How Credit Cards Work In The U.S. | CNBC Marathon

The current

credit

scoring system as it stands is flawed. And this mistake of being fundamentally misaligned has huge system-wide ramifications for millions of Americans. There is no doubt about this. Visa is dominant. We're not necessarily talking about the wealthy urban professionals who are more likely to gravitate toward, say, an Amex card or a Chase card. Discover really is something for the masses. There's no reason to think that American Express won't have a strong customer base after the next recession. 6.7 billion dollars. That's how much Americans spent on their debit or

credit

cards

in 2019. More than 60% of those purchases were made with

cards

from Visa, a company that has long dominated the payment card industry.

Not only are the majority of all payment card transactions in the United States made with Visa cards, but there has been a lot of litigation over time, including from the Department of Justice. And the Department of Justice has had very clear legal decisions showing that Visa has "market power," which is the legal term, as a matter of law. So there is no doubt about this. Visa is dominant. As payment cards become more essential in our daily lives, Visa has quickly grown to become one of the most valuable companies in America. As of October 2021, Visa was valued at over $480 billion and reported net income of $21.8 billion for 2020.

The company's stock has also seen a gain of over 170% in the last five years. A really good way to think about Visa's revenue stream is that for every $100 spent on a Visa card anywhere in the world, they earn about a quarter, that's $0.25, a real quarter. Every time you buy a pair of shoes, it's $100, they get $0.25 of that. As the net

work

has scaled, very high incremental margins are obtained. And so, naturally, the profitability of the business increases. But Visa's success hasn't always been good news for merchants who have no choice but to rely on them to make payments.

If I can ask Visa, on the one hand, it would be for relief in the area of ​​wire transfer fees. We are paying too much. You're making too much money off of us. And you know that the lack of competition you have with all your issuing banks charging the same swipe fees in every market in the country is really unfair. We don't do business that way. Other industries don't do business that way. So I don't know how you can get away with this. So how exactly does Visa make money and why does it dominate the payment card industry?

Bank of America launched Visa as the nation's first authorized credit card for middle-class consumers and small and medium-sized merchants in 1958. The computer is changing our world, the way we do business. In 1970, Bank of America relinquished its direct control over the card and passed control to a group of issuing banks that continued to manage, promote and develop the new net

work

in the United States. The company grew rapidly afterwards, expanding internationally in 1974 and introducing its first debit card in 1975. Each month, British shoppers signed up for £1.5bn worth of products with a credit card. In 2007, Visa completed its corporate restructuring with the formation of Visa Inc. and went public in 2008, raising $17.9 billion in one of the largest U.S. public offerings to date.

Visa was created to be dominant. They actually started as an association of thousands of banks across the country. So all these banks got together and created Visa to have this national credit card. But of course they had a dominant position because they were practically all the banks. There are still Visa Class B shares, which are actually still owned by those original banks. Today, Visa has grown to become one of the largest payment processing networks in the world, with more than 3.4 billion cards on the market in more than 200 countries and territories. Visa generated more than $4 trillion in purchase volume in the United States, according to the Nilson report from February 2021.

By comparison, MasterCard has more than 2.3 billion cards on the market, with purchase volume of approximately 1.7 billions. Visa has a large number of cards, more than MasterCard without a doubt. Discover slightly anomalous cards. They have more cards than transactions. But Visa cards, both credit and debit, are the most prevalent, and Visa dominates the transaction count in both markets. And it is a profitable business. Since going public, Visa has rarely seen a decline in revenue and its stock has continued to outperform the S&P 500, excluding just three years. And while the year isn't over yet, 2021 is on track to see Visa underperform the S&P 500.

In one of those years, 2020, Visa still reported net income of $21.8 billion, with operating expenses of $7.8 billion dollars. Its total net income for the fiscal year was approximately $10.7 billion. Their profit margins are enormous. The numbers I've seen over time have been, gosh, 30-40% profit margins. Where, to give you an idea, in the retail industry, profit margins tend to be in the 2, 3, maybe 4% range. So as a business, the reason it is so profitable is because it is primarily a fixed cost business. Once you have all that infrastructure in place, every incremental transaction that flows through that ecosystem has extremely high incremental margins because it's just this massive capacity network.

