Credit Cards Plus

In recent years the way credit cards have worked behind the scenes has changed dramatically, but this is something that the credit crunch has unsettled, which has meant that credit cards have become more restricted.

Credit cards used to work in the following way.  A bank would issue the credit card to the customer, would run the administration of the card and loan the money from savers’ funds.  Everything would be on the banks’ book and if there were losses the bank would take responsibility.  The administration of the payments (as opposed to the administration of the account) would be done by a credit card processor such as MasterCard or VISA.

In the new system there was added a new actor, the fund provider.  This was a third party bank or other financial institution that would buy the debt from the bank that had originally issued the credit cards.  This was a model that had originally been used with mortgages and business loans.

What happened would be that the money would be loaned out to a number of people; this would be aggregated and would be sold on to third party investors.  These investors were attracted by the higher returns and a perception of safety.

It took a while before credit card debt was packaged up in this way, but once this became common then the amount of credit card lending was increased dramatically.  This was because debt on a credit card was no longer coming from the saver’s accounts and so was far more available as they were coming from a far wider pool.

The increase in lending meant that a number of things happened to credit card lending.  Firstly the perceived risk was lowered as the funds increased.  This meant that many people who could not easily get credit cards could now get far more unsecured credit than they had before.   The interest rates for those people with good credit also fell and credit limits increased.

The credit crunch happened partly because of this behaviour.  What happened was that it became clear that a number of these loans were unlikely to be paid.  This meant that investors started to become suspicious of previously optimistic projections of the card’s credit worthiness.  This meant that there were so many loans originating from credit cards that were no longer being seen as a good credit risk and could not be sold.
In the end the lack of lending this meant that credit card interest rates rose, card limits fell and risk standards tightened.