Congress Drops an Axe on the Credit Card Industry

Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) fell nearly 10% on Friday on news the Senate passed an amendment to restrict debit-card interchange fees. Markets tend to overreact to such news, but this may have been warranted. Let me tell you why.

Interchange fees are charged when anyone swipes a card, debit or credit. They typically range from 1%-3% of the transaction amount. So when you buy something for $100 and put it on plastic, the store you bought it from only gets between $97 and $99. The rest comes out as interchange fees.

Where do those interchange fees go? There's been some confusion here since this story broke. Many jumped to conclusions and assumed it's Visa and MasterCard that are getting fat and happy off of interchange fees. CNNMoney wrote, "Industry kingpins Visa and MasterCard collected interchange fees of at least $35 billion in 2007, according to government estimates."

But while Visa and MasterCard do collect interchange fees, they then send essentially all of those fees back to the banks that issued that card. Visa's annual report clearly states: "Although we administer the collection and remittance of interchange reimbursement fees through the settlement process, we generally do not receive any portion of the interchange reimbursement fees."

In this case, Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and JPMorgan Chase (NYSE: JPM  ) dominate the card issuing market. They're the ones that get most of the interchange fees, and they're the ones that will presumably eat the brunt of the losses from this legislation.

Visa and MasterCard make money from other sources. They milk two streams of income: One is called data processing fees, which are small token fees per transaction. The other is called service fees, which is based on a percentage of payment volume and is paid from the bank issuing the card.

So how would the new rules affect Visa and MasterCard? Visa actually anticipated this happening, and its annual report gives a pretty clear heads-up about what could ensue (emphasis mine):

If we cannot successfully defend our ability to set default interchange rates to maximize system volume, our payments system may become unattractive to issuers and/or acquirers. This could reduce the number of financial institutions willing to participate in our open-loop multi-party payments system, lower overall transaction volumes and/or make closed-loop payments systems or other forms of payment more attractive. Issuers could also begin to charge higher fees to consumers, thereby making our card programs less desirable and reducing our transaction volumes and profitability. Acquirers could elect to charge higher merchant discount rates to merchants, regardless of the level of Visa interchange, leading merchants not to accept cards for payment or to steer Visa cardholders to alternate payment systems. In addition, issuers or acquirers could attempt to decrease the expense of their card programs by seeking incentives from us or a reduction in the fees that we charge.

So to be clear, the worry isn't that lower interchange fees will hurt Visa and MasterCard directly: It's that lowering interchange fees will hurt the issuers (the banks), which are then less incentivized to entice consumers into using debit cards. That, in turn, is an axe on Visa and MasterCard's bottom line.

And it might not be insignificant. See, the Senate's ruling specifically targets debit transactions. That's particularly harmful to Visa and Mastercard's business model because both companies have become increasingly reliant on debit growth while credit has been stuck in the mud:

Visa payment volume growth

Segment

Q1 2010

Q4 2009

Q3 2009

Q2 2009

Credit

8.5%

4.1%

(0.6%)

(1.6%)

Debit

21.9%

16.5%

8.3%

7.1%

MasterCard payment volume growth

Segment

Q1 2010

Q4 2009

Q3 2009

Q2 2009

Credit

7.2%

3.1%

(2.5%)

(3.5%)

Debit

13.4%

16.9%

10.5%

9.7%

I've long argued that both these companies were dangerously priced for perfection. Many readers countered that the high valuations were justified because of the promise of unrelenting debit growth, which I never fully bought. With the Senate's ruling, debit growth is now an even bigger question mark.

Got another take? Share it in the comment section below.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


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