And as Visa has grown, its profitability has increased dramatically for that reason. So how exactly does Visa make money? Contrary to popular belief, Visa does not make any profit from credit card interest. Instead, those fees are collected by the card issuer. In most cases, banks do not allow Visa to face any of the risks that come with lending money. So Visa does not have direct relationships with individual consumers. The banks do it. Banks issue the cards. So you can get your card or I can get mine from Bank of America or Wells Fargo or Citibank or any number of these other banks, including local banks.

But although many people think they are Visa cards, in reality they are not. They are the bank cards that have a visa. And Visa is the network for those cards. Visa's business model is largely based on what is known as the four-party model. When you use a Visa card to make a purchase, four entities typically come into play. You, the customer who makes the purchase. The bank that holds the client's money. The merchant who sells the product and Visa, who works as an intermediary that connects the three entities. They are a physical network, not unlike a telecommunications network or an Internet-style network.

It's just that telecommunications could transmit voice. The Internet carries information. The Visa network carries money, right? Therefore, it is a different type of physical network that connects around 18,000 banks and other types of financial institutions around the world. And every time you use a card, a series of messages must go back and forth between the register, the website, or wherever you're making a purchase. Going back to your bank that issued you the card to see if you are who you said you are and if you have the money to do an authorization. And then also go back and settle and settle the transaction, which means transferring the money from your bank's bank account to the merchant's bank account.

The majority of Visa's gross revenue, around 39%, comes from the data processing fees required to complete this practice. About 34% consists of service revenue, a fee Visa charges card issuers, such as banks, for working with Visa-branded payment methods. They charge a set of fees associated with that type of brand network that builds trust in the ecosystem. The trust that allows it, you know, you can just walk into any merchant anywhere in the world and hand them a piece of plastic. But if it says visa and the merchant accepts visa, then the transaction works. Imagine if you had a card that didn't have that, right?

It would not work. Revenue from international transactions represents approximately 22% of the company's gross revenue. Beyond the three main revenue streams, Visa has also been continuously investing in other payment types that could generate more revenue streams for the company in the near future. This is like B2B payments, business-to-business payments, this is like disbursements. That's when a company pays, think like an Uber or Lyft driver or insurance payment, things like that. There are a lot of person-to-person payments, two people, two individuals exchanging money. If you really look at Visa over the long term, like five, ten, twenty years, more and more other forms of payments are going to be a bigger and bigger part of their business.

Visa's success in the payment processing industry has also led to a number of investigations and legal cases over the years. The Department of Justice has sued Visa several times, has issued consent decrees on everything since Visa used to have rules that said any bank that issued its cards couldn't issue any Discover or American Express cards, and that was found to be an antitrust violation. problem. Visa had rules that linked credit cards and debit cards, so merchants, if they wanted to accept a credit card, had to accept a debit card and vice versa. It's almost hard to think of other industries that have had more antitrust litigation than this one.

In December 2019, Visa and MasterCard agreed to pay $5.5 billion to settle against merchants who had accused them of charging excessive fees. The largest class action settlement ever in an antitrust case, according to the case's co-lead attorney, Berger Montague. Visa also notably abandoned its $5.3 billion acquisition of Plaid. Visa and Plaid end their $5 billion merger. After the Department of Justice filed an antitrust lawsuit alleging it would limit competition in the payments industry. Most recently, in August 2021, a federal judge certified a class-action lawsuit accusing Visa and MasterCard of charging excessive ATM fees to consumers and operators. Visa declined to comment on the matter.

Meanwhile, retailers argue that the transfer fees incurred by Visa are simply too high for smaller businesses to survive. I don't think the average consumer thinks about swipe fees when using their credit or debit card. Business owners certainly do. Because for me, swipe fees are the second highest expense item in my PnL. Immediately after delivery. And right after our payroll expenses. Ahead of the rent. In 2009, bank card fees charged by Visa and MasterCard amounted to $25.6 billion. A decade later, it more than doubled to $67.6 billion in 2019, according to the National Retail Federation. Overall processing fees paid by US merchants to accept all card payments totaled $110 billion in 2020.

It tends to be in the range of 10% of what merchants pay for a transaction. I know a lot of business owners and it makes me sad because a lot of people have come to accept it for what it is. And I'm like, no, I mean, these prices are so ridiculous. The amount we pay in swipe fees is so high that we have to do something about it. Someone has to do something about this. This is a core part of the problem with their dominance: it's banks acting collectively and setting prices where they should compete on price like every other American company does.

