing gimmick; it's a way of maintaining credit quality.

One last question: The OCC [Office of the Comptroller of the Currency] recently set out guidelines. Among the things that they were issuing the guidelines about were the repricing of accounts -- "increasing a cardholder's annual percentage rate or otherwise increasing a cardholder's cost of credit when the circumstances triggering the increase, or the creditor's right to effectuate the increase, have not been disclosed fully or prominently."

It says [to me] that there is a concern if there hasn't been adequate, fair disclosure. To me, if I am going to have universal default, I want the customer to know it, and I want him to know that he is getting a better rate going in, because we don't expect him to become less responsible in his payment behavior than he has been up to now.

So really, the failure to disclose is what you hear in there.

Rule of thumb is -- and has become more predominant as the years have passed -- if you want to introduce some unusual or new terms on an account, then you have to make sure that you have made the new customer aware of that, other than by hiding it in the fine print. And so more and more banks -- I think, roughly speaking, all of the larger ones -- would say if universal default, as you call it, becomes, as it should be, widely practiced and known, then there won't be any need to underscore it, put it in bold type and put it on the first page of the letter or whatever. But unless and until that's the case, if it's something that your new customer or newly affected customer is unlikely to expect or understand, then you have a duty to motivate it and explain it.

The credit card business is a very frictional business. Card accounts are always going to generate far more complaints per thousand accounts than checking accounts, because with card accounts, you have people going over their credit lines, people who are being dumped because they are late. That kind of thing doesn't happen, or virtually with no frequency, in checking, savings accounts or whatever. So it's highly interactive. And just because it is so useful, and it's so necessary, that if you cut off somebody's credit, that's a serious blow. So for all of those reasons, it can be a tempestuous relationship. And I like to deal with happy customers rather than ones who are upset.

And I am happy with what I have done in card and what the results have been. But I recognize that it's always going to be more emotional, more subject to concerns and recriminations than most other businesses are.

Just so I understand, your philosophy, your way of looking at these issues is, in a sense, a value-free analysis of both human behavior and the economics involved. Would that be accurate?

Absolutely not. My "value" is to satisfy the customer in a lasting way so that once he has been exposed to the whole process and the service and the terms, he will freely choose to continue and to strengthen the relationship with the vendor of the product.

So the "value" is, as measured by the consumer, not in an instant, not in a 30-second reading, so to speak, of a mailing, but over the course of his relationship with the account. It's not value-free at all; it's focused on value.

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posted jan. 5, 2005

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