The Credit Card Market: Recent Trends, Funding Cost Issues, and Repricing Practices
Prepared for Members and Committees of Congress
Rising consumer indebtedness and increased reliance on credit cards over the last two decades
have generated concerns in Congress and among the general public that cardholders may be
paying excessive credit card rates and fees. Specifically, some borrowers have reportedly been
unaware of assessed penalty fees and interest rate increases. Consequently, legislation such as
H.R. 1461, the Credit Card Accountability Responsibility and Disclosure Act of 2007 (introduced
by Representative Mark Udall with 39 co-sponsors); H.R. 5244, the Credit Cardholders’ Bill of
Rights Act of 2008 (introduced by Representative Carolyn B. Maloney with 72 co-sponsors); and
S. 1395, Stop Unfair Practices in Credit Cards Act of 2007 (introduced by Senator Carl Levin th
with nine co-sponsors) has been introduced in the 110 Congress.
This report examines developments in the revolving credit market, including recent trends in
profitability, consumer usage, funding, and repricing practices. Information regarding issuer
profits as well as descriptive data documenting U.S. household credit card usage and delinquency
patterns are presented. Next, the funding of credit cards, with a particular focus on the
securitization process, is discussed. Credit originators are increasingly using securitization to fund
revolving credit because this method minimizes the costs to fund these loans. Payoff and default
risks, however, may increase funding costs and result in repricing of such risks. A brief overview
of credit card repricing practices is presented followed by a summary of possible policy
This report will be updated as events warrant.
Introduc tion ..................................................................................................................................... 1
Recent Profit and Consumer Usage Trends.....................................................................................2
The Funding and Pricing of Revolving Credit................................................................................4
The Impact of Securitization on Funding Costs........................................................................5
Risks to Yield and Impact on Funding Costs............................................................................7
Convenience Users and Early Amortization Risk...............................................................7
Summary of Current Risks to Yield....................................................................................9
Proposed Policy Responses...........................................................................................................10
Author Contact Information..........................................................................................................12
Financial innovations have increased credit availability for U.S. households over the last two
decades. For households with collateral assets, financial innovations, specifically those in the
mortgage market, have allowed households to leverage their balance sheets and finance large
expenditures they might otherwise have had to forgo. Such developments can be advantageous
because they make some households less sensitive to temporary disruptions in income or cash
flow. Financial innovations, however, also make consumers more vulnerable to unexpected
changes in asset prices. A sudden increase in the value of underlying collateral assets used to
secure consumer borrowing, such as house prices, may entice some households to increase their 1
borrowing; a sudden decrease may translate into financial distress.
Financial innovations similarly facilitated greater borrower access to revolving credit or credit
card loans. Although all types of lending may reduce sensitivity to cash flow disruptions,
unsecured lending can be used by borrowers who hold few, if any, collateral assets to draw upon
to avoid a financial crisis. Furthermore, credit card borrowers may be less affected than those
with collateralized or secured loans when asset values fall. Credit card borrowers, however,
generally pay higher rates relative to secured credit borrowers. The relatively higher borrowing
costs, fees, and repricing practices, therefore, may undermine or offset the financial benefit of
being detached from a decline in collateral asset values, which adds to borrower financial distress.
Rising consumer indebtedness and increased reliance on credit cards over the last two decades
have generated concerns in Congress and among the general public that cardholders may be
paying excessive credit card rates and fees. Specifically, some borrowers have reportedly been 2
unaware of assessed penalty fees and interest rate increases. Because of this and other issues,
legislation such as H.R. 1461, the Credit Card Accountability Responsibility and Disclosure Act
of 2007 (introduced by Representative Mark Udall with 39 co-sponsors); H.R. 5244, the Credit
Cardholders’ Bill of Rights Act of 2008 (introduced by Representative Carolyn B. Maloney with
Senator Carl Levin with nine co-sponsors) has been introduced in the 110 Congress.
This report discusses developments in the revolving credit market, including recent trends
profitability, usage, funding, and repricing practices trends that have prompted new regulatory
proposals. The first section provides a brief summary of information regarding issuer profits as
well as descriptive data documenting U.S. household credit card usage and delinquency patterns.
