By Jen Saarbach & Kristen Kelly, Co-Founders of The Wall Street Skinny
In a political environment where “affordability” has become the rallying cry for both parties, radical new policy changes are being proposed at both the local and federal level. The latest? President Trump’s call to cap credit card interest rates at 10% for one year.
This proposal is unlikely to become enforceable policy. But, stranger things have happened. So it’s worth discussing seriously what it might mean for not just bank earnings, but also the securitization market, access to credit for marginal borrowers, and the consumer credit system that much of the U.S. economy depends upon.
At a practical level, the credit card business is priced the way it is for reasons that may not be immediately evident. Credit cards are unsecured loans, meaning: there is no collateral for lenders to recover when borrowers default. If you borrow money to buy a house, your lender has a claim on that house if you can’t pay them back. If you borrow money on a credit card to pay for your Doordash order, the bank can’t exactly foreclose on your cheeseburger.
Beyond that, credit cards have an embedded option within them where borrowers can pay off their balance at any time. Lenders cannot, therefore, lock in a fixed stream of cash flows the same way they can with other loans.
Under normal circumstances, the credit card industry manages these risks through portfolio economics, where the profitability of prime customers and high-spending cardholders subsidizes losses elsewhere in the system.
A hard 10% cap would immediately disrupt that math, and would have outsized impacts on the segments of the market where risk is highest and rates are currently far above the proposed ceiling (well into the mid-20% range).
Moreover, what about the impact on the ABS market? Just as banks securitize and sell off portfolios of mortgage loans in the mortgage-backed securities (“MBS”) market, there is an asset-backed securities (“ABS”) market, where credit card receivables are pooled into securitization trusts and sold as bonds. Those bonds are backed by the cash flows from consumer payments, and I’ve seen estimates for the size of that market ranging from $70-85bn. Its stability relies on the cushion of excess spread: the difference between what borrowers pay and what bondholders are owed after servicing costs and charge-offs. If the income from loan portfolios suddenly drops due to a rate cap, excess spread compresses, loss absorption disappears, and the existing terms of various structures may trigger capital injections into the trusts that back these bonds, or accelerated paydown mechanisms that protect bondholders. During the global financial crisis, many issuers took steps along these lines. Those of us with longer memories know how quickly the nature of these structures can lead to a seizing up of the lending market when cash-flow buffers shrink.
So, what would this all mean for the broader picture? Remember, securitization is not just some financial engineering trick. It’s a funding and risk-transfer mechanism that supports the giant system of consumer credit that drives our whole economy. If this cap is put in place, lending will become far more conservative, and underwriting will likely dry up for all but a fraction of consumer borrowers.
So the consequence isn’t that credit suddenly becomes cheaper for American borrowers. Instead, it means they simply get less credit. When lenders cannot adequately charge for risk, how can they lend to riskier cohorts? If banks cannot earn enough to cover their funding and operational costs, let alone their inevitable losses, credit lines shrink, approvals become harder to obtain, and the customers who rely most on revolving credit are likely the first to be rationed.
This means, quite simply, fewer people buying things. That means slower growth across the ENTIRE economy, not just the banking sector. The U.S. economy is dependent on credit cards as the liquidity bridge that helps households manage uneven cash flows and unexpected expenses. For most families, credit cards are the system that keeps spending and bill payment patterns stable even when wage growth lags inflation or emergencies occur. Slower growth leads to lower pay leads to lower spending…you get the picture.
That’s why the macro risk of a credit card cap is much larger than the impact on bank earnings (even though the latter would still be disastrous). The irony is, a policy pitched on the premise of consumer protection could ultimately make the affordability problem worse.