March 13, 2007

 

Congress and Credit Cards.  Last week the Senate Banking Committee held hearings investigating the way the credit card industry works in this country.  The committee seemed concerned that many Americans were being caught off guard by many of the fees credit card issuers were charging and other common industry practices.

 

Some of the practices that came under attack from committee members included:

 

- Universal default:  if a borrower is slow paying on any other account, even if it is with another financial entity, the credit card issuer increases interest rates and fees.

 

-  Zero tolerance late fees:  even if a payment is received one hour late the card holder is hit with a hefty late fee.

 

- Over the limit fees:  some unsuspecting credit card customers were charged thousands of dollars in over the limit fees for being only a few dollars over their credit limit.

 

The press and members of the committee seemed surprised to learn that, last year Americans owed over $800 billion on their credit cards.  The average American household had over $9,000 of credit card debt.  Clearly credit card debt is something of “interest” to Americans (pardon the pun) and thus the Banking Committee’s desire to “do something” about fees and questionable practices in the industry.

 

Many believe that these hearings represent the start of some significant changes that might impact the U.S. economy.  The first significant change is that there maybe a new wave of government regulation over the U.S. financial industry.  The second significant change is that the long consumer debt binge might be coming to an end.  The first seems likely; the second is a bit more complicated.

 

While the Senate Banking Committee was holding hearing on the credit card industry there was buzz around Washington that more regulation was ahead.  It is rumored that Congress, or the SEC, or both might look at placing regulations on the alternative asset market, specifically hedge funds and the private equity industry.

 

Hedge Funds and Private Equity

 

Hedge Funds have always been the “whipping boy” of financial markets.  Pundits in the press like to characterize hedge fund managers as over paid, risk taking, financial gun slingers. The pundits argue that hedge funds are disruptive to financial markets and they put innocent people’s money at risk. The anti-hedge fund pundits point to massive losses suffered by hedge fund investors because of blow-ups like Long Term Capital Management and Amaranth.

 

The Private Equity industry has also recently come under a growing amount of political pressure similar to hedge funds.  Pundits worry that these “secretive” financial entities are playing with fast and loose with the pension money of workers from across the country.  The pundits complain that managers of private equity funds receive obscene amounts of compensation while secretly taking on massive amounts of risk.  The anti-private equity pundits bemoan the fact that once a private equity fund gets a hold of a company the fund will gut the company, stripping away assets, and firing workers.  All the while the managers of the private equity fund are lining their pockets with hefty fees in a risky attempt to resell the shells of the companies they have acquired.  The pundits claim private equity managers are getting rich quick by using workers pension funds to destroy companies in these secretive transactions.  The pundits write op-ed pieces across the business press that “something must be done” about the private equity industry.

 

The truth, as usual, is not so dramatic. 

 

Yes, hedge funds take on a great deal of debt are can be very risky investments.  But that’s the point.  That is what they are supposed to do.  Institutional investors who put their money in hedge funds should first understand the trading strategy of the fund, as well the role a hedge fund investment plays in a well diversified investment portfolio.  If these institutional investors don’t “do their homework” in understanding how hedge funds work, the problem lies with the investors not really with the hedge funds.  Government regulation of hedge funds will probably not create better institutional investors.

 

There is a similar story with private equity.  Not all private equity funds are same.  Some perform very well and add value to the firms they acquire and thus increase employment.  Others, it is sad to say, are poorly managed and they destroy the companies they acquire.  But these poorly run private equity funds ultimately lose money for their investors and should be driven out of the market.  So, the institutional investors also need to do their homework when they invest in the private equity.  Simply pouring money into private equity because “everyone else is” is a mindless strategy sure to result in horrible results.

 

This is not to suggest that hedge funds and private equity markets could not be made more efficient.  Certainly a standardization of reporting results would go a long way in making these markets more efficient.  Industry insiders for years have been claiming that both the hedge fund and private equity industries will “reform from within” and do a better job or reporting results in a consistent, verifiable way.  And yet nothing of the sort has come about.  So, since the industry is failing to reform itself Congress or SEC is probably going to do it for them.  The results will most likely be sub-optimal. (in English:  Congress and SEC will probably screw it up)

 

End of the consumer binge?

 

Does all of this talk of changes in financial markets mean that the end to our financial market “imbalances” is near?  Will American households finally wake-up and realize that they can not continue to support their lifestyle with credit card debt?

 

Some think the answer is yes.  Martin Feldstein, the very well respected Harvard economist, argues that in the not too distant future American savings rate will return to their historical average, meaning Americans will stop charging so much on their credit cards.  Basically Feldstein argues that the “wealth effect” from equity returns and real estate appreciation has to come to an end and when it does savings rates will increase.  This, of course, necessitates a reduction in spending and thus credit card debt.  Will this mean a collapse of the U.S. economy?  Most likely the answer to that question is no, but it could disrupt some segments of the economy.

 

But will the American consumers really start to save?  Some are not so certain.  Maybe this American appetite for debt goes well beyond the wealth effect.  Have Americans simply learned to be comfortable with massive amounts of debt?

 

Will financial markets continue to allow Americans to care such a heavy debt load?  Look at the recent shake-up in the sub-prime mortgage market.  If that market starts to shrink considerably, many high debt Americans may find they no longer are eligible for homeownership.

 

So which is it:  will the change in American consumer debt markets come from the demand side (Feldstein’s argument), the supply side (no more credit for the indebted), or from the regulation side (back to those Congressional hearings)?  Or will it be all three?

 

Maybe, just maybe, the Senate Banking hearings are the start of some dramatic changes.

 

Regards,

-M. Brandl