Peaking Interest
Peaking Interest
Interest payments are reaching new peaks. What does it portend?
Borrowing is necessitated in business when there is a mismatch between cash inflow and cash outflow. Interest is the penalty that you pay for requiring someone else’s money.
A corporation such as Apple borrows money using bonds and their interest rate negotiations tend to be in basis points (bps in industry parlance). Apple would be bargaining between paying 1.75% or 1.85% per annum interest, a difference of 10 basis points.
When a well-to-do individual needs to buy something expensive such as a car or a home, they borrow money from banks and they often negotiate percentages. You might end up paying 4% - 5% per annum in the US or 8% - 10% per annum in a country like India which has high inflation.
Poorer people end up borrowing to tide over the month and many of them use credit cards or informal channels of lending. In the case of a credit card, a non-payment can send your interest rates from 24% to 42% per annum and informal lenders (loan sharks) end up charging as much interest for a month.
Not to mention the criminal fees that credit card companies slap on over and above the interest which brings the actual interest paid to 60% - 75%. Let us average that out at 50%.
Now if you had $1 billion who would you want to lend to? Depends on your risk appetite, but think about it.
Apple would give you $17.5 million on that capital. If you gave it as a part of a credit card, you would get 500 million on that same capital.
In Hindi we have a word - Aukaad which loosely translates to status; but does not have a literal English equivalent. Rich people have it and poor people don’t.
So while Apple can borrow $1 billion, a poor person cannot. So the banks and other financial institutions find a million people and give them $1000 credit cards to extract the $500 million in interest.
Over the past 8 years, there has been an explosion in the number of companies that have been taking advantage of the low-interest rate environment that was unleashed by the 2008 crisis to start lending companies that use an App and hence are euphemistically known as Fin-tech companies.
Every payment company everywhere in the world is a lending company that is masquerading as a payment company. Processing payments is not a very profitable business. In India, they get to charge 2% at most, and in the US about 3%. 60% - 80% of that goes to VISA and MASTERCARD. After all costs, they are left with 10 basis points or about 0.1%.
Now take a company that is processing $1 billion, they get about $1 million in revenue out of it!
That probably covers the server costs. Rents, salaries and other costs need to be financed with VC money. Their only salvation is lending.
Startups being startups don’t call it Credit Card - They call it Buy Now, Pay Later. I wrote about this a while ago.
When you scale a bad idea quickly -
Source: Quartz
The last time interest rates peaked like this, was in 2007. That time it was mortgages that caused the spike, this time around…
Source: Quartz
Banks take deposits from depositors and pay them a measly rate of interest. They further lend it out to Non-Banking Financial Corporations at a higher rate, who then lend it out or create a line of credit to a fintech company that further lends it out to individuals.
When individuals default on payments to fintechs, they would have to default to NBFCs who would then struggle to pay back the banks.
Credit card rates, which make themselves felt in wallets much more immediately, have jumped from less than 15% on average in February 2022 to nearly 21.5%. Data from the Federal Reserve Bank of New York (pdf) suggests that there has been a big spike in the amount of credit card and auto loan debt going into delinquency. And that’s on top of student loans coming back into the economic picture.
Source: Quartz
Some point to the rising federal rates for this spike but that is rubbish. It is not like credit card providers were charging 4% interest before the rates spiked. It would have been an excuse to increase already sky-high rates a bit more. Much the same way that the oil companies profited from the Ukraine war.
At the same time, they are pushing the late payment fees higher and higher since the credit card industry has been undergoing a consolidation over the years.
In response to new late-fee caps announced on Tuesday, the banking industry’s largest trade group is arguing that consumer penalties and sky-high interest rates account for the risk of people failing to pay their credit card bills. But as a recent federal report showed, credit card companies have nearly doubled the interest rates they charge to consumers — far outpacing the financial risk they’re taking on by lending people money.
[…]
Critics argue that as a handful of companies now control most of America’s credit card transactions, lenders are able to use their outsize market power to increase rates far above the underlying interest rate the Federal Reserve sets for credit cards without fear of price competition. And they say the situation will worsen if regulators approve a proposed merger between Capital One and Discover.
Source: Jacobin
And like that the minimum wage workers are being robbed blind to make the rich, richer.
The first question is how long can this party last? How long will credit card holders be able to keep up with these interest payments? I think the days are numbered.
The second question is what happens when the party stops? The first to go will be the Buy Now, Pay Later companies and fintechs who are lending at insane speed to justify their valuations. Then depending on how well they are capitalised with VC money, the next domino will fall and so on.