THE PLASTIC TRAP
Soaring Interest Compounds Credit
Card Pain for Millions
By PATRICK McGEEHAN
Published: November 21, 2004
This article was reported by Patrick McGeehan, Lowell Bergman,
Robin Stein and Marlena Telvick and written by Mr. McGeehan.
When Ed Schwebel was whittling down his mound of credit card
debt at an interest rate of 9.2 percent, the MBNA Corporation
had a happy and profitable customer. But this summer, when MBNA
suddenly doubled the rate on his account, Mr. Schwebel joined
the growing ranks of irate cardholders stunned by lenders' harsh
tactics.
Mr. Schwebel, 58, a semi-retired software engineer in Gilbert,
Ariz., was not pleased that his minimum monthly payment jumped
from $502 in June to $895 in July. But what really made him angry,
he said, was the sense that he was being punished despite having
held up his end of the bargain with MBNA.
"I paid the bills the minute the envelope hit the desk," said Mr.
Schwebel, who had accumulated $69,000 in debt over five years
before the rate increase. "All of a sudden in July, they swapped
it to 18 percent. No warning. No reason. It was like I was
blindsided."
Mr. Schwebel had stumbled into the new era of consumer credit,
in which thousands of Americans are paying millions of dollars
each month in fees that they did not expect and that strike them
as unreasonable. Invoking clauses tucked into the fine print of
their contract agreements, lenders are doubling or tripling
interest rates with little warning or explanation.
This year, credit card companies are changing the terms of their
accounts at a historically high rate, said Michael Heller, an
industry consultant.
As those practices spread, they are creating a rift between the
lenders and some of their more lucrative customers, according to
cardholders, current and former bank consultants and regulators
who were interviewed for a joint report by The New York Times and
"Frontline," the PBS documentary program.
People like Mr. Schwebel, who carry balances from month to month
and pay finance charges regularly, feel they should be the favored
customers of the credit card business, which is now the most
lucrative segment of banking. They make up the profitable majority
of the 144 million Americans who have general-purpose credit cards.
To a degree, they subsidize the 40 percent of credit card customers
who pay in full each month without incurring any fees or charges.
But increasingly, they say, what should be a warm embrace has
turned into a painful squeeze as lenders employ new tactics to
extract more and bigger penalties for even the slightest financial
transgressions. In the last few years, lenders have more frequently
raised customers' rates because of slip-ups elsewhere, like late
payment of a phone or utility bill, or simply because they felt a
customer had taken on too much debt.
The practice, called universal default, started after a rash of
bankruptcy filings in the mid-to-late 1990's and has increasingly
become standard in the industry. While MBNA declined to comment on
any specific customer's account, its general counsel, Louis J. Freeh,
the former F.B.I. director, said in a statement that it was being
prudent by raising rates when it had reason to think the risk of
not being repaid had increased.
Edward L. Yingling, executive vice president of the American Bankers
Association, said bankers must have the flexibility to change terms
on short notice. The bankruptcy filings of the 90's - many by customers
who had been paying their bills on time - caught banks off-guard,
he said.
Lenders decided they needed to watch for signs of trouble elsewhere,
like missed car payments, he said. In those cases, he added, there
are only two logical responses: "We're not going to let you have
this credit card loan anymore and we're going to say, 'Pay it off,'
or we can say, 'You're now more risky; we're going to raise your rate.' "
Still, some critics say the severity of the punishment does not
match the risk of default. The suddenness and perceived unfairness
of the penalties have left many consumers feeling burned by lenders
who relentlessly courted them with promises of low rates.
To some cardholders and consumer advocates, credit card companies
are acting like modern-day loan sharks, strong-arming their customers
to pay more - with no legal limit on how much they can charge.
In eight years, the major card companies have increased the fee
charged to cardholders for being even an hour late with a payment
to $39, from $10 or less.
Unleashing an Industry
Duncan MacDonald, who, as a lawyer for Citibank was involved in its
successful case for deregulation of fees before the United States
Supreme Court in 1996, now says he fears that he helped to unleash
a monster.
Until that ruling, most banks still charged an annual fee of about
$25 for the use of a card and a single fixed rate to all borrowers,
usually around 18 percent. Applicants either qualified for the
privilege of carrying a card or they did not.
"I certainly didn't imagine that someday we might've ended up creating
a Frankenstein," said Mr. MacDonald, who predicted that the penalty
fees could rise to $50 in another year. "I look at that and I say to
myself, 'Is $50 a fair fee, plus a 25 percent interest rate and all
these other fees that are thrown on, for folks who are probably not
that risky? Is that fair?' "
Mr. MacDonald said federal bank regulators should investigate the
fairness of universal default and some of the banks' harsh penalties.