Meanwhile, her supporters argue that Visa is on the side of merchants and not banks. Visa's business structure is very balanced and if anything, it is biased, believe it or not, towards merchants. In fact, they make most of their revenue from banks and the ecosystem that supports merchants. So they really are quite agnostic in the ecosystem, as if they are there to serve as a central part that facilitates effective digital payments, somehow balancing both sides. What is certain is that Visa has indeed changed the world of commerce forever. Visa, on some level, is a victim of its own success in that they are so ubiquitous, so secure, and so easy to use that people are starting to take them for granted.

For the consumer, it's fantastic. Simply facilitator of your life. I always tell people, imagine if you didn't have it and you literally had to pay for everything in cash and check, what your life would be like. However, the same thing happens on the merchant's side. I mean, cash is expensive for merchants. They have to have cash drawers. They have tohave armored trucks. They have to have management level people counting the cash and making sure there is no theft at the end of each shift. Of course, there are always debates and complaints about the kind of cost of accepting card payments.

The reality is that the alternatives are also extremely expensive. And it's so quick and easy, especially with contactless payments these days where you can just tap and go, as it speeds up checkout lines and makes commerce easier. 52.9 billion. That's the total income net of interest expenses that Amex earned in 2022. But despite its impressive profits, Amex is far from dominating the credit card industry. Its domestic payments volume lags far behind Visa and MasterCard, and it trails Discover based on the number of cards in circulation. It's a tough business for American Express, given the threats posed by Visa and MasterCard.

They've leaned on people who use the card a lot, spend a lot of money and pay it off, and they're willing to cater to that crowd by offering them premium perks, whether it's at the airport or on things they can use every day, whether it's a membership to Walmart Plus or Uber cash or things that allow you to use that card, keep it at the top of your wallet. Armed with impressive rewards and a loyal customer base, Amex has achieved impressive growth. The company's revenue has increased more than 32% since 2017, and the company's stock has shown resilience and growth in a tumultuous market.

At Amex, I would consider them a little bit more of what we call a quality composite, like a very stable business, growing revenue, high single digits at 10%, and then they get a little bit of operating leverage. On top of that, their profits are increasing by double digits. They have learned a lot through COVID. They have diversified their business model. They have sharpened their pencils on what matters to their customers. And it is really showing and they are coming back strong. So what is the secret to Amex's success and where is it headed next? American Express began as a freight transportation company in 1850, transporting various products across a rapidly expanding nation.

It was not until the end of the 19th century when it began its transformation into a payments company. It began to introduce financial products and travel services. Then in the 1950s, following the huge success of traveler's checks, it introduced its first credit card to offer customers a more convenient way to pay. Where the brand as we know it today really begins, in my opinion. And you know, they've launched several products, the gold card, the platinum card, and they really focus on the end consumer, the corporate card business. What sets Amex apart from the rest of the industry is the way it operates its network.

Most credit cards from companies like Visa and MasterCard operate on what is called an open-loop system. When a cardholder uses the card on their network to make a purchase from a merchant, they generate revenue by transmitting that information from the issuers. Generally, they are the banks that have issued the cards to the acquirers or the merchant's bank. Amex, on the other hand, operates in a closed-loop system where it functions as a combined issuer, acquirer, and network. Amex differs from Visa and MasterCard because Amex is a lender. Visa and MasterCard are simply card networks, so they process transactions but don't actually issue credit.

American Express is both. They are a credit lender and also a card network, a transaction processor. That really allows them to see exactly what their customers are spending on each item and have all that additional data where they can then advertise or target different rewards spent on that item. That will be very different from what Visa and MasterCard can see, which would actually be total dollar amounts. It allows them to tailor some of those offerings, especially on the business side. If there is a reason they want a specific merchant's business, they can change their normal terms to fit that situation.

They don't have to worry about a bank getting upset about what those terms are. While Visa and MasterCard would do so. This closed-loop system also allows Amex to make money with interest, unlike Visa and MasterCard. The company generated around $9.9 billion in net interest income in 2022. It is advantageous to be diversified, so they get paid every time a transaction is processed. And then there are other levers as well, like people paying annual fees or having debt or other things that generate fees. But interest income is just the tip of the iceberg when it comes to Amex's total income.

