Credit Where Credit Is Due

The credit card industry has few friends at the moment. The Credit Card Accountability Responsibility and Disclosure Act of 2009 recently signed into law by President Obama passed the House and Senate with broad bi-partisan support. The vote in the House on the final bill was 364-64. The tally in the Senate was an even more lopsided 90-5.

In the hearings and floor debate that preceded passage of the bill, few lawmakers could bring themselves to say anything nice about the industry. At a hearing in February, the ever quotable Rep. Maxine Waters excoriated the CEOs of the nation’s largest financial institutions for simultaneously taking TARP funds and raising rates on credit cards, revealing that all of her life she has been “in disagreement with the banking industry.” Even the industry’s chief defender in the House, Rep. Jeb Hensarling, conceded that if the question being debated was whether the credit card industry uses unfair and deceptive practices, a resolution in favor “could pass . . . with unanimous consent.”

Given the context, when the President stood before a podium in the Rose Garden on May 22nd to give some brief remarks before signing the bill into law, many in the small crowd probably expected him to offer a scathing critique of the industry. After all, as he and Mrs. Obama pointed out during their long campaign for the White House, the President knows what it is like to carry a revolving balance on a credit card. But he chose a different path. He offered a portrait of the industry that was remarkably free of the shrill complaints that had defined the legislative debate. In tone and detail, his remarks evoked his campaign promise to “cast off the worn-out ideas and politics of the past” and the test for governance that he articulated in his inaugural address: “[t]he question we ask today is not whether our government is too big or too small, but whether it works.”

Unfortunately, the CARD Act will likely fail the test set by our Law Professor-in-Chief. It is unlikely to improve the lives of ordinary Americans. It will not help people who have fallen behind on their credit card bills catch-up with their payments. It is unlikely to prompt a fundamental revision of the compact between credit card issuers and their customers. With that said, the Act is historic. It breaks sharply with the market-driven approach to consumer protection that has prevailed in the credit industry since the enactment of the Truth-In-Lending Act in 1968. And it may even lead to the very thing that motivated at least some lawmakers, including Representative Waters, to support the legislation in the first place–further increases in the APRs that appear on card solicitations and statements.

President Obama Sets A High Bar

President Obama’s brief survey of the risks and rewards of credit largely explains why the CARD Act seems destined to fail on the terms by which the President has asked his efforts to be measured. His discussion begins with a point that critics of the credit card industry generally ignore–most adults in the United States use credit cards every day without incident. As he puts it, “in the majority of cases, [a credit card] is a convenience or a temporary, occasional crutch, a means to make life a little easier, to make the rare, large or unexpected purchase that’s paid off as quickly as possible.”

In explaining his ambitions for the bill, the President limits his concerns to the “minority of customers” that have “an uneasy, unstable dependence” on credit cards. Even within this group, the President accepts as true a point that many strenuously resist–that the credit card industry is not to blame for everyone who ends up with more debt than they can repay. As the President points out, some credit card users “end up in trouble because of reckless spending or wishful thinking.” And he offers no sympathy to people who fall victim to their own bad choices. “We don’t,” according to the President, “excuse irresponsibility.”

The President hails the Act as an important step forward for a slice of the minority: “people who relied on credit cards not because they were avoiding responsibilities, but because they wanted to meet their responsibilities.” Even here, however, the President does not lay all of the blame on the industry. He admits that part of the problem lies with “the broader economy.” But according to the President, the industry must accept some responsibility. In his view, credit card companies “write contracts not to inform but to confuse.” They charge “mysterious fees,” shift payment deadlines, and raise rates. And by doing so, they transform what should be a “lifeline” into an “anchor.”

The President’s pre-signing remarks about the card industry follow pretty directly from his personal experience with consumer credit industry. President Obama appears to be the first occupant of Oval Office to admit publicly that he once revolved a balance on a credit card. Both he and the First Lady publicly discussed their struggles with debt during the long campaign for the White House. At one stop in Pennsylvania, Mrs. Obama recalled the days when she used to worry about the calls and letters from debt collectors warning that “you’ve got a few more days before you’re in trouble.” But even as they criticized some of the industry’s tactics, they acknowledged that access to credit was critical to their ultimate success. As the President explained during his campaign, neither he nor his wife came from “wealthy families,” and both borrowed money to go to college and law school.

President Obama’s nuanced survey of the industry captures the impossibility of the task ahead for the CARD Act. Revolving credit is a ubiquitous feature of our economy. Virtually every adult in the country carries a credit card. Although some people end up with more revolving debt than they can repay, the vast majority of Americans do not. And as the example of the President and First Lady vividly attests, access to credit is one of the great levelers of our society. It enables a poor young man raised by his grandparents in Hawaii to attend world renowned (and very expensive) universities and launch a political career. In order to be judged a success on the terms laid down by the President, the CARD Act must preserve the benefits of credit to all while solving the problems that befall the few. Nothing in the legislative record suggests that the Act is likely to accomplish this feat.