But regulators and lawmakers have been reluctant to crack down on a
popular consumer product that fuels America's economic engine.
Consumer spending pulled the country through the last economic
downturn, powered largely by purchases financed with debt, to the
tune of $2 trillion.
Few consumer products today are as cherished or reviled as credit
cards. The typical household has eight cards with $7,500 on them.
People like Mr. Schwebel are known as "revolvers" in the industry
because they roll balances over from month to month, never paying
in full.
Without the 85 million Americans who revolve, card issuers would
be struggling to please their investors. But with them and the
hefty finance charges they accrue from the moment cashiers swipe
their cards, the industry is reaping record gains. Last year,
card issuers made $2.5 billion a month in profit before taxes.
"I think it is generally understood that those that use the
revolving part of the credit card are kind of the sweet spot,
"said Mr. Yingling of the bankers' association, who spoke on behalf
of several of the biggest issuers, including Citigroup, J. P. Morgan
Chase and MBNA, all of which declined to make executives available
for interviews.
But the lenders' aggressive tactics have prompted a surge in
complaints and lawsuits and even a warning from the primary
regulator of national banks in September. In an advisory letter,
the Office of the Comptroller of the Currency said banks should
not raise card rates without having fully and prominently disclosed
the circumstances that might cause an increase.
Changing the Terms
The case that opened up the industry came in 1978 when the Supreme
Court decided that a bank could charge its cardholders any rate
allowed in the bank's home state. Major banks swiftly moved their
credit card operations to places like South Dakota and Delaware
that had removed caps on interest rates. There is no federal limit
on consumer credit rates.
After that ruling on interest rates, credit cards, which until
then had generally been an uncertain business, started to look
potentially lucrative. Banks began to innovate and compete. They
cut the required minimum monthly payment to 2 percent of the
balance, from 5 percent, to encourage customers to borrow more
and stretch out the repayment. They dropped annual fees and
dangled offers of low interest, or none at all, to lure new
customers.
At the same time, legal teams crafted contracts of 12 or more
single-spaced pages that gave the banks the leeway to change
their terms whenever they wanted. A typical term sheet for a
Visa card issued by Bank One, which was acquired this year by
J. P. Morgan Chase, includes: "We reserve the right to change
the terms at any time for any reason."
John Gould has worked in and around the credit card business
for 25 years, but he said he was shocked when his wife tried
to make a last-minute payment over the phone and was charged
an extra $15.
"What a rip," he said. "That does get me mad."
Fees like that are accounting for a greater share of the
revenue that card companies garner from their customers.
Last year, they collected $11.7 billion in penalty fees,
more than half of the total $21.5 billion in fees they
collected from cardholders, according to CardWeb, a research
firm.
Mr. Gould, a former executive of MasterCard International
who conducts research for TowerGroup, a company owned by
MasterCard, said he did not think that card companies were
trying to trap people into financial distress. But he said
it was "absurd" that 44 percent of them tell their customers
that they might be penalized for one or two late payments
with maximum rates that now exceed 28 percent.
This practice has gone on while the short-term interest
rates set by the Federal Reserve Board have been unusually
low, now at 2 percent, he noted, but the rates have been
rising in recent months.
Credit scores are used to determine everything from how much
a person can borrow to how much he or she pays for life
insurance to whether he or she can rent a home. A utility
company in Texas even experimented last summer with using
credit scores to set prices for electricity.
The number crunchers at Fair Isaac do not make lending decisions.
They simply take information collected by the three largest
credit-reporting agencies, Experian, Equifax and TransUnion,
and apply mathematical formulas to boil it down to a single
number on a scale that runs to 850.
"Lenders use that score, almost like a thermometer, to
determine if they're going to grant credit or not," said
Tom Quinn, a spokesman for Fair Isaac. He estimated that
his company had calculated a credit score for about 75
percent of American adults.
The average FICO score is 720, he said. A score below 620
lands a consumer in the riskiest category, known as subprime,
and virtually ensures the highest borrowing rates, if the
consumer can obtain any credit at all. Credit reports
generally note only those payments made at least 30 days
late.
Consumers with better-than-average scores are usually,
but not always, eligible for the lowest rates. As Steve
Strachan, a flower importer in York, Pa., learned, a
relatively high credit score does not guarantee favorable
terms.
A thick credit report on Mr. Strachan from January showed
a FICO score above 730, but by then he had already been
through a battle with the issuer of a card that had once
been his favorite method of payment.
In the 1990's, Mr. Strachan traveled frequently from his
home on the West Coast to Amsterdam and other foreign cities
to meet with suppliers of tulips and exotic flower varieties
that he distributed to domestic florists and wholesalers.
He obtained a WorldPerks Visa card that rewarded him with
seat upgrades through Northwest Airline's frequent-flier
program.