Revenue from discounts or fees charged to merchants who accept its cards generated more than $30 billion in 2022, contributing to more than 58% of Amex's total revenue net of interest expense for that year. They charge their merchants a premium to accept their cards, and merchants are willing to pay that premium because American Express serves the richest and highest spenders. They earn swipe discount revenue, so they charge merchants a certain discount rate, two and a half or so, it depends. In fact, this can vary depending on the size of the merchant. But a lot of its revenue, unlike its competitors, comes from this transfer fee versus net interest income.

Because of its reliance on discount rates, high spenders are Amex's most important asset. Recent reports claim that Amex cardholders spend on average three times more per year than non-members. Amex targets these wealthy cardholders through a spend-centric model that focuses on generating revenue primarily by driving spending on their cards. That's where the rewards come in. In 2022 alone, Amex spent nearly $17 billion providing services and rewards to its cardholders. When they talk about a spend-focused model, they really mean being your benchmark card. And I think a very good example of this is the Amex Platinum card, one of their flagship premium products.

At first glance, this is a travel card and it has a lot of travel benefits with rewards, airport lounges, and all that fun stuff. But you can also get a free Walmart Plus membership and many other types of everyday credits. They're trying to make this an everyday option, not just something you do a few times a year when traveling. That high-spending model is why they can offer such strong rewards and why customers are willing to pay those higher annual fees than for other cards because they get the spending and rewards benefits. Because the people who spend are actually making up for it with their spending behavior.

Having a closed-loop system means that how much the cardholder spends is often more important than the number of transactions made. Amex also uses the immense information collected through its closed-loop system to create offers that attract and retain customers. A lot of the tricky part about big, you know, more conventional card rewards programs is that the rewards are a little ad hoc, like they might have really cool rewards, but they might not be. things that you as a consumer value. In the case of American Express, because of that closed-loop dynamic and because they know you and the merchant, they can create rewards that will make you as a consumer feel like this program was custom designed for me.

Like they can go out and recruit all the best hotels and all the best restaurants and have specialized offers and specialized rewards and things to attract consumers, the wealthy consumers, to those hotels, to those restaurants. And everyone sees the benefits of their role in connecting those dots. Having a wealthy client base also provides the added advantage of lower credit risk. Amex's delinquency rates have remained substantially lower compared to other major issuing banks. Credit losses over the cycle will move closely with unemployment, as expected. If you think about changes in unemployment, they increase about 1.7 to 2.25 times in a recession, and the largest credit card issuer will see about the same type of increase in credit losses during that time period , while an American Express might actually see a little less than that.

So if it went up twice, it's possible that American Express would go up 1.8 times. And that makes a big difference in terms of the cyclicality of the business, the overall risk to earnings and returns. It's really one of the reasons investors focus on this stock during a recession. It is considered a safety play and that is why we get better results with stocks today. In recent years, Amex has begun to further diversify its customers, primarily targeting millennials and unbanked Americans. I really think Amex is also doing a good job winning over younger customers. They've talked about about 60% of their new card acquisitions being from Gen Z and millennials, and I think they've done some creative things there with experiences, whether it's trips or dinners or exclusive concerts like they did one with Jack Harlow and , you know, they're just trying to reach a younger audience.

Those will be the leaders and big spenders of tomorrow. Amex has also made significant investments to expand and improve its technology, allowing its offerings to be more competitive against the rise of alternative premium cards. They continue to progress abroad. In fact, they were the first US-based credit card issuer to gain approval in China, and they're partnering with local brands there to tap into that increasingly affluent consumer audience. In Europe, places like France and Germany, credit card adoption, both by wealthy consumers and small businesses, is much lower than, for example, in the United States, the United Kingdom and Australia, where it is quite high.

And so there is an enormous amount of opportunity for fair growth. I think there are more and more technology companies in some way, whether it's the apps and web experiences they provide or all the data they collect. You know, some people say that a concept like buy now, pay later could be a big threat to the Amex model. In fact, they were the first traditional credit card issuer to reveal their version. A few years ago they launched Amex Pay on Planet, which I think again speaks to offering something for everyone. The biggest threat to Amex is competition within the credit card industry.

