WV Executive

Issuers of credit cards, and that includes nearly every bank in the country, have good reason to be pleased with the passage of the new bankruptcy law. The law, which became effective in October 2005, made significant changes in the way America’s courts handle the insolvencies of Americans and American businesses. Most importantly for the bill’s chief cheerleaders, America’s credit card companies, the nation’s unsecured, defaulted debt now has a greater possibility of being repaid. Thus, for those who owe money through uncollateralized, revolving credit arrangements, it has become much harder to get out of debt when they are hard pressed to pay.

Many financial planners regard the law as a sort of one-sided affair. While agreeing that the responsibility for paying one’s bills should be observed, it is hoped that subsequent legislation will be passed to counterbalance what they see as an industry running amuck.

It is no secret that the credit card industry practically wrote the new law, lobbied for it and lavished contributions on those lawmakers already inclined to vote for it, or those that they hoped would decide to do so. The banking lobby today is possibly the most powerful of all and its remarkable strength has been shown repeatedly in recent years in the steady dismantling of various banking regulations through congressional action.

To get an understanding of why consumer advocates and many financial advisors are concerned by the new law, one should first get an understanding of the unsecured lending business and the sweeping changes that have occurred in its recent history. It is not just the new law that is disconcerting. It is the behavior of credit card companies that is causing significant concern among conscientious advisors.

Interest Abounds

Only a few years ago it was illegal for Americans and American banks to charge the sort of interest rates that are routinely levied today by the nation’s credit card issuers. While most Americans have never heard of “usury laws,” such laws have been around since ancient times. They were put into place to protect borrowers from being charged excessive interest rates, a practice referred to as “usury.” For example, in ancient Rome, Julius Caesar capped the empire’s interest rates at 12 percent and in Justinian’s reign they were reduced to 8 percent. In fact, nearly all of the world’s cultures have implemented usury laws.

In America, usury laws are state-enacted laws that place ceilings on the interest rates that lenders are allowed to charge. Usury laws were part of English law when the nation was colonized and were established by colonial America at its outset. Each state passed usury laws after the American Revolution, but the rate caps varied. As recently as 1978, usury laws were still effective nationwide in restricting credit card companies to interest rates ranging from about 6 percent to the neighborhood of 12 percent.

So what changed in 1978? In a word, everything. It all started with a period of unusually high inflation coupled with an obscure court case, Marquette National Bank v. First of Omaha Corp. (1978), simply known as Marquette. In Marquette, the United States Supreme Court ruled that the laws that govern bank lending practices are not those of the state in which the bank is headquartered or the borrower lives, they are the laws of the state in which the bank makes the decision to grant the loan. Thus, from the Marquette decision forward, the best location for a bank’s credit card operations has been the state which permitted the bank to charge the highest possible interest rates.

At the time of the Marquette decision, the nation was enduring unusually high, domestic inflation rates. In fact, one would have to look all the way back to the close of the American Civil War to find a period of comparable inflation. In combating inflation, the Federal Reserve was compelled to raise the interest rate to a level that was higher than the inflation rate itself. Banking concerns nationwide were forced, in turn, to operate their lending operations at a loss, or nearly so. These business woes arose directly from the unusual necessity for banks to pay higher interest rates to attract deposits and receive money from the Federal Reserve than the various states’ usury laws would permit them to charge their borrowers.

South Dakota: A Financial Center?

South Dakota was in a dilemma related to that of the nation’s banks. The state’s economy, as much of the nation’s then, was in a serious downturn. Making matters worse, South Dakota banks had all but stopped loaning money because they could not charge enough interest to cover their costs due to the state’s usury law. In an attempt to stimulate its economy, South Dakota set about to abolish its usury law.

Meanwhile, half a nation away in New York, Citibank had lost more that $1 billion in the prior year on its credit card division. Not surprisingly, South Dakota’s anti-usury law action caught the attention of Citibank’s president, Walter Wriston.

