The Business Of

Banking | Goldman Sachs | Credit Cards

Morning All!

TGIF! The weekend is so close! But before we get there, we’ve got one final newsletter to round off The Business Of Goldman Sachs. Let’s have a quick recap of some of the fun, surprising things we’ve learnt about the elite investment bank this week…

• Tesla (Stock) Is Popular - buying and selling shares for clients is lucrative business for Goldman. And guess which share is the most traded in the US…

• Office Or Warehouse? A 1st year analyst at Goldman gets a base salary of $110k. Which is ~$23/hour… only a tad more than the $19/hour at Amazon!

• 4th Isn’t Bad - Goldman’s EBIT margin of 33% saw it slot in at 4th in our EBIT Margin ranking. Only behind, TSMC (50%), McDonald’s (40%) & Nvidia (37%)!

Okay so, today we’ve got a very special newsletter - we’re going to explore the world of credit cards! Some of us may have credit cards. Some of us may be thinking about getting a credit card. But my bet is that most of us won’t know exactly how credit cards work! Like, how do credit card companies actually make money from us? What are their costs? Should you even have a credit card?!

Well we’re going to explore all of that today and also look at how a supposed credit card match made in heaven between Goldman Sachs and Apple went so wrong. So, without further ado, let’s get stuck in!

Buy Now, Pay Later!

Okay so, what are credit cards and why do people use them? Well, to answer that – let’s first look at debit cards. Debit cards are usually people’s first taste of cards. They allow us to pay for things using the money we’ve deposited into our bank accounts. For instance, if I go to McDonald’s and buy a Big Mac burger for £4.59 using my Barclays debit card, it’s me who’s paid for that burger. Money will have left my bank account.

Now, what about credit cards? Well, with credit cards, it’s slightly different. If I buy that McDonald’s burger with a Barclays credit card, it’s not me who’s paid for that burger. Well, it’s obviously me who taps my card… but it’s not my money! Barclays basically lend me that £4.59 and pay for my burger. And at the end of the month, Barclays will expect me to pay them back the balance (£4.59 for that burger). So, credit cards are a form of borrowing. Barclays give me money now, and I pay them back later.

Now, there’s several reasons why people take out credit cards. This survey from Money.co.uk shows us that ‘spreading out the cost of big purchases’ is the #1 reason for taking out a credit card in the UK. But what I really want to focus on today is the 2 types of credit card users. Those who pay off their credit card balances every month. And those that don’t! And the distinction between these 2 types of users is important for understanding how credit card issuers make money.

So, the first group of people – those that do pay off their credit card balances every month – are the ones who don’t get into credit card debt. These people are using credit cards to their advantage. They don’t need credit cards to pay off their purchases. But they use credit cards to (i) build up their credit score – to help them get a mortgage in future, and/or (ii) get cool rewards – like free flights!

FYI I think this promotion expired in February :(

Now, the other group of people, who don’t pay off their credit card balances every month are unfortunately the people who get into credit card debt. And we’ll talk more about this in the next section…

Interest + Intercharge = $$$

Okay, so let’s get into how credit card companies make money. And really, there’s 2 main ways. The first one we’ll look at is interest. When people pay for things on their credit card, but don’t pay off the amount they owe by a certain time – the credit card issuer will charge interest on that amount.

Let’s say I have a Barclays credit card. And in my first month of having the card, I spend £2,000. However, at the end of the month, I don’t pay back to Barclays that £2,000 I spent. What happens? Well, Barclays will start making money by charging me interest! How much interest? Well, the average interest rate on credit cards in the UK at present is ~24% APR. Which means that after every month, ~2% (24%/12) of interest will be added onto the amount I owe! In my example, interest of £40 (£2,000 x 2%) will be added after that first month.

Now, £40 seems small. But these monthly interest payments add up. If I don’t pay off the £2,040 I owe in month 2, I get another £40.80 (£2,040 x 2%) of interest added to my balance! And this pattern can lead to sizeable debts piling up. In fact, in the US, the average credit card user has a whopping $5,733 in credit card debt. Not great for the average person… but not too bad for credit card issuers. In 2022, American Express – one of the largest credit card issuers globally - made a staggering $12.7 billion from interest. $12.7bn! But here’s a question - what about for the people who do pay off their credit card balances at the end of every month? Do credit card companies not make any money from these customers?

Well, no they do! And the reason is because the second way credit cards make money is through intercharge fees (aka discount fees). And this is where American Express, and other credit card networks (e.g. Visa, Mastercard). will take a fee from every purchase you make on their credit card! To see how this works, let’s take a look at the graphic below. We can see that for the £4.59 I spent at McDonald’s earlier, McDonald’s don’t actually keep all that £4.59…

… because 1-3% of that goes to the network who helped make that transaction happen – usually American Express, Visa or Mastercard! For more reading on how this payment ecosystem works, I recommend giving this article a read. By the way, we will do a ‘The Business Of Payments’ series at some point which goes into this in even more detail!