To me, the biggest weakness or danger for American Express is really the market power of Visa and MasterCard and what they may decide to do with it, which may or may not be something American Express can control. The value they can offer from the closed-loop model is distinctive and unique. But as things like data analytics and artificial intelligence improve, and the entire process of card issuance and card program management becomes more digitized as their technology advances, those open-loop card programs can replicate best what American Express is uniquely capable of doing. So they can run better analytics to understand their consumers' spending and better tailor their rewards.

But while provisions for credit losses have increased after a period of high inflation, experts believe Amex is more than prepared to weather a potential recession. They are by no means immune to a recession. But at the same time, with that high-spending, wealthy customer, those credit losses are probably significantly lower than some of their peers who focus more on the average consumer, even subprime borrowers. And so, there's no reason to think that American Express won't have a strong customer base after the next recession. America runs on credit. The three-digit score represents a person's likelihood of paying his or her bills and affects nearly every aspect of an American's financial life.

It's like your passport to everything you need to do as an adult. And it affects many things, not just access to credit. So your ability to get a credit card, a mortgage, a reasonable car loan. Landlords use credit reports and scores, so it will affect your ability to get an apartment. Insurance companies use them. Having a low or no credit score can have serious financial consequences. 42% of Americans said their credit scores prevented them from accessing financial products like credit cards or loans. Life can become more expensive and more difficult as your credit score drops. But some credit experts argue that current credit scoring and reporting systems have major problems.

The current rating systemcredit, as it stands, is flawed. And this mistake of being fundamentally misaligned has huge system-wide ramifications for millions of Americans. Others say that many of these criticisms are wrong. The reality is that the credit reporting system we have here in the United States is like the crown jewel of the world. Many of the criticisms are based on some fundamental misunderstanding about how credit scores are calculated and how they are used. If you take a moment not to get upset about financial services for even a minute, then I think a reasonable person would have to conclude that these are actually good for consumers relative to a world without credit scores and what that would mean for our bottom line. . lines.

So how do credit scores work in the United States? Do they help or hurt consumers? A credit score generally refers to a number between 300 and 850, which represents the financial stability and creditworthiness of the holder. The higher the number, the better the consumer will look to potential lenders. Credit scores in the five hundred are considered very bad. The credit ratings of the 1600s began to use terms such as subprime, almost prime, approaching the average. But you really need to get to the seven hundred before you reach the national average, which is between 710 and 720, and then start to get to the elite level scores, which are well into the seven hundred and certainly into the eight. hundreds.

Credit scores and reports are two separate things. Reports refer to account statements that contain information about your credit status. While the scores are calculated based on that information in the report. The credit report is like the test you took. The credit score is the grade you earned on the exam. One influences the other, but they are not the same. Today, scores calculated by the Fair Isaac Corporation, or FICO, have become the industry standard, used by 90% of major lenders. They are calculated using five main categories: 35% for payment history, 30% for amount owed, 15% for length of credit history, and 10% for new credit and the types of credit you have.

It is based on an analytical algorithm. That's why we look at real data patterns to say what helps us predict whether you'll pay back credit in the future. One of the main benefits of having a credit score is that it provides a quick and empirically sound method of measuring creditworthiness. Americans are borrowing more today than ever, and household debt surpassed $16 trillion during the second quarter of 2022, making credit ratings crucial for many businesses. It allows lenders to make very, very precise decisions and have a very deep understanding of the likelihood that someone will pay you back. Experts say such a simplified process is also the reason Americans have been able to enjoy low interest rates for so many years.

The credit scoring system allows the industry to make quick and economical decisions about whether to have credit or not. The cheaper it is for the lender to decide whether or not to grant you credit, overall, the lower the cost to the lender and hopefully that will be passed on to consumers in a more efficient system. Without this system, lenders will do what they do: mitigate their risk. What that means in practical terms is higher interest rates, because that's how lenders mitigate risk: they charge everyone more to subsidize the risk everyone poses, or more declines. It is easier to say no to an applicant than to hire an applicant who you know will not repay a loan.

Representing a person's credit worthiness using numbers also supposedly helps prevent credit discrimination. Lenders often relied on more subjective evaluation methods before the invention of credit scores. Credit scoring, when it was first developed, was a breakthrough. It's better than having a banker sit in front of you and judge you and read the information in your credit score, because they bring a lot of their subjective analysis and their own life experience to the analysis. And if his life is different than yours, frankly, if it's a white man sitting across from a woman of color, that analysis may be wrong.

