Wednesday, May 27, 2009

The New Credit Card



Last week there was a great deal of buzz and coverage surrounding future regulations of the credit card industry. I’m surprised that everyone stopped talking about it so quickly. I believe these regulations will have a serious impact on the growth of both the US and Canadian economies. The credit card is the least discriminating form of credit widely available to humans. Regardless of how old you are, what you do for a living, what assets you own and what you want to do with the money - you can get a credit card.

Consumer spending represents over 70% of America’s GDP and personal credit cards facilitate a great deal of that spending. This entails that the US GDP growth is joined at the hip with individual consumer spending. Restrictions on credit cards will hinder consumer spending resulting in slower economic recovery. At the same time, the American consumer clearly needs to be protected from fast and easy credit given the ridiculously high levels of consumer debt they’ve accumulated.

So what exactly are the proposed changes? In the US, a bill was recently passed by the Senate making it harder for people under 21 to get a credit card. It also stops the banks from raising the interest rate on a consumer unless he or she is more than 60 days late on making minimum payments. Relatively minor changes thus far, but will there be more?

This New York Times article hints that card companies will employ a completely different scheme for credit cards in the future among this changing regulatory landscape. They say there will be more user fees and a reduced (or eliminated) grace period where no interest is charged. This would affect customers that pay on time every month the most, which is estimated to be 40% of credit card holders in the States.

I find this hard to believe because consumers that pay on time don’t actually need the credit, in most cases. Many people only get credit cards because of all the perks they can earn, not because they need the financing. If they had to pay ridiculous amounts of interest and high user fees, it would cease to be an attractive option.

In addition to this, the credit card companies make money from vendors. A standard charge that Visa or Mastercard might impose on a vendor is 3% of the purchase price on each transaction, which might be capped if the vendor reaches a certain volume level each month. The reason these vendors have these credit card machines is because customers like paying with credit cards, and accumulating points. If credit card companies make their "gold" cards unattractive to their prime customers, they will start to lose revenue at the stores as well.

Let’s change focus to the majority of American credit card holders (the 60% that carry a balance from month-to-month). What the banks are implying is that everyone will be treated the way these customers are treated, extremely high interest rates and very little perks. Eerily similar to the business model of subprime lending, the incredibly high and volatile interest rate schemes serve to protect the credit card companies from a naturally high rate of default. Remember, they are giving you a completely unsecured loan to purchase whatever you like. At least with a subprime mortgage there is a house that the bank can takeover should someone default. With credit cards, the rate of interest has to be high enough to compensate these companies for all the customers that never pay back the loan. There is nothing else to fall back on.

In Canada, everything works exactly the same, except 70% of Canadians pay their bills on time so they never pay interest. This CBC news brief notes that Canada is also working on regulating the industry. Because of the diligent client base, our regulatory changes are not likely to be as drastic as in the US.

I want to share a story with you about my father in 1989, right around the time that the recession was surfacing in Canada, and credit became tight. He had been using an electronic typewriter for all his business communications, but once he learned about the word processor, he realized that it would save him an incredible amount of time. He would be able to customize documents for each sales pitch faster, meaning he could fit more appointments in each day.

He purchased an 80-86 computer (if you recall the progression, it was the one before 286, 386, 486, Pentium, etc). It had a monochrome orange monitor that weighed as much as a big screen TV even though it was 15 inches in diameter. He paid $100 extra to install an 8 MB hard disk (it came with no disk space) which was barely enough space to load the start-up disks and a word processor called "8-in-1." Add another $100 for a dot-matrix printer to complete the set.

He didn’t actually have the money to purchase this computer. What he did was use his credit card to make the purchase, and then obtain more credit cards to make minimum payments each month in order to avoid default or harm to his credit rating. This was by far the most expensive way to purchase a computer (let’s not even mention the fact that it was going to be obsolete in two years). He was fully aware that time was against him, and that ultimately he would run out of room on those credit cards and would be unable to make minimum payments this way. But he got through it, and he had the credit card companies to thank for it. Sure, they charged him an incredibly high rate of interest, but without them his business would never had made the jump that all the other businesses were making with the word-processor.

It certainly helped that the banks didn’t ask about how he was borrowing money from friends to make mortgage payments. Nor did they ask about how regular his income was. That is the reason he was able to get through a very tough time. Ultimately, he was a positive contributing member in the Canadian economy for years to come. Regulations will make credit card companies think twice about extending more credit to people like my father this time around. For example, if regulation forces card companies to reduce rates, then they will only lend to customers worthy of the reduced rate. Each time a rule is created designed to protect the customer, the card companies must re-assess how to maximize profits.

Expect more severe regulations to reduce the amount of credit available in the future through these cards and curtail consumer spending altogether. Reduced American consumer spending will slow the recovery of both the US and Canadian economies. But more importantly, these subtle tweaks to the rules will change the way we take risks. The new credit card will change how we live our lives.

Monday, May 11, 2009

Death Bonds



One evening at the dinner table, my father told me that he would probably die before my mother. He was much older than her, and he explained how he no longer needed to pay premiums on his life insurance now that all of us kids had grown up and made lives of our own. He and my mother would be comfortable for the rest of their retirement without this policy. He said that the insurance companies would refund some of his money, but those bastards completely rip you off. If you’ve paid ten grand in premiums, they’ll give you back two.

He offered me a chance to purchase his life insurance. I would pay him a few thousand, the same as what the insurance companies were offering, and take over ownership of the policy although it was still tied to his death. I would continue to pay premiums, but I would be the one to receive the big payout in the end once he died. This way, all the money he poured in over the years would stay in the family.

