On May 22, 2009, President Obama signed the Credit Card Accountability, Responsibility and Disclosure Act (the Credit CARD Act) into law. The Credit CARD Act will be effective February 2010, bringing with it new consumer protections and particular challenges for credit card issuers.
The new Act comes at a time of particular stress for US credit card issuers. The rapid rise in delinquencies and charge-offs among their existing credit card portfolios has already cut into profits. Consumers and legislators have been consistently critical of the credit card issuers in this recession for cutting credit lines and raising interest rates on existing card borrowers in an effort to earn some returns in this environment, as well. Issuers like American Express are "paying the price" of their generous issuance practices 2 and 3 years ago with delinquency and loss rates that far out-strip the image of the American Express Card as a card held by only the highest credit-worthy borrower.
At the same time, the actions taken by the US credit card issuers since the onset of the recession portend improving metrics. Card issuers have actually reduced credit lines to their riskier borrowers therefore reducing the size of their future losses. American Express went so far as to offer $300 to certain cardholders to turn their American Express card back into the company. The higher rates of interest are also meant to help the issuers establish more of a financial reserve or cushion against future losses.
But the criticism has resulted in the Credit CARD Act. The Act largely mirrors actions already taken by the Federal Reserve to protect consumers against double-cycle billing, opaque cardholder rights, and the application of "universal default". The Congress chose to take the Fed's ideas and move up the timetable, adding more consumer protections along the way.
Among the changes, the Act prohibits the issuer practice of raising interest rates permanently on borrowers who are delinquent 60 or more days. If the delinquent borrower then pays on time for 6 straight months, the issuer must reinstate the lower rate. Along the line of interest rates, the Act also requires that initial low promotional rates must have a minimum 6 month duration and prohibits increased rates in the first year a cardholder has a new account.
A particularly good feature of the Act is the prohibition against issuers charging borrowers to pay by phone, mail, electronic transfer, or for online payments. The bill also features restrictions against issuing cards to individuals under the age of 21. This will effectively end the massive marketing effort by credit card issuers on college campuses. The scary trend has been the ever-increasing level of consumer debts some students have when they graduate college, on top of ever-increasing student loan burdens.
Credit card issuers may choose to adapt to the Act through a number of strategic changes. First, it will be likely that all cardholders will see an upward drift in interest rates on unpaid balances. Certainly before February 2010, issuers will try to establish some sort of baseline interest rate for the various tiers of credit risk they have in the card portfolio. It will also be likely to see fewer "no annual fee" cards. Because the Act prohibits some of the interest rate adjustments issuers currently have in their tool kit to adjust rates in line with changing cardholder credit risk, issuers will be more likely to seek alternative revenue sources.
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It is also likely that borrowers will see their credit limits trimmed prior to the February enactment. Reducing credit availability in a recessionary period is tricky. It hurts retailers and fails to stimulate the economy, just when economic stimulus is needed. But it also reduces the upper limit for borrowers who are increasingly stressed by the same recession and helps cap potential losses for the issuers. It also may anger the same borrowers resulting in a backlash in the form of reduced repayment, even default. No one can say that the credit card issuers are not going to ultimately act in a manner that is most beneficial to their portfolio and shareholders.
Any new credit card issuance will likely be limited by more stringent underwriting. Again, driven by the need to reduce losses and expenses and due to the limitations the Act places on the ability of a credit card issuer to re-price risk as is done currently, card issuers will be stingier in their new issuance activity. That is probably good news if you hate all the credit card solicitation currently mass mailed to households across the US.
It is also widely expected that marketing and promotion budgets will be slashed in an effort to boost issuer profits. This includes rewards cards. It is widely expected that many of the most desirable benefits will be trimmed by many of the large issuers or will be limited to only the top credit scores.
While the Act has some strong benefits for cardholders, the Act will likely be a net negative for current cardholders who use their cards judiciously and pay their balances on time, in full each month. While these cardholders will likely not experience any of the negatives of a general rise in interest rates charged on the card (since they pay their balance monthly), these cardholders will likely see reduced cardholder benefits and the implementation of annual fees. These cardholders might even see their credit lines cut due the reduced spending activity seen across the economy due to the recession. The cardholders will not be rewarded for their responsible spending and prudence. Finally, these cardholders will probably see fewer promotions and less competition for their business. Ultimately, these borrowers will see the Act as a net negative.
At the same time, the prohibitions against marketing cards to college students without the means to repay is a strong positive in the Act. Further, there is some level of fairness within the Act that can make most cardholders (and Congressional voters) feel that the Act is a long-term net positive for the country.
Thursday, May 28, 2009
Monday, May 4, 2009
Lessons Learned #1 - Diversification
In the coming weeks, I plan to write a series of thoughts on what we should have learned from the current financial crisis, keeping it direct and to the point. Lesson #1 is Diversification.
Diversification is defined as the process of reducing risk by spreading investment risks across various asset types and tenures. In the case of personal investments, diversification means, to use an old adage, "you don't have all your eggs in one basket". It essentially says a good investor does not get too greedy.
Asset types include stocks (equities), bonds, real estate, collectibles and antiques, and cash (or cash equivalents). A diversified investor has spread his/her invested dollars across many, if not all of these categories.
