I'm wondering if someone who reads this board also has real insight, probably from working for a loyalty program or credit card company, of the economics behind these loyalty programs.

I did read that 39% of credit card holders carry a balance, and I'm sure that cardholders who both carry a balance and don't default are hugely profitable.

Obviously there is also revenue in the transaction fees.

I'm not sure what the real costs of points programs are. On the DL board there was some indication that Amex pays DL something like 0.5 cents per mile, and that DL values outstanding miles on its balance sheet at 0.57 cents. Obviously there's an assumption that some of the miles will not be redeemed, and when they are redeemed, I'm sure they don't expense the full retail price of a ticket.

On the other hand, some deals must be big losers, most specifically, bonus points with first year fee waived. When Chase gives 50K (or "only" 40K as they are now) on a card that allows points to be redeemed for at least a penny each, and someone gets the card, charges $300, pays no fee, they must lose big time. Now I got a SP card, expecting to cancel after a year, but now I will probably keep it, so they will get my business (although I use it almost exclusively for restaurants at 2X points) and $95 a year.

There is probably software they could apply to predict the profitability of accounts and use it in the approval process. Maybe they do.

Anyway, I'm wondering if anyone has the inside scoop on this stuff.

Credit card accounts are securitized, bundled and sold the same as mortgages and other types of debt. The issuers earn fees when selling the securities, and the revenue subsequently generated by those accounts is shared.

I believe that only the outstanding indebtedness can be securitized. If I owe Chase $5000, they may bundle that and sell the debt to a third party, getting a lump sum in return for remission of the money as I pay it off (with Chase also getting a fee for servicing the account).

However, I'm pretty sure that the future flows from the account are not securitized; i.e. the buyer doesn't participate in my future borrowing or repayments.

(I work on a team with a bunch of financial types, and one of them confirmed this, so it's less than notarized by Jamie Dimon, but more than idle speculation.)

Based on recent events, those two options may not really differ all that much...

Also keep in mind that most of these banks purchased billions of miles at huge discounts when the airlines were going through their respective bk's.

http://www.federalreserve.gov/boardd...retention.html

In any event, the point is not to understand the mechanics, but to appreciate that a flow of new card accounts creates value for the big issuers because they generate fees in the process of creating these trusts. I have read that American Express has even managed to securitize charge card debt where there is no real potential for interest income.

Wow, fascinating stuff. I'll share this with the banking guys on our team. (My company writes very serious banking risk management software.)

As you point out though (and not to diminish the fact that you were right and i was wrong), ultimately it's about the profitability of the accounts. Securitization makes markets more liquid, but barring the Greater Fool theory (which of course is not insigificant) it doesn't create profits where there were none.

So I still kind of wonder... how much does each account where the person grabs the bonus points and run cost, and how much profit do they make from an average "successful" account where the person keeps and uses the card long-term?

I think it remains profitable because churners are a small percentage of their customer base. Even some of those who do churn may be tempted by a particularly valuable card to hold on to it and pay the annual fee (I have five Chase cards and have no plans to ditch any of them).

On the expense side, banks have to pay for:
(1) A sign-up bonus. Let's call this $500 given the earlier Ultimate Rewards card bonus with 50K points at minimum valuation of 1 cent each.
(2) A referral bonus. I would argue that most customers do not actually sign up through referral links, and Chase actually does well by usually offering the same bonus on its own page. This way it doesn't force everyone to use affiliates for the best deals. Let's average across the entire customer base and say it costs them $50 per person.
(3) More points with spend. I assume $24K spend per year as described below. So that's $240.

On the income side, banks can make a lot of revenue:
(1) Annual fee. Not all people will stick around that long, but some like the Sapphire Preferred are pretty valuable. Let's call it $100 a year after the first year (which is usually waived).
(2) Fees based on number of transactions. Banks earn a minimum amount per transaction. I don't know the specifics, and I know they split it with the processors. Let's call it 10 cents per transaction. I make about 1,000 a year on my Sapphire. So that's $100.
(3) Fees based on amount of transaction. Again, banks earn a percentage and they have to split it. I don't know the specifics. Let's call it 1% that goes to the bank. So if you spend $2K a month or $24K, that's $240.

With my numbers, the cost of the points is free; the merchant is paying them. But with breakage and slightly higher transaction fees, the bank is probably making money off of this.

As for the rest, after three years the bank has made $200 in annual fees and another $300 for charging 10 cents on each transaction. That's $500 total. In contrast, the bank only paid one-time fees of $300 to sign up the person.

Again, all of this changes if the card actually gets churned. But there are plenty of cards like the US Airways MasterCard (with 5K redemption discount) or Hyatt Visa (with free tier-4 hotel each year) that have benefits worth the cost of renewing. I plan to keep these cards. A lot of other people do, too. If a few people churn, it lowers the average profit margin, but not by a huge amount.

Don't forget the value of the data - the bank knows who you are and what your spending habits are. The value of that knowledge in and by itself easily trumps the value of the direct revenue stream in most cases.

Interesting comments above, mostly based on the unstated assumption that the banks are run in a rational fashion.

This appears to be an unwarranted assumption. @:-)http://articles.chicagotribune.com/2...jpmorgan-chase

I have to wonder if the whole bonus miles things isn't really kinda nuts from the bank's POV, assuming they are trying to make money. Guess as long as Uncle Sam is willing to keep 'em going with their wacky giveaways I'm willing to keep flying in F for free.

You also forget that banks (and all marketers) have a target cost of acquisition per customer. They have the data, knowing that on average (this is just random, not real info, obviously) a customer is worth to them say $1000 a year (including churners, people who pay in full, people who carry a balance, people who go into bankruptcy - everyone). So if they spend 40,000 points (~$400) to acquire you as a customer through a direct channel, then that's a profit of at least $600..

Assuming that consumers acted rationally, the whole thing would be crazy for the banks.

Fortunately for them, for each conscientious Flyertalker there are 5 suckers who will carry a balance on a credit card at 19% APR in order to get some airline miles that they will never use.

I think more than economics it's statistics that the credit card companies struggle with. Many people assume correlated data has causation and make massive blunders. Here is an example.

CC company X determines that they make about $650 per cardmember per year based on their historical data. They want to make $15,000,000 more this year so they decide to get 100,000 more customers at an 'acquisition' cost of $500 each. since they will have 100,000 * (650-100) or $15,000,000 more in profit.

The problem is that the correlation between customers and profic does not dictate that one will cause the other. So when a bunch of us take those deals and then bolt they are screwed. Not all customers are the same value and averaging what you have doesn't mean your new customers will act the same. Especially when you used outside forces to acquire them.

But that assumes they're trying to make their money from the customer. If they're making their money from securitization, what they need from the customer is more accounts to sell and maybe they can justify spending crazy amounts to get them.

Here is another incentive for banks to open new card accounts, even if the accounts do not appear profitable:

http://online.wsj.com/article/SB1000...913330702.html