I’m sure that analyzing the numbers would have made the decision much harder for me, but I have one important rule when it comes to investing or gambling: if everything inside you says it’s a bad idea, don’t do it. Besides, I don’t think there’s very much on this earth that can destroy him anyway. He’s filled himself with smoke since he was ten. Up until recently, fried chicken was a weekly tradition. His father and siblings abandoned him or stole from him. He's had over 20 different jobs, careers and business failures under his belt. And now, to top it all off, he’s embraced death. There’s no freaking way I would bet against him.

My father is an insurance broker. He had been introduced to this idea a few years back at an annual conference he reluctantly attends. What he discovered was that there are investors out there willing to accept the proposition that I couldn’t. They were buying insurance policies from people who no longer needed them. But why?

To fully understand, let’s go over some more details about life insurance. Most people are like my father. They take out life insurance so that while the kids are growing up, should anything happen, the family is taken care of. But once the kids grow up and move on, paying those premiums becomes harder to justify. There’s no need for the big payout anymore. In fact, insurance companies count on people to accept the “cash surrender value,” to end the contract. They refund you a fraction of what you’ve paid in premiums over the years – you surrender the rest. That’s your only option if you want to stop paying the monthly bill.

But a new option has emerged in the last few years. With outside investors willing to pay a premium to take control of these unwanted insurance policies, people like my father can get a lot more cash back than what the insurance companies traditionally offer in surrender values.

It’s a great investment for the outside investors too. Because cash surrender values are so absurdly low, the investors are still able to scoop up the policies at a discount. They focus on cherry picking policies from older, unhealthy people. Once the investor takes over, part of sustaining the investment is to continue paying the premiums, and waiting for the jackpot. The earlier people die, the greater the profit. The beauty of investing in insurance policies is it has nothing to do with the economy. Markets can go up or down, but you can always count on people dying.

So who’s buying all these policies? Enter: Death Bonds. Numerically sculpted like the Grim Reaper, this is a financial instrument composed of unwanted life insurance policies. Institutional money managers, like hedge funds, are letting insurance brokers everywhere know that they are interested in buying insurance policies from people who need the cash. As they aggregate these policies, they securitize them. Securitizing is just a fancy word for taking similar financial instruments (like several insurance policies), and lumping them together to make an industrial sized financial instrument (like a bond that is based on several individual insurance policies).

Now that we have all the pieces, here’s the recipe for a Death Bond:

  • Picking the fruit is essential. Lucrative insurance policies tend to come from people who are older and have paid into these policies most of their lives. Their recent health history shows a lot of risk. Of course, the big payout at the end is crucial too. Buy as many of these policies as you can;
  • Add up the total death benefits of all of these policies once everyone is ultimately dead (assume $1 Billion);
  • Securitize these individual policies to make a much simpler, larger, and more attractive financial product for institutional investors: the Death Bond;
  • Find investors that collectively will give you $1 Billion in exchange for your Death Bond;
  • They effectively invest $1 Billion in your bond. The investment will pay them interest each year, and 15 years from now, the Bond will return their $1 Billion principal;
  • The issuer of the Death Bonds receives $1 Billion in cash up front. They take this money and continue paying the premiums in order to keep the underlying insurance policies alive. They can invest the rest in low to moderate risk investments for the next 10-15 years. Part of this cash would be used to pay a coupon to investors each year, so they receive about 5% per annum on their $1 Billion dollar investment in the Death Bonds;
  • By the time these bonds have matured, most of the underlying insurance policies should have paid the death benefit. There is plenty of cash available to pay the investors their principal back when the bond expires. Also, the Death Bond issuer has been investing the excess cash during this time which they can draw from as well, just in case people outlive their calculated life. Once they have paid back the investors in full, the remaining cash is gravy.

It sounds like a win-win situation, right? Individuals that need the money get more cash for their policies because of this emerging market. Creators and issuers of Death Bonds are able to make a profit on these policies by securitizing them, making them attractive to other institutional investors. Finally, those institutional investors make a moderate and safe return during a time of extreme volatility. But in finance, someone has to lose. In this case, that would be the insurance companies.

The Death Bond market is growing. They are especially attractive right now because they provide a decent rate of return that isn’t correlated with the markets. As the policies change hands, from individuals to institutions, more of the policies will be carried out until maturity (death). This means insurance companies will have to make additional lump sum payments that they may not have accounted for in their reserves.

Insurance companies calculate reserves based on the probability of death, but remember, historical data reflects that a great number of people traditionally accept the cash surrender value – there was no other alternative before. With the emergence of Death Bonds, these policies are kept alive until the death benefit is collected. Insurers must respond by facilitating this drastic change in their cash outflow. The faster the Death Bond market grows, the harder it will be for insurance companies to recalculate what a sufficient reserve is.

By forcing insurers to pay out these death benefits, rapid growth in the Death Bond market will pose liquidity problems to life insurance companies. This is primarily an American phenomenon, but we can already name life insurers (AIG) that are barely staying afloat, kept alive by periodic government cash injections. Should the Death Bond market explode, this could push struggling insurance companies to the brink of extinction.

But I don’t want to end this on such a pessimistic note. Let’s assume that everyone involved is doing their homework and only transacting on insurance policies that are backed by healthy insurance companies. Let’s pretend that Wall Street won’t try to lowball people like my father for their insurance policies to enhance their profits. Let’s even go as far as saying that all the issuers of Death Bonds, who by the way have no prior experience with predicting life expectancy, somehow grasp the actuarial task proficiently enough to structure the duration of Death Bonds correctly. This way, everyone involved lives happily ever after – until they die.