Diversification also speaks to the tenure or maturity of the investments. In the case of bonds or certificates of deposit, a diversified investor has "laddered" or structured his/her principal repayments so that all of the money is not repaid all at one time. This helps manage interest rate risk or the risk that the investor has too much of his/her money come due in the same period of rising or declining rates. In other words, you do not want all of your investments to re-price at the same time.
A diversified investor has also considered liquidity. Liquidity speaks to the time it takes to convert the asset into cash, particularly in the event of an emergency. A diversified investor has some less liquid investments like their home and some very liquid investments like cash in their portfolio.
Let's use the Madoff fund as an example. The investors reportedly obtained a near-12% return routinely, despite the regular gyrations of the stock and bond markets over time. Investors with Madoff often put all of their invested dollars with Mr. Madoff (or increased their concentration of investments with him) because of the high rate of return and its consistency. In the future, I will talk about the lesson that "if it appears too good to be true, it is", but as investors increasingly over-weighted their investments with Madoff due to his routinely high returns, the same investors were later burned by their lack of diversification. While sympathetic to the widows moving in with their children because their nest egg is now lost, the lack of diversification is in part a flaw in the victim's investment strategy that helped Mr. Madoff destroy all of his investor's net worth in many unfortunate cases.
Will diversification then lead to lower returns? It might in the short run. A mix of bonds and equities is desired in any investment portfolio. Over time, bonds have been outperformed by equities because there is greater risk associated with equities and therefore, at times, they pay higher returns (or else no one would buy a stock). Bonds pay lower returns because, in the case of a bond issuer's bankruptcy or default, the bondholders get repaid with any remaining funds in a business before equity holders. Therefore, the probability a bondholder gets nothing for an investment, even in default, is lower than the probability a stock goes to essentially $0. Bonds also pay interest, a form of return, unless the bond issuer defaults. Stocks may pay dividends, though dividends are not guaranteed.
Diversification should match your age group and/or your investment goals. A young person with 35-40 years of employment earnings ahead of him/her can take more risk because he/she can earn money lost in the markets over their remaining working lives. A person in retirement may have no sources of income outside of pension and social security and a shorter expected remaining lifetime. There might not be time to earn money lost in the stock market, even in a soaring stock market. I think of my in-laws who had a money manager who had them too focused on equities. Last fall, they lost a quarter of a million dollars in their investment portfolio because not only did he have them too focused on the stock market, but he also had them focused on bank stocks.
Not only should there be a mix of bonds and equity, but there should be a mix of different kinds of industries among the bonds and stocks an investor holds. Jim Cramer does a skit on his Mad Money show about "am I diversified?" While cartoonish, the lesson is a good one. If you own 5 stocks in your portfolio, each should represent a different industry - for example, a bank stock, an industrial company's stock, a tech stock, a healthcare stock, and maybe an agricultural company's stock. On a macroeconomic basis, the stock market will move up or down en masse often, however, there will be stocks that do better than others so the investor will get a range of outcomes.
Liquidity is also increasingly important today because banks are not lending. A main source of liquidity for many is their credit card(s). If you had a major bill, like an unexpected medical expense, you would probably pull out a credit card to pay. Given the recent moves by Congress to rein in a number of questionable practices by credit card issuers to adjust fees, interest rates, billing cycles, etc. in response to changes in a card holder's financial situation (or the issuers' assessment of the change in risk), credit card issuers will likely reduce their mass marketing of credit cards and/or will charge higher rates, offer lower credit lines, and will increase annual fees on a proactive basis in advance of the enactment of the legislation. Many consumers report having their lines cut already. Will you be able to turn to your credit card in an emergency? If not, do you have cash savings (or investments that you could and would sell to raise money) for an emergency? Most do not have 3-6 months of income saved for a "rainy day".
Liquid assets do not need to be cash - they could be "in the money" stocks, CDs, savings accounts, money market accounts, and other items that can be sold within a day or two. And some might be sold at a small loss - but that is a price for liquidity.
Real estate and collectibles are examples of non-liquid assets, for the most part. There is a market for real estate and there are places, like flea markets and antique dealers, where you can sell your grandmother's hutch for cash, but some planning is involved and a hurried sale could result in a greater opportunity for a loss on the investment. A "quick sale" is a method of selling a house in order to discharge part of a mortgage. This is an alternative to foreclosure but typically, because the sale is in haste, the sale amount does not cover the mortgage balance. A more deliberative sale could allow the seller the time to select the bid that more closely approximates the value the seller has placed on the home - even if it takes years.
One lesson learned from the financial crisis is diversification. A smart investor will regularly review his/her portfolio to ensure that all of the goals of diversification are met - no undue concentration in any asset type, in any tenure of investment, and in any investment sector - and a consideration of liquidity in investments. There is no one "right or wrong" answer for an investor but diversification should keep in mind possible losses and the remaining time the investor has to recover losses.
Post your comments/questions!
Diversification is defined as the process of reducing risk by spreading investment risks across various asset types and tenures. In the case of personal investments, diversification means, to use an old adage, "you don't have all your eggs in one basket". It essentially says a good investor does not get too greedy.