Putting The CARD Act In the Consumer Protection Context

Since Congress passed the Truth-In-Lending Act in 1968, consumer protection law regarding the extension of credit to consumers has been premised on the view that the market is the most effective and reliable protector of consumers. So long as firms accurately disclose the terms on which they provide services to consumers, consumers will select the terms and providers that best meet their interests. The CARD Act of 2009 signals a sharp break with this view.

The Act dictates the manner in which issuers must treat consumers, regardless of whether the issuers had been completely and accurately disclosing their practices. The list of proscribed practices is long. It begins with bans on double-cycle billing and “any time, any reason” rate increases. But it extends to seemingly minor points such as regulating the dates on which payments are due and the time of day by which a payment must be received in order to be considered timely.

The Act itself does not explain the basis for rejecting markets as the most reliable protector of the interests of consumers. The legislative record gives a glimpse of the progression. After Democrats gained control of the House and Senate following the mid-term elections in 2006, these Democrats and a host of consumer groups built the case that the revolving credit industry had failed its customers. This was an easy case to make, given issuers’ image as predatory and the perceived failure of deregulation of mortgages and securities.

Much of the public record criticizing the revolving credit industry focuses on the supply-side. Sponsors and supporters of the CARD Act argue that there is insufficient competition among issuers of revolving credit to discipline bad behavior. They claim that “some consumers may not be able to find another card with a rate that is comparable to [a] pre-increase rate.” Advocates also claim that some consumers will not look for a different card because all issuers generally reserve the right to unilaterally change terms.

Sponsors of the legislation offer little to support these claims that the industry is not a competitive. To support the idea that consumers will not be able to find other cards with lower rates, the Joint Economic Committee cites two theoretical papers on price discrimination and price dispersion. For empirical evidence, they rely on Larry Ausubel’s 1991 study of interest rates on revolving credit balances in the mid-1980s. But as the Government Accountability Office, the investigate arm of Congress, has elsewhere observed, the card industry appears to have become significantly more competitive in the early 1990s (after the period of Ausubel’s study). And this more recent competition has, according to the Government Accountability Office, “likely caused … reduction in credit card interest rates.”

To some extent, these concerns appear to be a cover for the real basis for intervention–the feeling that on the whole, consumers cannot be trusted with revolving credit. Elected officials tend to shy away from proposals that obviously question the ability of constituents to figure out what is in their own self interest. But the academic supporters of intervention in the revolving credit business like Elizabeth Warren and Oren Bar-Gill freely make this claim (although these claims have been forcefully rebutted by anti-interventionists like Richard Epstein). Diluted versions of these claims appear in the public statements of public regulators. Just last month, Ben Bernanke, Chairman of the Federal Reserve, claimed that revolving credit contracts had become too complex for “even the most diligent consumers.” According to Chairman Bernanke, this complexity “and leads consumers to make poor choices.”

Taking the Problem by the Tail

Given the Act’s premise, it is somewhat surprising that Congress did not use it to enact more dramatic restrictions on the industry. There was plenty of political and academic cover. Last year, in her run for the White House, then Senator and now Secretary of State Clinton called for a return to the era of usury laws. And none other than Judge Richard Posner recently urged policy makers to consider imposing limits on credit card debt and “resurrecting usury laws.” Although the CARD Act is important as symbolic matter for those who would like to see greater regulatory control of the credit card industry, the Act’s principle prohibitions are directed at practices that are rather obscure–double-cycle billing and “any time, any reason” rate increases.

Double-cycle billing is a method for calculating the interest due on a revolving balance. Most revolving credit lines calculate average daily balances on a single-cycle basis. The calculation is pretty straightforward: Sum the balances since the close of the last billing cycle and divide by the number of days since the end of the last billing cycle. When an issuer calculates interest on a double cycle basis, the calculation of the average daily balance looks back to the balance on the card for the prior billing cycle as well. To see the difference between the two balance calculations, assume that cardholder had a balance of $500 in the prior month, paid off $450, and did not use the card in current month. An issuer using a single-cycle balance calculation would calculate interest based on the $50 dollar average balance in the current month. An issuer using a double-cycle calculation would calculate interest on the $500 balance from the prior month as well as the $50 in the current month.

