Overview
There has been a great deal of talk about credit card companies lately, and none of it has been positive. On Thursday, company executives will be heading to the principle’s office, i.e. a meeting with the Obama administration (See Policy Makers Take Aim at Credit-Card Practices from today’s Wall Street Journal). Granted, all the negative news generated by credit card companies is well deserved. Most of these firms have been raising interest rates on consumers with seemingly reckless abandon while simultaneously reducing credit limits, actions that not only increase the cost of being in debt, but negatively impact credit scores, effectively making it more difficult for consumers to refinance debt with 0% interest rates.
Unfortunately, the rush to put credit card executives up on the same wall of shame populated by AIG and Lehman Brothers executives may have as much to do with impending credit card laws as it does with reckless and unfettered greed. While its not easy to defend these companies, especially given the credit card complaints we’ve received from shell-shocked consumers, the current credit card crisis is likely a desperate cash grab to stop the flood of losses piling up on the balance sheets of credit card companies.
Risk Re-Pricing = Good Business = Unfair Credit Card Practices
A key weapon in the arsenal of credit card companies is the ability to re-price risk. This power is buried in the fine print of card terms and conditions and is being utilized to a much greater extent then in the past. Essentially, a person who accepts a credit card signs away their life without fully understanding how. This is the key reason behind the new credit card legislation which will require greater transparency.
Put simply, re-pricing risk allows credit card companies to raise rates on consumer accounts that, for one reason or another, are riskier than they were when interest rates were initially determined. In the past, many credit card companies preyed on consumers with universal default clauses. When universal default was being widely employed, credit card companies would raise the rates of consumers to their default rate (generally around 29%) if they were late on any other account.
Taking advantage of universal default to fleece consumers drew the ire of regulators and is not frequently used today. However, credit card companies have been utilizing less dramatic, seemingly random metrics combined with the powers granted to them when you accept their product to increase interest rates by 20%, 50% and even 200%. The reasons for these increases are varied. They could stem from any number of factors, such as:
1.) An increase in your credit utilization ratio: This would occur if you start using a larger percentage of your available credit. Ironically, if one credit card company slashes you credit limit, your credit utilization ration will increase. This, in turn, could lead a different company to consider you a higher risk and raise your interest rate.
2.) A decrease in your monthly payments: If you used to pay 10% of your outstanding balance every month and now pay 5%, credit card companies may see this as a sign that you are having trouble with your bills. This makes you a riskier customer, which could lead a company to raise your interest rate. (Ironically, this is akin to cutting off one’s nose to spite one’s face, as an interest rate increase could push the customer over the edge, leading them to give up paying altogether.)
3.) A change in shopping patterns: This is one of the most absurd reasons credit card companies have used in the past six months to slap consumers with credit limit decreases. The first occurrences of this effected American Express customers late last year, when people who starting shopping at low-cost stores such as Wal-Mart saw their credit limits slashed dramatically. (See Card Companies Adjusting Credit Limits from the Atlanta Journal-Constitution for more details)
4.) Where you live: Credit card pricing is based almost entirely on mathematical models, and people who live in certain areas such as Florida, California, and Nevada pose a higher risk than residents of Connecticut or New Jersey. Consequently, where you live can impact a credit card companies view of your risk, regardless of your credit score, income, or history of payment.
5.) Where you work: This is pure speculation, as there have been no public disclosures on this subject, but if credit card companies are basing rate and credit limit decisions on where you shop and where you live, it is not improbable to presume they are looking at where you work to determine credit risk. For example, a real estate agent in a depressed market is at a greater risk of default than a public school teacher. Again, this is pure speculation, but it would not be surprising to learn that where a person works is now playing a role in credit decisions.
Why Credit Card Companies Are Engaging in “Unfair Practices”
Now that we’ve examined some of the potential causes that lead to interest rate increases or credit limit decreases, its time to turn our attention to the reasons credit card companies are using these tactics.
1.) To stop the bleeding: Bank of America’s first quarter earnings included a massive loss on credit card loans which were accompanied by CEO Ken Lewis’ less than rosy forecast for the future of consumer loans. While some companies may be faring better than others, any company engaged in credit card lending is facing historically high losses and an uncertain future. As credit risk models are adjusted for an ever-worsening future, credit card companies must find ways to make more money and hedge against future losses. The solution: raise interest rates. From a business standpoint, it makes perfect sense. Is it fair? No. Is it legal? YES!
2.) Because they won’t be able to do it once new credit card legislation becomes law: This is the ultimate Catch-22 and perhaps the main reason our credit card issuers have gone wild. When the Credit Cardholders’ Bill of Rights becomes law, banks will no longer have the freedom to raise interest rates as easily as they can today. The passage of this law a few months ago eerily coincided with the massive increase in extortionist practices by credit card companies.
In short, The Credit Cardholders’ Bill of Rights will change the way credit card companies do business in fundamental ways. Knowing this, credit card companies are aggressively taking action now. If our credit card companies weren’t worried about the impact this law will have on their future earnings power, it is highly unlikely that they would be taking such drastic, pre-emptive measures today.
Conclusions
It is truly unfortunate that credit card laws designed to help consumers may be the root cause of the interest rate increases that are pushing people to the verge of insolvency. One could chalk this up to the law of unintended consequences, but if our leaders truly had foresight, they would have seen this issue coming from a mile away.
As consumers, our best defense against credit card companies is to get out from under their control. If you don’t carry credit card debt, you don’t have to worry about having a 29% interest rate . Sadly, consumers who currently carry debt will pay dearly as banks re-price risk before the Credit Cardholders’ Bill of Rights becomes law and benefit little after its passage.
To make matters worse, new credit card laws may bring about the end of 0% introductory rates, low rate balance transfers, and quality credit card rewards programs. Under the old credit card rules, consumers with good credit could utilize 0% balance transfers to get out debt faster and at a lower cost, while rewards programs that offered as much as 5% cashback allowed consumers to offset interest expenses or even profit from credit card usage. Unfortunately, these programs may no longer be profitable, and smart consumers who enjoyed these benefits will end up footing the bill for laws that limit free enterprise.
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April 21st, 2009 at 12:16 pm
A friend of mine just emailed me one of your articles from a while back. I read that one and a few more. Really enjoy your blog. Thanks