Asset types include stocks (equities), bonds, real estate, collectibles and antiques, and cash (or cash equivalents). A diversified investor has spread his/her invested dollars across many, if not all of these categories.
Diversification also speaks to the tenure or maturity of the investments. In the case of bonds or certificates of deposit, a diversified investor has "laddered" or structured his/her principal repayments so that all of the money is not repaid all at one time. This helps manage interest rate risk or the risk that the investor has too much of his/her money come due in the same period of rising or declining rates. In other words, you do not want all of your investments to re-price at the same time.
A diversified investor has also considered liquidity. Liquidity speaks to the time it takes to convert the asset into cash, particularly in the event of an emergency. A diversified investor has some less liquid investments like their home and some very liquid investments like cash in their portfolio.
Let's use the Madoff fund as an example. The investors reportedly obtained a near-12% return routinely, despite the regular gyrations of the stock and bond markets over time. Investors with Madoff often put all of their invested dollars with Mr. Madoff (or increased their concentration of investments with him) because of the high rate of return and its consistency. In the future, I will talk about the lesson that "if it appears too good to be true, it is", but as investors increasingly over-weighted their investments with Madoff due to his routinely high returns, the same investors were later burned by their lack of diversification. While sympathetic to the widows moving in with their children because their nest egg is now lost, the lack of diversification is in part a flaw in the victim's investment strategy that helped Mr. Madoff destroy all of his investor's net worth in many unfortunate cases.
Will diversification then lead to lower returns? It might in the short run. A mix of bonds and equities is desired in any investment portfolio. Over time, bonds have been outperformed by equities because there is greater risk associated with equities and therefore, at times, they pay higher returns (or else no one would buy a stock). Bonds pay lower returns because, in the case of a bond issuer's bankruptcy or default, the bondholders get repaid with any remaining funds in a business before equity holders. Therefore, the probability a bondholder gets nothing for an investment, even in default, is lower than the probability a stock goes to essentially $0. Bonds also pay interest, a form of return, unless the bond issuer defaults. Stocks may pay dividends, though dividends are not guaranteed.
Diversification should match your age group and/or your investment goals. A young person with 35-40 years of employment earnings ahead of him/her can take more risk because he/she can earn money lost in the markets over their remaining working lives. A person in retirement may have no sources of income outside of pension and social security and a shorter expected remaining lifetime. There might not be time to earn money lost in the stock market, even in a soaring stock market. I think of my in-laws who had a money manager who had them too focused on equities. Last fall, they lost a quarter of a million dollars in their investment portfolio because not only did he have them too focused on the stock market, but he also had them focused on bank stocks.
Not only should there be a mix of bonds and equity, but there should be a mix of different kinds of industries among the bonds and stocks an investor holds. Jim Cramer does a skit on his Mad Money show about "am I diversified?" While cartoonish, the lesson is a good one. If you own 5 stocks in your portfolio, each should represent a different industry - for example, a bank stock, an industrial company's stock, a tech stock, a healthcare stock, and maybe an agricultural company's stock. On a macroeconomic basis, the stock market will move up or down en masse often, however, there will be stocks that do better than others so the investor will get a range of outcomes.
Liquidity is also increasingly important today because banks are not lending. A main source of liquidity for many is their credit card(s). If you had a major bill, like an unexpected medical expense, you would probably pull out a credit card to pay. Given the recent moves by Congress to rein in a number of questionable practices by credit card issuers to adjust fees, interest rates, billing cycles, etc. in response to changes in a card holder's financial situation (or the issuers' assessment of the change in risk), credit card issuers will likely reduce their mass marketing of credit cards and/or will charge higher rates, offer lower credit lines, and will increase annual fees on a proactive basis in advance of the enactment of the legislation. Many consumers report having their lines cut already. Will you be able to turn to your credit card in an emergency? If not, do you have cash savings (or investments that you could and would sell to raise money) for an emergency? Most do not have 3-6 months of income saved for a "rainy day".
Liquid assets do not need to be cash - they could be "in the money" stocks, CDs, savings accounts, money market accounts, and other items that can be sold within a day or two. And some might be sold at a small loss - but that is a price for liquidity.
Real estate and collectibles are examples of non-liquid assets, for the most part. There is a market for real estate and there are places, like flea markets and antique dealers, where you can sell your grandmother's hutch for cash, but some planning is involved and a hurried sale could result in a greater opportunity for a loss on the investment. A "quick sale" is a method of selling a house in order to discharge part of a mortgage. This is an alternative to foreclosure but typically, because the sale is in haste, the sale amount does not cover the mortgage balance. A more deliberative sale could allow the seller the time to select the bid that more closely approximates the value the seller has placed on the home - even if it takes years.
One lesson learned from the financial crisis is diversification. A smart investor will regularly review his/her portfolio to ensure that all of the goals of diversification are met - no undue concentration in any asset type, in any tenure of investment, and in any investment sector - and a consideration of liquidity in investments. There is no one "right or wrong" answer for an investor but diversification should keep in mind possible losses and the remaining time the investor has to recover losses.
Post your comments/questions!
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