To the shock of the then-governor of South Dako- ta, William Janklow, Wriston called unexpectedly to offer the state a deal. In exchange for assurances that South Dakota would abolish its usury laws and invite Citibank into the state, Wriston would move Citibank’s credit card operations, and ultimately 3,000 high paying jobs, to Sioux Falls.

South Dakota quickly passed the legislation needed (Citibank’s attorneys even wrote it) in an emergency session of its legislature. Thus, Citibank and South Dakota have the distinction of being regarded today as the parents of the modern, high interest credit card. As a result, the industry that began in 1950 with the Diner’s Club card and its quaint, low interest rate is now one of the most profi table in the country.

Crossing the Delaware

A year later, Delaware, a state always alert to business interests, was next to junk its usury laws. As a result of the early action of these two states, today most Americans are sending their credit card payments to addresses in South Dakota and Delaware.

Most states initially refused to act against their usury laws. Many paid a price for their inaction. Within a year of Delaware’s usury repeal, Maryland’s four largest banks, and many of its smaller ones, moved operations to that state. Among the banks fl eeing Maryland for Delaware was a small company called Maryland Bank, N. A. That little concern soon changed its name to MBNA, a name now nearly synonymous with credit cards.

While Bank of America was well into the game early on with its BankAmericard (now Visa), MBNA has probably made more of Marquette than any other concern. Founded by Alfred Lerner, a Cleveland transplant who was reared behind his parent’s Brooklyn, New York candy store, MBNA became king of the “affinity” credit card issuers. Today MBNA has more than 50 million customers and has more billions than any other company in card created loans. At his death in 2002, Alfred Lerner, the son of poor Russian immigrants, possessed a personal fortune pegged by Forbes at $4.6 billion.

More Borrowing, More Borrowing

As one would expect, the Marquette-induced de facto deregulation of bank card lending resulted in an explosion of credit availability, a rush to acquire debt, and punishing legal bank interest rates that had never been seen before in this country. The years since Marquette have seen average card debt go from below $500 per household to around $8,000 today. As a result, bankruptcy filing numbers have made regular, annual increases. When the Marquette case was decided, the nation averaged one bankruptcy per 1,000 households. By 2004, the number had risen to nearly 14 per 1,000 households. Utah and Tennessee led the nation at 27 and 26 bankruptcies per 1,000 households, respectively. West Virginia ranked in the middle of the pack at 13 per 1,000 households.

The credit card industry has pushed hard for a bankruptcy law change that would make filing for relief from their debts more difficult for their hard pressed customers. Each year the industry came closer to attaining its objective and, last April, it succeeded.

The new bankruptcy law titled The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 became effective in October. There are important changes that favor the lenders in the law, and American consumers, who are clearly not protected by the act regardless of its title, need to be aware of them. Today, it is more important than ever to be careful with debt. Usury is in full sway now in America and has power unlike anytime before in the nation’s history.

Consider that nowadays, changes in the terms and conditions of credit card contracts may occur anytime in a manner unheard of before and unique to that segment of fi nance. If travel, a busy schedule, cash flow variations or other distractions cause a late payment on a credit card account, expect no mercy.

Dr. Frankenstein's Financial Monster

Until 1996, laws capped late payments at $10.00, an amount acceptable to most borrowers. That is no more. In 1996, Citibank Credit Card’s general counsel, Duncan MacDonald, sued to overturn the statute and prevailed in the United States Supreme Court (Smiley v Citibank).

With the fee lid removed, the card companies had yet another rich vein to mine. Late fees and over-the-credit-limit fees quickly jumped to an average of more than $30.00. Industry watchers say that some will soon rise to $50.00. Last year, the nation’s credit card companies generated a whopping $1.2 billion in the new penalty fee revenue alone!

