loan

We don’t want no interest-free loans!

November 18, 2009 in Economics,Finance

A long time ago, when I was first learning to manage my finances, my dad instructed me to prepay my credit card. This effectively transformed the credit card into a debit card by running a positive balance on the account. It was a great learning mechanism because it still required me to make monthly payments, but provided a cushion in case I missed one or made a mistake. In my father’s mind (and I agree), the few dollars I was losing in interest opportunity costs were more than made up for by a lengthy credit history with no late payments.

These days, I would never ordinarily prepay any of my cards. Just the opposite, in fact – I schedule payments for the last possible day. The economic rationale is simple: positive credit card balances don’t earn any interest, therefore I want to hold on to my cash for as long as I can. Occasionally, however, I send the credit card companies a little extra cash. The most common reason is also (believe it or not) economically rational: consumption smoothing. For example, I prepaid part of my October balance in September, anticipating an abnormally high balance that month (thank you, California trip). The net result after two months was the same, but there was no month in which I had to make a particularly large payment – and that’s easy on the mind.

So imagine my surprise today when I went off to make my first payment on my Discover card and the site informed me of the following (emphasis mine):

A credit has been applied to your Account since your last statement was posted. This credit has reduced your overall Discover Card balance.

Since you may not make an online payment for more than your current balance, we are showing you the Current Balance instead of your Last Statement Balance.

I found that very surprising (enough to write about, anyway!) – you would think, especially in this economic climate, that credit card companies would love to receive cash in advance on which they have no obligation to pay interest. I think that’s especially true because there’s a chance I might not use up my positive balance for some time, effectively giving the company an extended interest-free loan. So why would they ban this practice?

My theory is that their view is exactly the opposite of my father’s – by preventing customers from prepaying, they increase the probability of a customer paying late. That, in turn, allows the company to levy late fees which are far more lucrative than a few bps of short-term interest (at today’s levels).

Any other thoughts on why prepayments would be explicitly prohibited?

{ 3 comments }

Spotted: a free lunch

June 11, 2009 in Finance

The internets are buzzing about the CDS trade that netted small brokerage firm Amherst a nice profit at the expense of Wall Street giant JPM.

I may be missing something, but it seems to me that the risk hasn’t disappeared (as is being implied), it has merely been transferred from the mortgage originators (or whomever they sold the bonds to) to Aurora, the mortgage servicer. It’s a key distinction.

Basically, as I see it, Amherst raised a lot of money based on the fear of default and used those proceeds to eliminate the possibility of default as it pertains to the original risk-takers. It so happens that they were able to “raise” so much money that they ended up being paid to perform this service (such as it may be). They did not, however, eliminate the risk of mortgage default. Aurora now holds those bonds and is on the line if homeowners should fail to pay; I’m sure Amherst has passed on enough of the profit so that Aurora can not lose money on the deal.

So the “risk” still exists nominally, but so much profit was extracted from the trade that there is no downside risk to the arbitrageurs.

Ah, there’s the key word that I haven’t seen in any article – arbitrage. Not often you can point to such an obvious example in plain daylight, but nonetheless I’m surprised no one is calling this what it is. Amherst was able to sell (potentially unlimited) amounts of CDS at a price which was obviously too high. At a lower price, simple cash constraints may have prevented them from exploiting the trade, since no counterparty would sufficiently pay them enough to call the entire bond issue.

The system isn’t broken; on the contrary, this is it in action! To all you Markowitz mean-variance CAPM scholars out there: you need events like this to ensure equilibrium! Unless, of course, you assume them away (or worse, into the mysterious realm of “endogenaity”).

{ 0 comments }