-- Tommy Newsom was shocked when his bank nearly doubled his credit card interest rate this year, to 27%, for no apparent reason. A customer rep told him the law allowed the bank to do so, and that was all the justification it needed.
"I never missed a payment," says Newsom, 63, of Mesquite, Texas, who owes about $5,000 on the card. "The bank is just looking for a reason to maximize profits."
In recent years, banks have sharply raised interest rates and penalty fees on credit cards. As the economy tanks and banks' mortgage-related losses balloon, some banks are stepping up such increases to boost revenue. Bearing the brunt are consumers for whom a jump in rates and fees can make it tougher to pay their bills at a time when household budgets already are being stretched.
A key driver behind this trend: securitization. From 2003 to 2007, seven of the largest issuers of credit cards packaged an increasing amount of card debt into securities and sold them off to investors, just as banks did with mortgages, a USA TODAY review of banking records found.
Selling off credit card debt has given banks a powerful incentive to raise card fees and penalties, according to interviews with dozens of industry analysts, academics and investment specialists.
Here's why: When banks package and sell card debt, they pass along to investors some of the risk the debt will go bad. Yet, banks often get to pocket much of the profit from rate and fee increases on those accounts. Imposing higher fees on more accounts — without a comparable rise in risk — lets banks raise revenue and keep profits up, at customers' expense.
Securitization has been a "major impetus" for banks to expand penalty fees and rates in recent years, says Adam Levitin, a Georgetown University law professor and card expert. Banks "have little to lose if they squeeze too hard (if consumers default), but a lot to gain if they can extract additional payments" from card users, he says.
Banks deny any link between securitization and rising penalties. They say fees are rising because of superior data-tracking tools that allow banks to draw precise profiles of card users. Banks can price debt fairly, officials argue, with riskier borrowers paying more, as they should.
"Securitization is a method of funding credit card loans," says James Chessen, chief economist at the American Bankers Association. "Penalty fees and rates are entirely separate and completely avoidable."
As the debate unfolds about whether — and how much — securitization drove up penalties, analysts are bracing for an acceleration in credit card losses. Already, delinquencies are at their highest point in six years. Defaults, triggered when banks give up on collecting bad loans, are rising rapidly, too.
By the end of 2009, banks are likely to write off a record amount — up to $96 billion, or about 10% — of all credit card debt, says Innovest Strategic Value Advisors, a research firm that was among the first to predict the mortgage meltdown. The credit card market is a fraction of the size of the mortgage world, but its collapse could threaten some issuers' solvency and make it harder for others to absorb financial shocks, says Gregory Larkin, a senior analyst at Innovest.
"Mortgages were simply the first storm to make landfall," Larkin says. "Credit cards are next."
Experts worry that the $700 billion authorized by Congress to help stabilize financial markets will do little to solve the underlying problems.
"Securitization is an important economic tool," says Rep. Carolyn Maloney, D-N.Y. "But when we saw the subprime (mortgage) meltdown occur, we started really looking at credit cards as the next crisis. We have to crack down on the abuses."
Several bills in Congress, including Maloney's Credit Cardholders' Bill of Rights, seek to clamp down on hair-trigger fee and rate increases. The Federal Reserve has proposed limiting rate increases on existing debt and curtailing excessive fees for borrowers with marred credit.
Meanwhile, amid the slowdown of the securitization markets, Sheila Bair, chairman of the Federal Deposit Insurance Corp., wants more restrictions on mortgage- and credit-card-backed securities. "We're finding in retrospect that being able to securitize debt … weakens underwriting discipline," Bair says. "Whether it's credit cards or mortgages, this dynamic needs to be dealt with."
A proposal by the Financial Accounting Standards Board could lead banks to keep more card debt on their balance sheets, and hold more capital in case those loans sour. Banks' inadequate capital levels have prolonged the economic crisis, analysts say.
Reform is needed, says Travis Plunkett, legislative director for the Consumer Federation of America, because many of the credit card practices under fire "have been fueled at least in part by securitization."