Now, I know what you’re thinking - 12p is tiny! Surely this can’t be a huge revenue driver for credit card issuers. Well, you’re in for a surprise. Because in 2022, revenue from intercharge fees totalled an extraordinary $30.7 billion for American Express. ~2.5x more than the $12.7bn they made from interest in 2022!

Huh, Credit Card Issuers Take Out Debt To Pay For Me?!

Okay, so we’ve seen the 2 main ways credit card companies make revenues. What about costs? Well, a couple of ‘basic’ costs that credit card companies have are marketing costs – to attract customers to use their card. And administration costs – for things like customer support. But those are fairly boring costs, so let’s look at some of the more interesting ones!

And one super interesting cost is the cost of rewards. You know we said earlier that there are credit card owners who don’t really need credit cards, but use them to build up rewards like free flights, hotels, etc. Well, who pays for all these rewards? Is it the credit card issuer? Or the shops you purchase from? Or someone else? Well, it’s the credit card issuer! In 2022, American Express paid out a stunning $17 billion for these rewards + services!

Now, obviously $17bn is a lot of money. But remember American Express make $31bn a year in intercharge fees. So, yes, American Express could say, ‘You know what – we’re going to stop giving away points and rewards when you spend on our credit card’. But guess what? That’ll lead to less customers using their card. And less spending. Which leads to less intercharge fees… which remember is their main revenue source! So these rewards are crucial in keeping intercharge fees high for credit card issuers.

Another major cost for credit card issuers is interest expense. So, we saw earlier that issuers make revenue through the interest they charge on the amounts people haven’t paid back. But why is interest also a cost for them? Well, the graphic below helps us see that when I buy that Big Mac, American Express are using debt to pay McDonald’s!

American Express don’t want to be using all the cash on their balance sheet to pay for me! So they’ll borrow money themselves - usually at a low interest rate in the interbank market - to pay for my Big Mac. And then when I pay American Express back, they’ll pay back the banks they borrowed money from!

Goldman and Apple Gave Credit To People Who Couldn’t Pay Them Back!

Okay, so we’re about to wrap up. But you may be wondering – how does all of this relate to Goldman Sachs and Apple? And where could this super-couple go so wrong with credit cards? Well, there is one main reason for the struggles Goldman faced with their Apple venture. And that is due to credit losses. What do I mean?

Well, earlier, we talked about the two types of credit card users - one type being those that didn’t pay off their credit card balances every month. And we saw that interest would build up for these users. However, there’s more to this story. What if the credit card user just doesn’t pay back the amount they owe? What happens then?

Let’s say someone has built up $20k in credit card debt, but has no way of paying their credit card issuer back (they may have lost their job or had to pay a huge medical bill). Credit card issuers can contact debt collection agencies to help them speak to the credit card holders and try and recover some of the $20k. But quite often, a large proportion of these debts aren’t recoverable, and credit card issuers have to record a loss!

And this is what happened to Goldman Sachs. As we can see from the image below, in 2022, Goldman Sachs’s Platform Solutions division (which is basically their retail banking business) recorded a whopping $1.728bn in ‘provisions for credit losses’. Which followed $697m in 2021 and $487m in 2020. These amounts are basically amounts that Goldman Sachs estimate they will not be able to recover! More than their entire revenue in this division!

But don’t all credit card issuers have the same problem? And how do they manage these risks? Well, yes, credit risk is a risk for all credit card issuers – but it’s usually controlled through the use of credit scoring models (e.g. FICO scores in the US). These models give people a credit score based on their payment history and if they’ve run into any trouble before. And if they have too low a credit (FICO) score, the credit card issuer will say ‘I’m sorry but it’s too risky for us to lend you money – you may default and not pay us back – and so we can’t give you a credit card’.

Now, a big part of the problem for Goldman Sachs was that they couldn’t really have these credit checks. Because Apple wanted as many people as possible to join their Apple Card, they basically let anyone apply for and get the card! That means people with good credit scores… and those with bad ones! More than a quarter of Goldman’s card loans went to people with FICO scores less than 660. I’m not American but my research tells me that’s not too good!

To make things worse, the twin impact of (i) the cost of living crisis, and (ii) higher interest rates hit people’s discretionary incomes. And more and more people – who probably shouldn’t have been given credit cards - found themselves with credit card debts they couldn’t repay. Which meant Goldmans Sachs found itself with more and more credit card debt they couldn’t recover. As we saw on Monday, this led to the closing of the Marcus business unit completely!

To get a really nice, simple, in-depth view of the Goldman/Apple struggles, I recommend this article!

27th Oct 2023

Nigel Jacob CFA