Bankruptcy Blog: March 7, 2005

Some thoughts on credit card fraud from a fellow academic, Corinne Cooper:

Interest rates are made up of three things:
1. The cost of money (interest goes up and down based, in part, on the supply of and demand for money, just like any commodity.)
2. The expected inflation rate (so the lender gets back its money in constant dollars)
3. A risk premium.

If I apply for a credit card (and I get an average of 5 solicitations a week), the rate that I qualify for is around 9%. Given a fed funds rate of 2.5% (the “cost” of money) and relatively low inflation projections (let’s assume 2%), the difference is . . . (drum roll) THE RISK PREMIUM. For the best borrowers, the credit card companies collect over 4% to account for the risk of non-payment.

For riskier borrowers, the credit card interest rate is much higher, often as high as 29%: that’s a 24% risk premium.

Think of it as the premium that you pay to insure the bank against your non-payment.

Here’s what’ so strange: The credit card companies collect this risk premium, year in and year out. But when the risk actually happens and the borrower cannot pay, the lenders want the Federal government to intervene to force the debtor to pay, by passing a law prohibiting them from filing bankruptcy and discharging the debts. It’s as if a life insurance company took premium payments for years and then asked the government to pass a law prohibiting death! Bankruptcy is credit death, and if this bill passes, the courts will be clogged with credit “zombies”: consumers who can never pay back their debt, and never get rid of it.

Why, then, shouldn’t the debtor be able to recover all that extra interest paid to cover risk??

There is massive credit card fraud, but it’s by the credit card issuers, not the users.

Corinne Cooper is a retired law professor and communication consultant in Tucson, Arizona.

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