Has the CARD Act Helped You?

For years, members of Congress have named bills with flowery language to increase support for them.  After all, who wants to run a re-election campaign with an opponent blasting you for voting against the Clean Water Act, the PATRIOT Act, or the American Recovery and Reinvestment Act?  By implication, voting against this legislation could brand you as being against clean water, unpatriotic, and against economic recovery.

Another such example was H.R. 627, the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act).  During the midst of the credit crisis and bank bailouts, few politicians wanted to take sides with unpopular credit card companies.  And how could one be against accountability, responsibility, and disclosure?  The bill passed with flying colors:  279-147 in the House, 90-5 in the Senate, and was signed by the President.

By any objective measure, this vote was politically popular, but does that make the CARD Act good law?

Unlike mortgages which have secured collateral in the form of a home, credit card loans are unsecured.  Credit card loans are therefore riskier, so a lender needs to compensate for that risk by charging a higher interest rate.

Additionally, we must accept that some borrowers are much riskier to lend to than others.  Pretend that you are a lender for a moment – what are some important factors that will help you decide whether to lend someone money and on what terms?

·      Credit history à people with poor credit and younger folks with little to no credit history are riskier to lend to

·      Income à people with lower incomes are generally riskier

·      Other debts à if substantial income is needed to service existing debts, this increases a borrower’s risk profile

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Keeping this in mind, you need to be mindful of changing circumstances in order to accurately price for risk.  If a consumer is more than 30 days late on a payment due for student loans or a different credit card account, that consumer certainly becomes more likely to miss interest payments on the credit you have extended to him or her.  To accurately price for the increased risk, it is only natural to raise rates.

However, the CARD Act greatly curtailed a lender’s ability to do just that.  At first glance, this may sound good from a consumer’s standpoint, but it is imperative to dig deeper and examine the bill’s true consequences.  Without chronicling dozens of provisions in the legislation, here is a big-picture summary:

·      Many consumer advocates were heartened by the CARD Act, believing it would stifle what it deemed to be “abusive” and “predatory” practices by the credit card industry

While this approach sounds good in theory, I contend that virtually all consumers were actually hurt by this legislation.

·      Lenders were curtailed in their ability to entice customers with attractive offers, and later modify interest rates if a borrower’s financial situation and creditworthiness worsened.  In effect, people with poor credit histories and financial circumstances would pay enough in fees to help make the industry profitable while it offered more favorable terms for lower risk borrowers and also loyal customers.

Some legislators may have been well-intentioned to help protect struggling constituents who experienced interest rate increases on their credit cards at the first sign of trouble.  It is extremely commonplace, however, for legislation rooted in good intentions to produce a series of adverse and unintended consequences.

Here have been the primary effects of the legislation over the past two years:

1.     Credit card lenders reduced the availability of credit to solid and marginal customers alike.  Recent college graduates are often denied credit, and the ones lucky enough to receive credit have very limited borrowing capacity.  This development is particularly troubling for responsible borrowers with steady income and employment, as building a successful credit history becomes critical later when people obtain mortgages to purchase a house or apartment.

While borrowers with spotty credit histories would purportedly benefit from the CARD Act, it now makes little to no economic sense for lenders to offer credit if they are denied mechanisms to price appropriately.  As a result, many subprime borrowers who have experienced financial hardship and seek to make ends meet no longer have access to credit cards.  Many are instead resorting to payday loans that carry far more exorbitant interest rates than what credit card companies would charge, which only exacerbates the situation.

2.     Interest rates have risen across the board.  With the CARD Act provisions taking effect months after the legislation was signed into law, lenders sought to re-price for risk ahead of time.  Instead of re-pricing on select accounts depending on more individual circumstances, they raised rates on nearly everyone to help offset their future inability to do the former in a timely fashion.  Moreover, many of the fixed rate credit offers were converted to floating rate ones, which will prove significant when interest rates eventually rise.

If you take a hypothetical family with an exemplary credit history but is tight on cash, let’s suppose they had $8,000 in credit card debt at a fixed interest rate of 7%.  Following the legislation’s passage, an account like this would have likely been adjusted to a floating rate, with an interest rate equal to prime + 12% for instance.  Despite there being no change in the family’s own credit profile, it now costs hundreds of after-tax dollars more per year to service their existing credit card debt, which could represent a significant portion of discretionary income that would otherwise be used to boost the economy.

3.     Rewards programs have been curtailed for more stable customers.  At first glance, people who carry a small balance or no balance are not ideal credit card customers because they don’t pay what the firms would consider to be an optimal interest rate.  However, fees are assessed on these transactions, and the low-risk borrowers provide stable cash flows for lenders.  Many of these customers could easily pay in cash for any purchases but instead choose credit cards for convenience and programs that reward customer loyalty.  These rewards programs may include cash-back, hotels, airfare, and merchandise.

To offset a revenue decline from the CARD Act, many lenders scaled back on such programs to help stabilize their bottom line.

In summary, this legislation produced a cascade of bad consequences which affected borrowers across the economic spectrum.  Many of the most vulnerable people became unable to obtain lines of credit, forcing them to seek alternative financing sources that were more expensive than anything they experienced while having access to credit cards.  Customers with good credit histories but tight budgets had their rates preemptively raised ahead of the legislation’s effective date, and they are incurring more financing charges than was previously the case.  The most responsible and creditworthy consumers who valued rewards programs experienced their own economic loss as well from these developments.

Important lessons from the CARD Act should be learned and applied elsewhere.  Politically popular legislation hardly guarantees that it is good legislation that will benefit the country.  It is healthy to apply some skepticism to proposals that sound too good to be true, and there must be recognition of behavioral changes by individuals and companies that could undermine a law’s stated intent.

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