Credit card companies hand out cards to millions of consumers, with the greatest profits coming from those least able to keep up with the payments. Photo by: Courtesy to the Ledger Dispatch Credit card executives have found innovative ways to keep their companies profitable, while continuing to mail billions of new offers every year. Photo by: Courtesy to the Ledger Dispatch

An avalanche of "pre-approved" credit card offers that filled mailboxes across the country during the late 1990s and 2000s has given way to a new deluge, one of notices to cardholders that rates will be raised to usurious levels. Behind both is an explanation and a developing situation that is eerily similar to the mortgage meltdown.

Mortgage foreclosures and the effects they have had on banks and the world economy have dominated the financial news of the last couple of years. Almost unnoticed in the brouhaha has been the approach of what may be an even larger tsunami of credit card defaults.

"Mortgages were simply the first storm to make landfall. Credit cards are next," said Gregory Larkin, a senior analyst at Innovest, an international investor's advisory group.

Asset-backed securities

Behind the mortgage foreclosure crisis lies a hidden culprit: asset-backed securities, a sophisticated group of instruments used in the world of high finance. In the case presently vexing the financial world, mortgage loans are the "assets" backing the securities. Mortgage-backed securities are bundles of mortgages put together by financial firms and sold to investors as lucrative, high-interest-bearing shares in America's seemingly solid housing market. Until recently, they were among the most popular of all investments.

In the credit card industry, cardholder accounts receivable have been bundled together into securities and sold to investors. Recent estimates of the amount of cardholder debt held as securities range as high as half of the $916 billion total credit card debt. This has been going on for quite some time, though only recently attracting attention, due to steep rises in credit card defaults.

In October 2007, Fortune Magazine reported that three major credit card companies - Capital One, Bank of America and Washington Mutual - all said they were bracing for a 20 percent or higher increase in credit card losses over the near and medium term. These three companies, along with JPMorgan Chase, Discover and American Express, account for about 90 percent of all credit card debt.

Behind the scenes

Some backroom thinking at credit card companies is provided by John Ulzheimer, who worked for seven years at Fair Isaac and six years at Equifax. In an exploration of corporate thought processes, presented to Bankrate.com's Leslie McFadden, Ulzheimer outlines some of the reasons for hiking rates on established cardholders.

With sophisticated software capable of tracking every transaction by every cardholder, credit card companies are able to decipher people's financial situations with nearly X-ray vision. Inactivity is as much of a clue as excess use. Cardholders with high balances, who stop using their cards, are thought to be easy marks for the companies.

The company can also decipher from the data whether the cardholder is using another card with a lower interest rate. From this, the company can choose to assume that the consumer is strapped for cash and still in need of the credit he/she contracted for in the first place.

"So," Ulzheimer writes, "they are either going to close your account, reduce your credit limit, increase your interest rate or a do a variety of the other nasty things like lower your grace period, start aggressively calling you if you're over a day or two late."

The reasons for this are: If you are not actively using their card, they don't really want you hanging onto it; or, if you are trying to keep your rates down on what you already owe, they can assume your inability to immediately pay it off and simultaneously assume that you are defenseless against the imposition of a higher rate.

One explanation behind a rise in interest rate lies within the concept of "universal default." When a credit card company changes the interest rate on a card as a consequence of a customer's failure to make a payment on some other debt, it is applying "universal default." Many consumer advocates find this appalling, while advocates of its use feel that non-payment or late payment on any account in a consumer's debt portfolio provides an essential clue to that consumer's risk-worthiness.

Universal default may be the only explanation behind a mysterious rise in rates on at least one resident.

Wendy Fritz, a woman raised in Amador County, had no idea why her interest rate suddenly shot up from 16 percent to 23 percent. "I pay it on time," Fritz said. "I have not had any changes lately." Fritz added that she has cut back on how much over the minimum she's been paying, which may explain the card company's move.

A Ledger Dispatch online poll posted Friday asked readers whether their credit card companies had increased their interest rates. At press time Monday, 165 people had responded, with more than 41 percent reporting drastic increases. Nearly 35 percent said their rates hadn't been raised.

Usury laws differ

Lucy Lazarone, at Bankrate.com, warned of the approaching danger in 2002, pointing out then that a 1978 Supreme Court ruling affirmed national banks' right to charge the highest interest rate allowed in their home states to customers living anywhere in the United States, including states with restrictive interest caps.

Each state in the U.S. has its own laws to control interest rates. Citibank's decision to locate its credit card arm in South Dakota was based upon that state's laissez faire usury policy, legislated into being during the interest rate spike of 1980. With interest rates rising to 20 percent, Citibank realized that it could only lose money if its home state of New York refused to relax its usury laws, which it refused to do.

The Lectric Law Library points out that banks have separate rules. In 1980, the federal government passed a special law that allowed national banks (the ones that have the word, "national," or the term "N.A." in their name, and savings banks that are federally chartered) to ignore state usury limits and pegged the rate of interest at a certain number of points above the federal reserve discount rate. In addition, specially chartered organizations like small loan companies and installment plan sellers (like car financing companies) have their own rules.

No help can be expected from the state of California. The attorney general's office freely admits that "the limitations (on interest rates) also do not apply to most lending institutions such as banks, credit unions, finance companies, pawn brokers, etc. State laws place limitations on some of these loans, but at a higher percentage rate than the usury laws listed above."

Perhaps more troubling is the fact that credit card companies have been raising interest rates to unprecedented levels, with the highest rates imposed upon those least able to afford them. The reasoning is that 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 percent 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.

There are hopes that the new Obama administration will impose heightened levels of disclosure and regulation of interest rates on credit cards issued to lower-income consumers.

To a statement that credit card companies are sure to argue that such a move would dry up credit for higher-risk borrowers, ABC News reported Harvard law professor Elizabeth Warren's reply: "That is the most astonishing claim that I can imagine a corporate representative making. Let me retranslate it: 'If I can't trick these people and fool these people about the actual cost of credit, then I can't make a profit off of them, and I will stop lending it.'"

"When you have higher risk, you have to charge more, which is what investors (in credit card securities) demand," Michael Brosnan, a deputy comptroller at the Office of the Comptroller of the Currency, which regulates national banks, told USA Today.

Offers still coming

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.

A 1996 Supreme Court ruling removed the cap from penalty fees, which can be charged for any of numerous transgressions, including late payment, over-the-limit charges and returned checks.

In a mathematical coincidence, the $18 billion profit shown on the balance sheets of U.S. credit card companies for 2007 was almost identical to the amount of revenue generated from penalty fees. After securitizing credit card receivables, the banks are only responsible for a stipulated return to investors. Inasmuch as the banks continue to service the securitized accounts, fee revenues are retained by the banks, not passed on to the investors.

Even as the economy worsens, Americans continue to be inundated with offers of credit. In 2008, issuers sent 4.2 billion credit card offers in the mail. This number is down from the peak of 6.1 billion in 2005, but still nearly four times as many as the 1.1 billion sent in 1990.

As securitization took off in the 1990s and boomed earlier this decade, 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.

Fox Business reports that the card companies and industry representatives say that the weak economy and job losses have left more people unable to pay their credit card bills, leading to greater losses. The increased rates and fees are necessary, they say, to make up the difference.

But it also means that companies that benefited from infusions of cash from U.S. taxpayers are now turning around and charging many of those taxpayers more for their services.