A downward spiral
"Securitization," he says, "has increased the willingness of credit card companies to offer riskier loans. And to compensate, they have moved to a business model that involves hitting consumers with very high — often unjustifiably high — rates and fees."
Banks cite the destabilization of their industry as a reason regulators should refrain from cracking down on their ability to raise fees and interest rates as they wish.
Reforms would "clearly affect issuers' profitability" at a time when they're already struggling, says Mark Furletti, a lawyer at Ballard Spahr Andrews & Ingersoll, which represents banks.
Banks also warn that restrictions would reduce investors' appetite for card-backed securities. That, in turn, would force banks to cut back on card loans and raise credit costs, says the American Securitization Forum, which represents banks and investors.
Consumer advocates fear these arguments could sway regulators away from enacting strong measures to protect consumers from hair-trigger pricing. Proposed card reforms, while a good first step, won't dismantle a system that is increasingly relying on punishing fee practices to boost profitability, advocates say.
"In a bad economy … consumers need more protection from unfair practices, not less," says Ed Mierzwinski, consumer program director for the U.S. Public Interest Research Group.
Already, a downward spiral is unfolding, banking analysts say, as more consumers, pushed over the edge by penalties, default on their credit card bills. Banks are pulling back on credit to risky card borrowers even as consumers' access to other loans, including home equity, has dried up.
Revolving debt — most of it on credit cards — is soaring, topping $970 billion in September. The average household now owes $10,678 in credit card debt, up 29% from 2000, according to CardWeb.com, a research firm.
And more borrowers are paying their credit card bills before their mortgage bills, credit bureau data reveal, an alarming shift that suggests people are walking away from mortgages and using credit cards to get by.
Borrowers are also piling up card debt for other necessities.
Newsom, for example, began relying heavily on his Bank of America credit card after $25,000 in health costs depleted his savings. As his card balance climbed, Bank of America almost doubled his rate even though he regularly paid above the minimum and did so on time.
"I'm still managing," says Newsom, an energy company manager. "But it's tough."
Bank of America declined to comment on Newsom's case but says it "regularly assesses the risk profile of accounts." If the bank decides to raise a customer's rate, it will notify the customer first and give him or her the chance to "opt out" and pay off the card balance at the existing rate, bank spokeswoman Betty Riess says.
Banking specialist Levitin says credit cards have become "the drip pan of the economy," a short-term fix that merely delays a day of reckoning for many people and makes their crisis all the more ruinous once it arrives.
Rising rates and fees
Bank One helped pioneer credit card securitization in 1986, when it packaged $50 million in debt and issued securities linked to them. In doing so, it tapped a funding source that financial institutions had previously used mainly for home and car loans.
Other banks followed. They sold card-backed securities to pension funds, hedge funds and other investors. Today, nearly half the nation's household revolving debt is securitized via major banks.
Among large card issuers, Bank of America, Citigroup, Discover and Washington Mutual securitized more than half their outstanding credit card debt last year. JPMorgan Chase — which acquired Washington Mutual in September — securitized nearly half its card debt and American Express close to a third. Capital One sold off almost three quarters of its portfolio.
Outstanding card debt securitized by Capital One, Washington Mutual, Bank of America, Citigroup, Discover, JPMorgan Chase and American Express has doubled since 2003, hitting nearly $400 billion in 2007. Investor demand for securitized card debt has slowed with the economy, but not disappeared.
Securitization has helped large banks expand their dominance of the card market, says Arthur Wilmarth, a law professor at George Washington University. That, in turn, has given banks the "market power to charge such high fees to consumers."
As securitization ballooned, banks also won legal battles that gave them greater leeway to set credit card rates and fees. They've replaced cards with fixed rates and few fees with those carrying multiple rates and a variety of charges, such as phone-payment fees, balance-transfer fees and late and over-the-limit fees.
From January 2003 to December 2007, the average late fee charged by large card issuers rose 17%, to $35.24, and the average fee charged to those who spend beyond their credit limits surged 23%, to $26.88, according to CardWeb.com.