However, a late payment or two or the posting of charges that exceed the card’s credit limit could cause far more serious financial consequences than a penalty fee. The card’s interest rate on entire balances could move to the rate charged in the “default category.” Typically, that will jump the card’s rate for the ensuing twelve months by 10 to 12 percentage points. Card issuers adore this newer provision since statistically most people are late some fraction of the time.

According to Robert McKinley, CEO of the independent credit card research firm, Ram Research, “Some banks are increasing interest rates, adding new fees, and making the due date on payments a holiday or a Sunday in hopes that, maybe, the customer will trip up and get a payment in late.”

dreamed that he would be “creating Frankenstein” in his pursuit of the case. “All we thought was that there should be flexibility to allow up to $15.00 in late fees,” he told reporters in 2004. “It is unfair,” MacDonald says. “Millions and millions of people are being excessively charged late fees and bad-check fees and over-the-limit fees and then these 25 percent APRs to make the profits for the industry.” MacDonald’s dismay is felt even more by those who endure such treatment.

Financial planners are probably most upset by what is generally considered the zenith of the many dubious business practices of credit card companies, something known as the “universal default.” In this clever trap, even the most responsible customer of a credit card company, one who through many years of use has never been late or over the limit, even once, can be thrust into the highest default rate the contract provides. This can occur because of a bit of ultra-fine print in the contract permitting the card issuer to pounce on a misstep by the client on another, completely unrelated account. It is as though there has been no prior business relationship whatsoever. The credit card company can routinely examine any customer’s credit reports in search of a late payment anywhere in the “universe” of that customer’s credit. If one is found, it can propel the interest into the credit card stratosphere.

Enter the New Bankruptcy Law

So, into this essentially unregulated and consumer challenging credit world now is introduced a new, tough bankruptcy law. This law has provisions that make it more difficult to file for liquidation bankruptcy, known as a Chapter 7 filing. In Chapter 7 bankruptcy, the debtor’s assets, minus those exempted by the debtor’s state of residence, are liquidated and given to creditors. The remaining debts are cancelled, providing a fresh start for the debtor.

In a Chapter 13 bankruptcy, the debtor is placed by the court on a repayment plan for up to five years. Debts that are not addressed by the repayment plan are voided. Under the new law more people will be required to file under Chapter 13 and arrange five-year payoff plans. That is because the new law requires a two-part qualifying test. The first step is to start with the debtor’s income and then subtract certain allowed expenses such as food, rent and so forth to determine whether the debtor can afford to pay 25 percent of the “unsecured, non-priority debt.” The second step is to compare the debtor’s income to the median income of the debtor’s state. The debtor cannot file Chapter 7 if his income is above the median and he can afford to pay 25 percent of his unsecured debt. In America, unsecured debt is overwhelmingly credit card debt. The debtor may be allowed to file Chapter 13 bankruptcy, however, and set up a repayment schedule.

Under the former law the court had considerable latitude in determining whether debtors could file in light of their situations. With the new, formula-based law there are few possible exceptions to the means test, no matter how sympathetic a judge may be to individual circumstances.

The new law covers businesses as well as individuals. It is apt to make matters worse for small entrepreneurs that run into financial difficulty. Most experts feel that the law will make it difficult to reorganize, work out payment plans and stay in business due to the added regulations and red tape. However, since the bill is creditor-friendly by design, it provides for an increased possibility for the repayment of bills owed to small businesses by debtors in bankruptcy.

As for the credit card companies, repayment plans under the new law are expected to provide in excess of another $1 billion in revenue to their treasuries in 2006 and climb higher from there.

An open minded study of the evolution of the credit card industry, especially when coupled with the recent congressional action on bankruptcy, shows that it is more important than ever that Americans rid themselves of credit card debt as quickly as possible. In light of the remarkably aggressive and opportunistic behavior of card issuers, and the federal government’s implied endorsement of their conduct via the newly approved bankruptcy law, financial planners universally concur that taking immediate, protective action is imperative.