Admittedly, calculating interest payments on a double-cycle is somewhat complicated. But it really only affects people when they pay off some or all of their revolving balance. Consumers apparently pay little attention to how issuers calculate interest rates. But there does not appear to be any evidence that double-cycle billing systematically increases risk or reduces return. And this may explain why the practice remains fairly uncommon. Discover popularized the practice when it introduced its card in the late 1980s. But most other issuers did not embrace the practice. Three of the largest issuers, American Express, Citibank and Capital One, apparently, never implemented it. The GAO reported in 2006 that only two of the largest six issuers were using multiple cycles to calculate interest charges.

“Any time, any reason” rate increases have a somewhat different pedigree. The contract provision that allows an issuer to increase a cardholder’s rate for any reason is widespread in the industry. President Obama identified this practice as particularly unfair to consumers during his run for the White House. Although the presence of this language in credit card contracts has been well documented, there is very little information about how often the language is invoked, the extent to which cards with balances are targeted, or the nature of any ensuing rate changes. Using data drawn from the Payment System Panel Study (“PSPS”) comissioned by Visa USA, we have attempted to discern the answers to the following questions:

     o How frequently do APR changes occur and what is the nature of such changes?

     o Are cards with balances substantially more likely to see changes than cards without balances?

The PSPS contains information on the card APR, a continuous variable for which panelists are requested to report each quarter. Our sample consists of 1.2 million quarterly observations on general purpose credit cards, including Visa, MasterCard, American Express, Discover, and other cards. Sixty-two percent of quarterly observations of card ownership details contain information on card APR in any two out of three consecutive quarters. For cards with APR information, the data show that the average APR is 16.1 percent and the median APR is 18 percent for the 1994-2005 period. In fact, nearly 90 percent of card observations containing a value for APR have APRs of 21 percent or less during the period. In addition, as shown below, average and median APRs are basically flat for most of the period, with declines occurring toward the end of the period.

Figure 1: PSPS Average and Median APRs


Looking at changes on individual cards, the conclusions are even more striking:


  • Rates on 90 percent of the cards in the survey did not change during the survey period.

  • For any given quarter, APRs are constant for 97.4 percent of cards on average. As shown below, APR increases and decreases are equally likely once “teaser” rate changes are excluded.


FIGURE 2: PSPS Quarter-to-Quarter APR Changes by Type















  • APR changes tend to follow changes in the prime rate. APR increases on “non-teaser” cards tend to occur more frequently when the prime rate increases and less frequently when the prime decreases or remains stable. Similarly, decreases in APRs tend to occur more often when the prime rate decreases and less often when the prime rate increases or remains stable.


Figure 3: PSPS Types of APR Changes & Changes in the Prime Rate 94- 05  




  • As shown below, very few cards in each APR category experienced either APR increases or decreases in any given quarter. Cards with lower APRs in the previous quarter were more likely to experience increases in previous “teaser” rates, while cards with higher APRs were more likely to experience APR decreases.


Figure 4: PSPS Quarter-to-Quarter APR Changes by Previous APR Category












Although our data ends in 2005, average interest rates reported to the Federal Reserve continued to reflect movements in the prime rate through the end of 2008, as shown in Figure 5.

Figure 5: Credit Card APRs versus the Prime Rate 













In addition, other studies have shown that issuers continued to follow practices consistent with those revealed by our analysis, failing to confirm a general perception held by lawmakers and others that APR changes have become epidemic in recent years. Oliver Ireland, former General Counsel to the Board of Governors of the Federal Reserve (“Board”) and now a partner at Morrison & Foerster, submitted an analysis prepared by Argus Information & Advisory Services to the banking agencies in connection with the proposed rules regarding Unfair and Deceptive Acts or Practices. Ireland and Argus pulled together a data set covering approximately 70% of outstanding balances for the period from April 2006 through February 2008. Using that data set, they were able to identify interest rate changes that were imposed as a result of default and a unilateral change in terms. They found that the incidence of these rate changes across all accounts varied by month from a low of 1.1% of all accounts to a high of 2% of all accounts.

Of course, neither these findings nor the Ireland-Argus findings rule out the possibility that card issuers single out cardholders with revolving balances for rate increases. However, the PSPS data appear to contradict this hypothesis. APRs did not change in any given quarter for over 95 percent of cards regardless of whether cards had a previous balance. Cards with previous balances were slightly more likely to experience APR increases than cards without previous balances, as shown below. Such cards were also likely to experience APR decreases than their no-balance counterparts.

Figure 6: PSPS APR Changes for Cards with and without Previous Balances













Moreover, the amount of the balance did not appear to determine whether APR increases or decreases occurred. The difference in the average previous card balance for cards with non-teaser increases versus decreases was less than $100.

