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It's always refreshing when the bad guys lose and the good prevail. In the credit card business, that's exactly what happened when the Credit Card Accountability, Responsibility, and Disclosure Act became effective in July 2010. Gone was the ability of credit card issuers to raise consumers' rates willy-nilly, tacking on fees without prior notice, along with numerous other slippery practices to wrangle more money out of unwitting cardholders. Card issuers lobbied hard against this law, claiming that such restrictions would hurt their bottom lines. As it turns out, they were wrong: According to a new study, it was their bad behavior, not regulation, that dinged profits.
A free-for-all for banks and credit card companies
In the year before the law took effect, credit card issuers went on a tear, raising fees, interest rates, and customers' ire. Consumers had their accounts closed without notice, and many saw their credit limits lowered. The banks and card companies claimed that they had to do these things to fill their coffers before the changes became law and began eating into their profits.
JPMorgan Chase (NYSE: JPM ) and Discover Financial Services, for example, raised the minimum payment percentage for some customers, as well as the rate on balance transfers. In some cases, Chase also charged customers $10 per month to maintain their lifetime low interest rate, as well as informing them that they had to bump up their monthly payments. Bank of America (NYSE: BAC ) also raised various fees and, along with Citigroup (NYSE: C ) , lowered monthly limits and pushed up interest rates. Citi, in fact, had the dubious distinction of enacting the largest interest-rate increases of the top-tier card issuers. Capital One (NYSE: COF ) raised rates on low-risk customers by more than 6% in some cases, with little prior notice. Wells Fargo (NYSE: WFC ) joined its peers in the fall of 2009, raising interest rates by 3%, though it did remove fees for customers who exceeded their credit limits.
Why did these banks and card issuers do it? They claimed, at the time, that these changes were necessary because of the state of the economy and high unemployment, which increased the chances that customers would stop paying their credit card bills. Supposedly, raising fees and interest rates was making up for the idea that extending credit was becoming more risky.
Credit practices caused the very problems banks sought to avoid
What happened was the exact opposite of what the banks said they wanted to prevent, as people defaulted in droves. As it turns out, ratcheting up rates and minimum payments in an economic downturn isn't a great business plan.
A recent New York Fed report indicates that household debt has fallen over the past four years -- particularly credit card debt. Indeed, the news looks good when you consider that Americans are holding a mere $679 billion now versus a 2008 level of $866 billion on their cards, but there is more here than meets the eye.
In 2010, the year after all the hijinks on the part of credit issuers, the industry was forced to write off a huge amount of debt as uncollectable, representing a 300% increase from four years prior. Interestingly, charge-offs were up appreciably in 2009 as well, at the very same time as banks were raising rates and minimum payments. In fact, of the $93 billion decrease in credit card debt for that year, fully 90% was written off by the credit card industry. When a company boosts a customer's minimum payment to $900 per month from $373, as Chase did with one retired cardholder, problems should be expected.
Credit card issuers' behavior was directly linked to losses
The report from the Center for Responsible Lending pointed out how deceptive credit practices directly affected banks' bottom lines for the years 2006 to 2010. Among their findings was that banks tended to engage in several of these activities at once, and that the biggest offenders were among the top 10 credit card issuers. Issuers with the most consumer-friendly and easily understood credit rules tended to be smaller regional banks and credit unions.
The study compared pre-recession losses with those experienced by issuers during 2009 to 2010 and found that the loss rate was markedly higher for institutions with dicey credit card practices than for banks that had more transparent rules. In fact, when the CRL compared the bank with the least onerous practices with the institution with the worst profile, the loss rate more than doubled for the latter.
The bottom line
The study found that the very practices that banks insisted would protect their profit margins in the short term actually worsened the losses they sustained over time by triggering higher defaults. In fact, many of the banks' actions were not truly associated with risk management, such as deliberately applying payments to customers' accounts in a way that triggered higher fees and interest rates.
What does this mean for investors? For one thing, it supports the position that financial regulation protects not only consumers, but financial institutions as well. It would be hard to argue, given all the evidence, that banks and credit card issuers had read the market correctly when many decided to engage in shady credit practices. Apparently, legislative guidance is necessary to avoid such mistakes in the future, and the CARD Act will be of assistance in that regard.
This scenario also shows that customer-friendly policies can be good for business, and serious investors will do well to explore this factor when performing due diligence on financial stocks in the future.
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