Some people claim that the credit card industry has consistently earned extraordinary profits.

Claims of excess profits have surfaced in the press, in the debate to legislate ceilings on credit card interest rates, and in large antitrust litigation.

A recent contribution to this perspective was summarized in a New York Times article, "A Mystery Bankers Love: How Do Credit Cards Stay So Profitable?"

However, perceptions of excess profits commonly stem from either a misapprehension of shareholder risk or the mistaken reliance upon accounting figures in the credit card industry.

The recent work described in The New York Times is by Laurence Ausubel, whose work has oscillated between both misapprehensions.

We believe there is no mystery to credit card profitability when risks and returns are measured properly.

Accounting measures of profitability are biased, because the typical balance sheet does not define "equity" to include the significant investments required to attract new credit card customers.

These investments include advertising, direct mail solicitations, credit checks - and the willingness to absorb losses, as new credit card accounts experience high defaults while yielding little interest revenues.

The illusion of excess profits arises if one ignores this "off-balance- sheet" investment and simply divides accounting income by the equity recorded on a company's books.

The biases generated by such factors as the failure to capitalize intangible equity have long been recognized and recorded in numerous academic studies. In the credit card industry the problem is pronounced, because the intangible equity in account acquisition is significant when compared with balance sheet equity.

By the time a portfolio has matured, losses have been absorbed, and unsuccessful accounts have been terminated, the average cost per successful remaining credit card account can range from $100 to $200. Book equity, by contrast, is only about $100 per account for a portfolio with average balances of $1,300 financed at 8% equity.

Intangible investment in account acquisition is reflected in the premiums that banks pay each other for sales of mature credit card portfolios. Premiums are paid to avoid the costs of generating new accounts from scratch.

Prof. Ausubel used accounting data to measure profitability for a 1991 study published in The American Economic Review. He found that credit card companies consistently earned returns on equity in the neighborhood of 60% to 100% before corporate tax. He also believed that premiums for credit card portfolios indicated excess profits.

We recognized the problems with typical accounting measures and with his calculations in particular when we were retained to examine industry profitability on behalf of Visa U.S.A. in the Sears v. Visa antitrust case. Our opinions were outlined in a working paper last year and raised before Prof. Ausubel at a conference.

Prof. Ausubel has responded by revising his methodology to estimate the intangible equity associated with account acquisition.

The estimate of intangible equity in his current work is based on an average premium of 20% over book paid for sales of credit card portfolios.

Prof. Ausubel's current results paint a dramatically more sober vision of industry profits. His revised methodology has dropped the perceived returns to somewhere between 21% and 38%, depending on the period examined.

The long-run average using all the data he examined from 1971 to 1993 is only 29%. Applying combined federal and state marginal corporate tax rates and correcting for technical errors in his calculations, his new methodology implies after-tax equity returns roughly at 20%, or even significantly below for the same time periods.

Prof. Ausubel still concludes that credit cards have earned excessive profits, but this conclusion is now driven largely by a failure to measure risk properly.

Because a high level of shareholder risk warrants a correspondingly high return in competitive capital markets, risk must be considered before concluding that an industry's earnings are excessive.

Prof. Ausubel's analysis of risk suggests that the credit card industry is essentially risk free, and that a competitive return for the industry should be in the same range as returns on short-term United States Treasury bills. He therefore maintains his earlier conclusion of excessive profits, despite finding significantly lower profitability than before.

However, we do not believe that his risk analysis holds up under scrutiny.

First, it is difficult to believe that the equity in a highly leveraged business bears no more risk than short-term U.S. Treasury bills. Even the debt used to finance the credit card business is riskier than United States Treasury bills.

Second, his measurement of risk is based on the correlation between an estimate of the credit card industry's annual economic profit and stock returns for the S&P 500.

However, stock returns are driven in great part by expectations with respect to macroeconomic variables such as inflation and economic growth. Current profitability is only a small factor in a larger equation.

Examining the correlation between the S&P 500's short-term profitability and its stock returns would suggest, paradoxically, that the market itself had little market risk.

It is more appropriate to measure shareholder risk with an apples-to- apples comparison of stock returns. In fact, measures of risk based on stock returns in the credit card industry appear to contradict Prof. Ausubel's findings.

In his recent work, he identified three publicly traded banks that specialize almost exclusively in credit cards. The stock returns of these "pure play" banks have demonstrated significantly greater market risk than returns on the S&P 500.

The simple average of the relative risk for these three companies is 1.72 times the market's. Applying this ratio to the periods examined by Prof. Ausubel indicates that after-tax equity returns in the range of 20% are not unexpected.

Findings of excessive profitability have often been portrayed as a paradox given the competitive structure of the credit card industry. The industry is not heavily concentrated, and intense competition is evident in such activities as the constant outpour of solicitations to switch or acquire new credit cards.

However, the paradox is generated by misleading indicators of profitability or the failure to measure risk properly.

The profitability of the credit card industry is consistent with competition and presents little mystery when equity returns and risks are properly measured.

Mr. Lapuerta and Mr. Kolbe are members of Brattle/IRI, a consulting firm in Cambridge, Mass.

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