If the information is not in a credit report, it is systematically impossible for your credit score to be influenced by it. What's not on your credit report? Things like your gender, your sexual orientation, your politics, your level of education, how much money you make, the socioeconomic makeup of your neighborhood, your level of education. Therefore, we can assess credit risk by looking only at past behavior listed in the credit report and only to the extent that it predicts future credit risk. However, despite its good intentions, experts say the credit scoring system still suffers from discrimination. A survey of 5,000 American adults found that more than half of African Americans reported having a low or no credit score, compared to 41% of Hispanics, 37% of whites and 18% of Asian Americans.

Credit ratings are based on past performance. So you're going back in history to make a judgment about the future. The further back in history we go, the deeper the structural racism in America. Intentional racism that occurred decades ago is baked into the pie, into the system, into the institutions and policies of our society. And that type of structural racism requires no animosity or intent, but it still harms Black and Brown consumers. If your parents put your name on a bill because they had bad credit and then were delinquent, you can turn 18 and inherit derogatory information on your credit report without anything you did.

If you are a new immigrant to this country, your previous credit history does not travel with you. These credit agencies are mostly national, so you show up with nothing. And by the way, a blank slate is a bad place to be in your credit score. It means that you are not scored and your information starts out low and poor. 19% of American adults have no credit history or are considered uncreditable by existing systems. Unfortunately, what the scores do is they kind of amplify those inequalities because they come in and say, okay, you're already at a disadvantage. Now you may be doubly disadvantaged because the objective score is that you are somehow not worthy of being given a chance, that you somehow deserve much higher fines and fees than everyone else.

Errors on credit reports can also often lead to miscalculated scores. A survey conducted in 2021 found that more than a third of respondents found errors on their credit reports. Of more than 700,000 consumer or credit report complaints received in 2020, more than half concern incorrect information in their reports. For me, it was a different person named Aaron Klein, who didn't pay his cell phone bill in New Jersey. I also lived in New Jersey for graduate school, and this stuck with me for years. One in twenty makes a mistake so serious that it could cost them their ability to get credit, a job, or an apartment.

However, those within the industry argue otherwise. When we analyze our data, it is astronomically reliable, so we constantly audit and evaluate it. Our regulators review us on a regular and ongoing basis. So they're looking at all of our systems around data integrity, data reliability, how we engage with consumers, etc. Under the Fair Credit Reporting Act, credit bureaus are responsible for correcting any inaccurate information in their reports. But research has suggested that many consumers find it difficult to correct errors. Credit agencies are like a judge that always rules in favor of the defendant. So if your mortgage servicer tells you that you were late, even though you were never actually late and you have documentation showing that you were never late, it will still appear as late.

Correcting errors is costly and time-consuming for the credit reporting and scoring industry. They are not incentivized to be accurate, especially if the errors are symmetrical and level. Our entire role in the consumer credit ecosystem is to provide reliable and accurate information. If we couldn't do that, no one would have any interest in collaborating with us. Our position is that the system only works and we can only be successful if our data is incredibly reliable and accurate. And that means engaging with consumers continually to try to make sure that they can manage their credit effectively and that they feel like they can engage with us about any concerns they have.

Another major concern is the lack of regulation and supervision that can ensure fairness and transparency within the industry. You know, I think the idea that the industry is unregulated is a fiction. And, you know, we operate in one of the most regulated spaces possible. It has a 50-year-old federal statute called the Fair Credit Reporting Act, which essentially mandates that everything that has to do with credit reporting is our right to dispute the information, our right to freeze our credit reports, our right to get copies of our credit reports. You have the Consumer Financial Protection Bureau, which regulates credit bureaus regarding the accuracy of credit reports.

There is the Federal Trade Commission that shares that regulatory responsibility. I have to say that the Consumer Financial Protection Bureau, which took over oversight of this industry about ten years ago, has done a very good job of trying to reform the credit bureaus. But it would go beyond more regulations or even more laws. Over the years, credit rating and reporting agencies have made several changes in response to criticism of the industry. Perhaps the biggest change will come from using alternative data to improve accuracy and inclusivity. They have begun to try to incorporate other, quote-unquote, non-traditional information.