Late and over-the-limit fees have grown at a "remarkably similar" pace to the growth of securitized credit card balances, Levitin says. Such fees have boosted banks' profits. In 2007, lenders collected a record $18.1 billion in credit card penalty fees, up 69% from 2003, according to R.K. Hammer, a consulting firm. Fee income is likely to rise another 5.5% this year as people struggle to pay bills and get hit with more late fees, Hammer says.
Ken Clayton of the American Bankers Association notes that users who abide by terms of their loans pay no penalties. He contends that securitization has allowed banks to meet growing demand for cards, resulting in a "lower cost for consumers and more access to credit for everyday Americans."
Yet, while the average interest rate has fallen from 18.2% in 1990 to 14.7% in 2007, those who pay late or exceed the credit limit — even once — can be hit with far higher rates, up to 32%.
The average card rate has declined only "because banks have figured out (other ways) to get their revenues," says Duncan MacDonald, a former group counsel at Citigroup. "These guys have figured out how to deconstruct pricing."
Rising demand for credit card securities enabled banks to become more innovative in raising rates and fees, says Nomi Prins, who formerly ran a Bear Stearns group that analyzed securitized consumer debt.
"As long as investor demand grew for credit card collateral embedded with these fees and higher rates, issuers knew they had a place" to offset their risk and boost their profits, says Prins, now a senior fellow at Demos.
Securitization gives banks "more of the upside with less of the downside," agrees Elizabeth Warren, a Harvard law professor. If a bank that sells off card debt doubles a borrower's interest rate, it will typically keep most of the profits from this increase — yet, may not bear all the exposure if the account later defaults.
Vernon Wright, former chief financial officer at MBNA, now part of Bank of America, says that selling off credit card debt doesn't give an issuer more incentive to raise card fees than if it held the loans on its books.
Banks may raise rates and fees if card defaults rise because these profits will be "part of the cash flow that's going to make up for the losses," says Wright, regarded as the "grandfather" of credit card securitization.
But the banks would do so, he adds, whether or not they sell off debt.
Tom Deutsch of the American Securitization Forum, a trade group for banks and investors, argues that by spreading the risk to investors, securitization has become "one of the largest reasons why credit is available to borrowers in low-income, minority neighborhoods."
But experts say card securitization led banks to offer too much credit, too fast, to too many, similar to what happened in the mortgage world.
Patrick Sargent, a partner at Andrews Kurth law firm, says that banks wanted to get as many cards securitized as possible. To do so, he says, they expanded lending indiscriminately.
"They were being too flip with underwriting," says Sargent, whose firm worked on some of the first card-securitization deals.
As securitization took off in the 1990s and boomed in the 2000s, banks' card mailings to households with less than $50,000 in income also surged, peaking in 2001 at a record 2.1 billion offers, compared with 1.2 billion offers five years before, according to Synovate Mail Monitor.
Lower-income consumers who carry a balance can be more profitable for banks than other borrowers.
A 2006 Demos study reveals that households with incomes below $25,000 are twice as likely to pay credit card rates of more than 20% than those earning $50,000 and five times more likely to pay such rates than those earning $100,000. Lower-income, single and minority borrowers were also more likely to pay late fees than others were.
"When you have higher risk, you have to charge more, which is what investors (in credit card securities) demand," says Michael Brosnan, a deputy comptroller at the Office of the Comptroller of the Currency, which regulates national banks.
Yet, in a society where credit has become a necessity rather than a luxury, many people who can ill afford it are now paying high rates on debt swollen with penalty fees.
Tim Bellamy, 35, of Grove City, Ohio, says he opened a card account in 2005 with the best of intentions: to fix a credit record marred by a bankruptcy filing.
Card offers poured in. He racked up $5,000 in card debt after his girlfriend lost her job and he had to pay the couple's bills. Eventually, he fell behind on card payments. The banks increased his rates and tacked on hundreds of dollars in fees.
"It's my fault I got in this problem, and I understand that banks need to make money," Bellamy says. "But they are ruthless."
Contributing: Mike Bondi