"I used that card whenever I possibly could because of the
travel benefits," he recalled, sitting in his living room
before stacks of credit card bills, change-of-terms notices
and other correspondence between him and several lenders.
"Never paid a penny of interest."
He was such a valued customer then, he said, that US Bank,
which issued the card, had extended him a high credit limit
of $54,000 even though the card rate was just one percentage
point above the prime rate. When the economy wilted after
the collapse of the stock market in early 2000, so did Mr.
Strachan's business. He began using his credit lines on that
Visa card and a few others to stay afloat, paying smaller
portions of his growing balances.
Then, in May of last year, US Bank sent Mr. Strachan a
letter telling him that it planned to raise the card's
rate to 20.21 percent, nearly quadrupling the existing
rate of 5.25 percent.
"I wasn't late, and I didn't go over the credit limit,
and I didn't write bad checks," Mr. Strachan said. A
representative of US Bank told him he was using too much
of his available credit, he said.
A US Bank spokesman declined to comment on Mr. Strachan's
account.
The monthly interest charge on his $50,000 balance jumped
from $209 in June to $756 in July and $808 in August. He
eventually persuaded the bank to restore the original rate,
but the bank closed the account, shutting off a key source
of credit.
By then, Bank One, another creditor, had compounded Mr.
Strachan's woes. He was carrying a balance of about
$70,000 on one account when the bank started raising his
rates, first to 19.99 percent in April 2003, then to 22.99
percent the next month, then to 24.99 percent in June. By
October of last year, he was incurring a monthly finance
charge of about $1,500 on a $77,000 balance.
"It was like they almost all had a little meeting in the
back room and said, 'Let's get Strachan,' " he said of his
creditors. "How does it serve them to treat people like that?
Are they trying to force them into bankruptcy?"
Lawyers he consulted advised Mr. Strachan to take the easy -
and increasingly popular - way out by filing for bankruptcy
protection, but he refused. He is struggling to make good
on his debts "because I have principles and ethics."
But the battle to dig out of a deepening hole has taken a
toll. Mr. Strachan said he had lost 30 pounds and described
himself as a "broken man."
Lately, he said, Bank One has periodically reduced his
credit limit to a level just above his remaining balance,
leaving him little margin for error. Some months, he said,
if he were to pay only the minimum due, the ensuing finance
charge would put his balance over the limit, triggering a
penalty fee.
By doing that, he said, "They create their own little monster."
The Regulators
Consumer complaints prompted the Office of the Comptroller of
the Currency, which oversees the nationally chartered banks
that constitute most of the major card issuers, to warn banks
about giving fair notice of term changes and about sending
out tempting offers to people who are unlikely to qualify for
them.
Julie Williams, the acting comptroller, said in an interview
that as long as the lenders were not intentionally deceiving
their customers, they were free to set whatever rates and fees
their home states allow. If customers do not want to pay a
particular rate, "they have choice," she said. "They can find
another card."
But consumers clearly are unhappy with the choices they have.
About 80,000 people lodged complaints with the comptroller's
office last year. Ms. Williams said the largest single source
of their ire was credit cards. Those complaints are routed to
examiners who monitor the banks, she said, but the examiners'
foremost concern is to make sure the banks are financially sound.
Ms. Williams described her agency as a "tough regulator," but
critics contend that the comptroller's office has taken strong
action against only one major issuer of credit cards in the last
five years. In 2000, the O.C.C. joined in an investigation into
Providian that had been started by the San Francisco district
attorney's office.
Providian customers complained that they had been hit with late
fees for payments that had been sent in on time but not credited
to their accounts for days or weeks. Some said the resultant
penalties pushed them over their credit limits, leading to
additional fees.
Later, Ms. Williams said, the two agencies joined forces to
extract $300 million in a settlement with Providian.
The comptroller's office has since angered state attorneys
general by trying to limit their ability to regulate how national
banks behave in their states.
Eliot Spitzer, the attorney general of New York, said his office
gets "thousands of complaints every year about credit card issues
relating to the major banks, the major card issuers." But more
often, he said, the banks' response has been that " 'we don't
need to deal with you because the O.C.C. has told us - indeed,
directed us - not to deal with state enforcement entities.' "
Elizabeth Warren, a professor at Harvard Law School who has
been a vocal critic of consumer lenders, said the comptroller's
office should do more than express discomfort with the practices
of credit card companies, as it did in September.
The regulators did not say that "those are unfair practices,
they are unsafe and unsound and don't do them," Ms. Warren said.
"Instead, they said it's a problem. Look, if they think it's a
problem, then tell the credit card companies to stop doing it."
"Secret History of the Credit Card," produced in conjunction
with this article, will be shown Tuesday on "Frontline"
(PBS, 9 p.m. in most cities).
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