For example, if you pay your mortgage on time every month, your credit score will increase. But if you pay your rent on time every month, nothing happens because that information is not reported. We've innovated with scores like FICO Score XD and Ultra FICO Score. They augment traditional credit data with rich alternative data, such as how you pay your telecommunications company, utilities, as well as information found in your checking and savings account. The goal of these new scores is to allow consumers to find ways other than historical credit to demonstrate their ability to repay credit. More regulatory changes could also come.

In 2020, the House passed two bills, the Protecting Your Credit Score Act and the Comprehensive Credit Act. With the objective of reviewing the credit rating system with more supervision and provisions aimed at protecting consumer credit. They have not yet been put to a vote in the Senate. One of the initiatives that we are advocating for because we really believe that the solution to many of these concerns about helping consumers access financial products is alternative data legislation called the Credit Inclusion and Access Act, which would really encourage the introduction Reporting on rent data and utility data will bring new data to the system that would allow literally millions of Americans to access financial products and services.

But ultimately, credit in its current state depends on the consumer's financial decisions. I will tell you the two things you need to do and it will be impossible for you not to get a good score. Number one, never ever miss a payment. That is easy. It's writing a check at the end of the month and paying your minimum payment. Good. Number two, you should avoid credit card debt. And I'm not saying don't use credit cards. What I'm saying is don't overload your credit cards. Don't use them to supplement your income, or to keep up with your neighbors, or to impress someone.

Pay your bills on time. Stay away from excessive credit card debt. Lather, rinse, repeat, and you'll have fantastic credit scores. Knowing how you manage your credit is a sign of responsibility. It's not. Many people have negative items on their credit report because they were victims of bad luck, not because they are bad people. So they got sick, lost their job, and now they can't pay their bills and their credit report will prevent them from getting a new one? That's crazy. Credit cards represent a trillion-dollar industry. In 2018, they were scammed almost 45 billion times, paying for products and services worth just under $4 trillion.

Americans mustabout $1.1 trillion in credit card debt, about $5,700 each. The American consumer is doing very, very well. Strong consumer sentiment, strong retail spending, very low unemployment. All of those things are great for the credit card industry. Giants like MasterCard, Visa and Amex dominate the network market. Chase, Citi, Amex and Capital One are the largest issuers. A quiet but stable and perhaps less talked about competitor is Discover. We're not one of those companies that are always talking about how great we are. The best-performing stock of all S&P financial companies over a ten-year period isn't just your average company.

Discover has the 10th largest credit card portfolio in the world, despite having a smaller footprint outside the U.S. Still, there are 57 million Discover cards. It's not really for the type of people who want to fly first class to the Maldives. Discover really is something for the masses. When you think about the average consumer and probably where they borrow and what their FICO scores are, I think they're right in the middle of all of these issuers. Discover credit cards topped the J.D. Customer Satisfaction Survey. Power in 2019. So how did they win over the American middle class?

To understand the credit card industry, it is important to know the difference between a credit card network and an issuer. The network is basically the digital rails on which transactions are processed. The card issuer is the company that actually assumes the credit risk. Discover and American Express are both an issuer and a network. That gives them some diversity in their business model. It also gives them a really stable source of income, at least from a processing standpoint. Very different from the credit side of the equation, where you could be much more profitable if they charge you 18, 20 or 25% interest.

But there are risks there too. And it's also less predictable in terms of who makes the transactions and the revolvers, the people who pay their bills in full or the people who carry debt month after month. 40% of Americans trade and 60% have debt month to month. We spoke with Discover CEO Roger Hochschild by phone. Our model is focused on the loan. We look for people and we get most of our money from people who borrow money. The American Express model is much more focused on issuers' spending. American Express and JPMorgan exchange the first two positions in outstanding debt.

Citibank, Bank of America and Capital One occupy slots 3 through 5. Discover is in sixth place. The Discover Credit card was launched in 1986 by Sears Roebuck, the largest retailer at the time. Back then, it was part of Dean Witter, which was part of Sears, and they released it during Super Bowl 20. They had this commercial in early 1986. This is the dawn. The dawn of Discovery. They talked about the dawn of Discover. And they really pioneered two main categories: cash back and no annual fee. Sears wanted to expand into financial services and decided to only accept the Sears Discover card in its stores.