A Lot of Work to Save Some Consumers $7 per Month

Our analysis suggests that those hoping the CARD Act will transform the revolving credit industry in the United States are likely to be disappointed. Even if we were to suspend disbelief and assume that issuers will not change interest rates, annual fees or some other dimension of the card contract in response to the passage of the Act, the impact of the change on the relatively few consumers with balances that saw non-teaser rate increases would amount to $7 a month on average, based on average increases and previous quarter balances for these consumers during 1994 to 2005.

But that, of course, misses the important point that President Obama made in the Rose Garden before signing this legislation into law. As the President explained, nearly everyone has a credit card, but only a small number of people find themselves heading down the “one-way street” of debt. And of those that do head down that street, some are there because they fail to use their heads.

Yet the CARD Act makes no distinction. It forbids an issuer from adjusting rates to reflect the experience with a customer. If the issuer started three customers at a given rate, all three customers must receive that rate even if they behave very differently. The issuer may not distinguish between the consumer who gets a card and runs up a debt but manages to stay current from the customer who misses the occasional payment or even the customer who defaults for a while but manages to make six consecutive payments before missing again.

And this, even apart from the Act’s other prohibitions and mandates, seems likely to lead issuers to raise interest rates for all consumers. If issuers cannot adjust rates in response to the experience with the cardholder, they will almost surely build the risk into their underwriting models. They will likely raise rates, increase annual fees, and/or lower credit limits. And none of these responses seems even remotely likely to make all Americans better off. This is true even if the adjustments are slight because the interest income lost as a result of the Act is minimal.

But that’s just the tip of the spear. The clamor for more extensive regulation of the card industry rests on the claim that consumers get the credit cards that they demand but not the ones that they need. Support for this conclusion, however, falls somewhere in the range of weak to non-existent. Most articles advocating for paternalistic intervention in the credit industry rely on the work of behavioral economists. And while behavioral economists have documented that people make decisions in ways that diverge from the rationality assumptions that support neo-classical economics, they have not yet shown that consumers fail to make rational decisions regarding their use of revolving credit.

Actual human beings are not fully informed, risk neutral automatons, and their lives are often messy. As President Obama noted, some consumers may make bad decisions that have unfortunate consequences. But for many people, as President Obama noted, credit cards provide a way to cover an unforeseen medical bill, a layoff, or a long weekend to forget about that medical bill or layoff. The decrease in available credit that is likely to result from the CARD Act will curb certain practices by card issuers, but it will also deprive consumers of some of their options for financing that unfortunately timed medical bill, layoff, or vacation. Limiting consumer choices may prevent some people from making a bad decision, but it does nothing to improve their alternatives.

And this observation takes the conversation full circle. In explaining why he opposed the CARD Act of 2009, Rep. Henserling conceded a point for which there appears to be universal support: card agreements contain provisions that many people find surprising after the fact. And the Federal Reserve’s exhaustive focus group research has established conclusively another apparent truth about the industry: even well-meaning consumers do not always succeed in deciphering their card agreements. But it does not follow that eliminating such practices by legal fiat makes people better off. Revolving a balance on a card that calculates interest on a double-cycle may be a “poor choice,” but it could well be the best option available. And eliminating the choice likely will create all sorts of inefficiencies and hidden subsidies that may make everyone worse off, even those who previously steered clear of cards that featured double-cycle billing.

Markets provide a much more effective cure for the sorts of problems at which the CARD Act seemingly is directed. This is an industry defined by standard agreements. As Richard Epstein has observed, standard agreements, whatever the objections that may be directed at them, reflect mutual gain. Although people surely make mistakes in choosing among different standard contracts or electing options within a given standard contract, they have every incentive to learn from and correct those mistakes. Standardization makes the process of learning and correcting easier. It decreases the transaction costs associated with sharing and comparing experiences, and it increases the gains to be had from new entry.

For those who think that this is purely a theoretical point, consider the movie rental business circa 1999. The entire industry had adopted a pricing model based on a small up-front payment for the rental and a significant penalty for the failure to return the move in the allotted time. A new entrant came along and offered consumers an alternative–a set number of movies at a fixed price per month. The new entrant, Netflix, quickly displaced the dominant incumbent, Blockbuster. And their stock prices tell the story. Shares in Netflix have more than tripled since May 2002. Shares in Blockbuster have lost 97% of their value. Competition may not be perfect, but it is still the most effective protector of the consumer’s interest.


About the Authors


Thomas P. Brown is a partner at O’Melveny & Myers, LLP, San Francisco, CA and Adjunct Professor, U.C. Berkeley Law School. Tom’s practice focuses on competition law and legal issues affecting the financial services industry.

Lacey L. Plache is a Vice President, COMPASS LEXECON, Los Angeles, CA. Her research has included empirical analysis of behavioral law and economics hypotheses related to consumer payment card use.