The Credit Cardholders' Bill of Rights
We at the Slips have been remarkably silent about the proposed Credit Cardholders’ Bill of Rights, easily the most major proposed credit card legislation in a long time, perhaps since the Truth-in-Lending Act of 1968. I think we’ve all been expecting each other to take the lead in piping in. It’s high time we started a discussion on this legislation, so here goes (warning, this is a long post, but this is a hugely important issue).
The Cardholders’ Bill of Rights takes aim at some of the most troubling and odious practices of the card industry. The proposed legislation has lots of features (summarized here), but the most important is that it would prohibit or limit a number of card issuer billing practices that are substantively unfair or that consumers rarely know about even if disclosed: (1) universal cross-default clauses; (2) any-time, any-reason rate changes; (3) retroactive application of interest rates without a opportunity to cancel the account first; (4) two-cycle billing; (5) unlimited applications of overlimit fees in a single billing cycle; (6) give consumers the ability to opt-out of overlimit transactions; and (7) require pro rata application of payments to balances accruing at different interest rates.
These terms and practices may not be familiar to all readers of the Slips, so let me briefly explain each in turn, because chances are some apply to at least one of your credit cards.
(1) Universal cross-default means that if you are declared in default (accurately or not and with notice or not) by any other creditor (another credit card, the cable company, the landlord, your uncle Jim), then that constitutes a default on your credit card and penalty interest rates can be applied, even if you have been making payments on time to the card issuer.
(2) Any-time, any-reason rate changes permit the card issuer to change the interest rate it charges you for any reason at any time. You opened up another credit card (to get the extra 10% off the initial purchase)? Well, your interest rate just went up 5%. Your issuer made a lot of lousy subprime mortgage loans to other people? Say howdy to a 10% APR increase. You’re wearing yellow today? Meet my little friend Mr. 32.99% APR. If your issuer feels "insecure" (all the other banks are so much prettier)—hey why not a 200% APR? Delaware doesn’t have usury limits, after all, so let's shoot the moon....
(3) Retroactive application of interest rates is exactly what it sounds like. At the time you borrowed your cardholder agreement provided that your APR was 7.99% above Prime. Now the issuer has unilaterally changed the rate to 20.99% above Prime, and applied that to the balance you accrued when the rate was 7.99% above Prime. You thought you had made a deal? Guess again…
(4) Two-cycle billing means that if you revolve a balance, interest accrues not just on the actual balance being revolved, but also on the balance from the previous billing cycle, even if it has already been paid off. To illustrate, in month one you charge $600 and pay it off in full at the end of the month. In month two, you charge $500 and pay off $400. Interest accrues as if on a balance of $700, even though you only owe $100.
(5) Unlimited overlimit fee applications means that if you go over-the-limit multiple times in a billing cycle, you will be charged multiple overlimit fees. So if your limit is $1000 and you go $10 over the limit on day 5, and another $20 over the limit on day 6 and another $25 over the limit on day 18, you will be charged 3 overlimit fees, whereas if you simply went $55 over-the-limit all at once, you would be charged on overlimit fee.
(6) Limits on overlimit. Your credit card may have a credit limit, but that doesn’t mean you can’t charge more than that limit. Whether you can or not is at the issuer’s discretion, but if the issuer allows you to exceed your credit limit, it will cost you in overlimit fees. The bill would allow consumers to elect to have their credit limit actually be a limit which they could not exceed.
(7) Pro Rata Allocation of Payments. Currently if you have balances accruing interest at different interest rates (e.g, a purchase balance and a cash advance balance), the card issuer can, pursuant to the cardholder agreement, apply the payments however it wants. Typically this means that payments are applied to lower interest rate balances first. The Cardholders’ Bill of Rights would require payments to be applied pro rata to balances (although issuers can always apply them to higher interest rate balances first).
The card industry’s primary argument these days against any sort of regulation is that it is engaged in “risk-based” pricing and anything that changes their pricing model will destroy the putative benefits of “risk-based” pricing, namely lower costs of credit to creditworthy individuals and greater availability of credit to subprime borrowers.
I've written at length about the fallacies of the risk-based pricing argument elsewhere. Suffice it to say that it is a real stretch to say that credit card pricing overall is risk-based; certain elements of card pricing are partially risk-based, but many are not. Moreover, there is no empirical evidence connecting the advent of risk-based pricing to lower costs of credit to creditworthy consumers or greater credit availability to subprime borrowers. There is a study that correlates late fees and overlimit fees with banks' aggregate cardholder risk, as well as with banks' market power, but there is no research connecting fee levels, which are often one-size fits all, with individual cardholder risk. The putative benefits of risk-based pricing depend on pricing being sensitive to individual level, not aggregate level risk, so that low risk cardholders don't subsidize high risk cardholders.
In any case, the benefits that the card industry attributes to risk-based pricing are explained at least as well by other factors: lower costs of funds explain lower interest rates to creditworthy consumers (issuers’ annual net interest margin has been fairly static for the last two decades), and securitization is at least as good of an explanation for the expansion in subprime lending.
The Cardholders' Bill of Rights is essentially a challenge to the industry to do what it says it is doing in terms of risk-based pricing. It's message is that “if you’re actually doing risk-based pricing, great, but that means the pricing has to be fixed before the risk materializes.” Just as an insurer cannot decide premiums after the coverage event occurs, so too can a lender not decide what interest rates apply after the borrowing. Pricing after a risk materializes isn’t risk-based pricing. It's rent extraction.
It is important to note that, although this is not a case of a few bad apples, not all issuers engage in all or even any of these practices. Therefore, it is far from clear that any of these practices are a necessary part of the risk-based pricing model, and even for issuers that do use them, it’s hard to believe that these are such essential ingredients of their business model that we would see noticeable price increases or credit supply constriction as a result of banning them. Is the sky really going to fall if issuers can’t do double-cycle billing?
Beyond addressing odious billing practices, the Cardholders’ Bill of Rights also has some other important provisions. It requires issuers to define the due date, requires payments received by 5pm EST on the due date be treated as timely, and creates a presumption of timely payment for payments sent by common carrier at least 7 days before due. It also defines the terms “Fixed Rate” and “Prime Rate” that are often used in cardholder agreements so as to eliminate consumer confusion about what these terms mean.
The bill would also limit the issuance of certain subprime “fee harvester cards” that offer low credit limits, most of which are tied-up with initial fees. ($250 credit limit, but $200 in initial fees to get the use of $50 in credit). These cards are lucrative enough that one of their issuers, First Premier Bank, could endure a 62% charge-off rate in 2007 according to the Nilson Report, and still have its owner make the Forbes 400. (First Premier is closely held, so I can’t get the 2007 financials—it is possible that 2007 was a terrible year for First Premier and that all the earnings were from previous years.) These cards have higher effective APRs than payday lenders.
Finally, and of crucial importance for future policy-making, the bill would require more detailed data collection by the Federal Reserve about credit card pricing. Our current state of knowledge is woefully limited, and it is hard to make good policy without good information.
The Cardholder’s Bill of Rights won’t solve all the problems of the credit card industry; it doesn’t deal with deep-seeded problems of price structure, rewards programs, antitrust, merchant fees, or identity theft prevention, among other issues. The card industry might well find other ways to extract rents from unwitting cardholders even if the ways enumerated in the bill are shut down. But it is an important first step to reining in an industry that has run wild in a regulatory no-man’s land of outdated and threadbare federal laws, preempted state laws, and somnolent consumer protection by federal banking regulators. The Credit Cardholders’ Bill of Rights is a major piece of federal consumer protection legislation that will help shield consumers from the worst abuses of the card industry.