In reality, many merchants saw them as a threat and thought that accepting a Discover card meant they were helping rival Sears. So that really created a lot of doubts and difficulties for Discover to establish itself. In 1993, Dean Witter Discovering Company became a publicly traded company when it was separated from Sears. Sears eventually filed for bankruptcy in 2018, but that's another story. In 1997, Dean Witter Discovering Company merged with Morgan Stanley. The mid-2000s were eventful for Discover, and the barrier to entry didn't end at Sears' front door. Mastercard and Visa were established in the industry and Discover wanted in.

In 2004, the Supreme Court upheld a ruling in favor of Discover. Discover claimed that MasterCard and Visa had harmed its business by preventing its member banks from issuing Discover network credit cards. They did everything they could, including contacting merchants to tell them that accepting Discover would help Sears. After the Supreme Court ruling, Discover's business began to take off. GE Consumer Finance, Walmart and Sam's Club became card customers and Pulse, a debit card network, was acquired. With more than 50 million cardholders, the company had become a major player. In July 2007, just six months before the Great Recession, Discover severed its ties with Morgan Stanley and began trading on the New York Stock Exchange as DFS.

We just set up our finance department, our Treasury function. Fortunately, we had a heritage going back to Sears of being conservative lenders. In the midst of the crisis, the company received good news. Visa and MasterCard paid Discover nearly $3 billion in damages after finally settling the lawsuit. Discover's strategy remains simple. Charge no annual fee, offer simple rewards like cash back, conduct all business online, 24/7 customer service in the US, and acquire and keep customers who will renew a balance every month. Here at Discover there is a relentless focus on a limited set of businesses. Compares us to most other banks that are major in credit cards.

They have commercial real estate. They have loans for small businesses. We are focused on consumers. That consumer is a primary borrower, with 81% of Discover customers having a FICO score of 660 or higher. Competitors like American Express serve a wealthier customer base with a higher average FICO score, and Capital One serves a larger number of subprime borrowers than Discover. We may be more like Toyota and American Express may be more like Mercedes. I would say the typical Discover customer is probably a little more likely to be middle class or even lower middle class, maybe more likely to be a parent, maybe more likely to live in Central America.

You know, we're not necessarily talking about the wealthy urban professionals who are more likely to gravitate toward, say, an Amex card or a Chase card. According to J.D. Customer Satisfaction Survey Power, Discover has been voted number one every year since 2014 except 2017. It is very difficult at this stage of the game in the United States, in a very mature market, to grow your business because there are so many people already have a card. But it's doing a very, very good job of keeping customers very satisfied with the value proposition that it offers. I think sometimes these airline mile cards get a lot more attention because they are a more attractive type of redemption.

Good? It's, you know, first class, airport lounge, all that fancy stuff. However, the fact is, we found that about two-thirds of credit card rewards seekers prefer cash back. Discover's balance sheet reflects the improvement in the company's finances since the recession of 2008. The investors that are here are looking for, you know, a high return on capital, and they've been around that 70% mark plus paying out investors through dividends and share buybacks. That's why it's about having a high ROTC, having a very stable but growing business model. Maybe it's the heritage of the Midwest. We're not one of those companies that are always talking about how great we are.

And there are others who do much more of that. But the last few years haven't been good for Discover stock. In a one- and five-year comparison, it underperformed the S&P 500 and multiple competitors. On January 24, 2020, one day after the company's earnings release, the stock fell 11%, the biggest drop in ten years. Its proportion of subprime clients, something called distressed debt restructurings, was announced to have increased by almost 50%, something that has worried investors. In an email to CNBC, Discover CEO Roger Hochschild said the market and individual stock prices can be volatile from time to time. Our focus is to continue building the long-term value of the Discover franchise, which we believe will be reflected in the stock's valuation over time.

This has shown that younger generations are not as enthusiastic about credit cards. And while people in general are spending more and more on credit cards, revolving debt has declined nearly every year for the past two decades, which could hurt companies like Discover that rely on finance charges. If you want to keep talking to your shareholders and tell them a success story, you're going to have to come up with something that looks better than just stable as you go. It wouldn't be surprising if we eventually see Discover making an acquisition via merger with another credit card issuer or being acquired by someone larger.

Nowadays, it's hard to know what's going to happen. But I would say we have a complete business model. We are strong on both sides of the balance sheet, if you think about our lending products, but also our deposit products. That's why I feel very good about Discover's positioning.