The CARD Act or Building a House of Cards

The Credit CARD Act went into effect this week, changing the rules for banks and other credit card issuers. One of the changes is that they will now have to put a statement on the front of your monthly bill, telling you how long it will take you to pay off your outstanding balance if you make only the minimum payment. I imagine that some people will get a notice that reads something like this:

“Your estimated life expectancy is 24 years and 7 months from your statement date. Four months later will be your last payment on the outstanding balance.”

Seriously, one of the major provisions of the legislation is that it prohibits the practice of universal default. Under the old rules, if you made a late payment on one bill, your credit card could raise your interest rate on the existing balance you had with them.

Universal default is one of those things that really hack people off. “I’ve never made a late payment to you guys,” the cardholder would cry out. “Why are you raising my interest rate?”

“Simple,” the bank would respond. “A) If you skipped a payment on one bill, we could be next. That puts you into the riskier class of customers who get charged higher interest rates. B) Because we can.”

I’ve never quite figured out the logic behind universal default. Oh, I get that once you start delaying payments, you are a riskier customer. The thing is, it looks to me like raising rates on an existing customer sets up a feedback loop. If you’re strapped for money, cranking up the interest you’re paying makes you more likely to default, not less. “Every month I pay, but my balance keeps getting bigger. Fine, I’ll just stop paying altogether. You want to hurt my credit rating, go ahead.”

I assume that the credit card companies have run the statistical models that tell them that even if they push some customers into default, the higher interest charges on the remaining customers more than make up for it. Or maybe their experience is that once the average customer misses a payment on any card, they only make a couple more payments on the other cards before they file bankruptcy, no matter what the interest rate is. In that case, you better make your money while you can.

Regardless, universal default is now banned. The credit card companies cannot raise your rate on existing balances just because you are late on another card. What they can do, however, is drop your credit limit with no prior notice.

To me, this looks like a fight over allocating risk management duties, between the guy who borrows the money, and the guy who loans it.

In the history of credit, there have been swings over time in terms of who bears the risk of default. For example, in the eighteenth and early nineteenth century, default risk was more evenly spread between borrower and creditor. Sure, if you stopped paying on your debts, your creditors had to write off the loss. But they in turn could stick you in debtor’s prison. That seems like a pretty fair tradeoff to me.

With the advent of modern credit cards, more of the default risk was shifted over to the creditor. All that backs up a credit card is your promise to pay it off. If you are an honest man, your word is your bond. When I meet one of those guys, I’ll let you know. Seriously, I don’t know too many people who would forego using a credit card to get something they wanted, just because they might have trouble paying off the debt. After all, what’s the worst that could happen? Your credit rating might get dinged. Most people will enjoy the good stuff now, and worry about that tomorrow.

With all of the risk on the part of the creditor, credit standards were naturally higher. It used to be much more difficult to get a credit card. As the pool of available credit expanded to include riskier borrowers, the banks undertook tactics designed to shift some of the default risk back onto borrowers. Tactics like universal default.

Now that Congress has pushed the pendulum back in the other direction, look for credit standards to tighten up again. Also, some of the benefits given to good credit risks, like rewards points and no annual fee accounts are probably going to fall by the wayside.

For our society as a whole that’s probably a good thing. Learning to live within your means isn’t a bad idea. In the meantime, I’m going to keep paying off my cards in full every month.