The next section analyzes the funding of credit cards, and specifically the securitization process
in detail, since this method minimizes those costs. Conversely, payoff and default risks, which are
also explained, tend to increase funding costs for credit card loans. A brief summary of credit card
repricing practices is presented, followed by proposed policy responses.
1 For more discussion about why households may increase their indebtedness, see Karen E. Dynan and Donald L.
Kohn, “The Rise in Household Indebtedness: Causes and Consequences,” Finance and Economics Discussion Series
2007-37, Board of Governors of the Federal Reserve System (August 2007), at http://www.federalreserve.gov/Pubs/
2 For example, see Martin H. Bosworth, “Credit Card Fees Rise, Disclosure Statements Inadequate,” at
http://www.consumeraffairs.com/news04/2006/10/gao_credit_cards.html and Anita Hamilton, “Exposing the Credit-
Card Fine Print,” at http://www.time.com/time/printout/0,8816,1715293,00.html#.
The SourceMedia’s Cards & Payments’ 2008 Bankcard Profitability Study and Annual Report is 3
useful for getting some understanding of industry profitability trends. According to this study,
credit card issuers after-tax return on assets was $18.08 billion in 2007, which was down from
$18.37 billion in 2006. Total revenue for Visa and MasterCard issuers increased from $114.99
billion to $117.76 billion over this period. Penalty-fee revenue increased to $7.54 billion in 2007
compared with $6.44 billion in 2006. Expenses, however, increased by 4% in part due to a 17%
increase in charge-offs or account receivables deemed uncollectible due to missed payments.
The Survey of Consumer Finances (SCF) is useful for tracking consumer usage trends. The SCF,
which is conducted tri-annually by the Federal Reserve Board, asks approximately 4,000
households to provide information about their income, assets, and debts. The discussion below
follows observations reported by economists from the Federal Reserve from 1989 to 2001 and 4
SCF findings indicate that the number of households having at least one credit card rose from
households with riskier financial characteristics were granted increased access to revolving 5
credit. A greater proportion of low-income households and households with lower liquid asset
levels became new cardholders. Although risk-based pricing, the practice of charging riskier
borrowers higher rates to reflect the credit or default risk, may have increased borrowing costs for
some borrowers, there is evidence to suggest that it allowed for increased participation in 6
consumer credit markets and fewer credit denials. Second, households over the 1989-2001 7
period increased their use of credit cards as a convenient way to make payments. Third, the SCF
also indicates a greater use of variable rate credit cards, which fluctuate with market rates. Given
more frequent usage of credit cards for making convenience transactions, it is arguable that
3 See “Credit Card Issuers’ Collective After-Tax Return on Assets Drops 1.58% Cards&Payments’ Annual Bankcard
Profitability Study Reveals,” at http://www.marketwire.com/mw/release.do?id=854884, which summarizes industry
profitability trends between 2006 and 2007. SourceMedia provides market information to the financial services and
related industries through various publications, seminars, and conferences. For more information, see
4 The SCF data is available at http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html.
5 See Kathleen W. Johnson, “Recent Developments in the Credit Card Market and the Financial Obligations Ratio,”
Federal Reserve Bulletin, vol. 91, autumn 2005.
6 For discussions about how the increased use of risk-based pricing strategies led to fewer credit denials and greater
credit accessibility for higher risk borrowers, see Raphael W. Bostic, “Trends in Equal Access to Credit Products,” in
The Impact of Public Policy on Consumer Credit, eds. Thomas Durkin and Michael Staten, Massachusetts: Kluwer
Academic Publishers, 2002, pp. 171-202; Wendy M. Edelberg, “Risk-based Pricing of Interest Rates in Household
Loan Markets,” Finance and Economics Discussion Series 2003-62. Washington: Board of Governors of the Federal
Reserve System, 2003; Wendy M. Edelberg, “Risk-based Pricing of Interest Rates for Consumer Loans,” Journal of
Monetary Economics, vol. 53, November 2006, pp. 2283-2298; Mark Furletti and Christopher Ody, “Another Look at
Credit Card Pricing and Its Disclosure: Is the Semi-Annual Pricing Data Reported by Credit Card Issuers to the Fed
Helpful to Consumers or Researchers?”, Payment Cards Center Discussion Paper, Federal Reserve Bank of
Philadelphia, July 2006; Kathleen W. Johnson, “Recent Developments in the Credit Card Market and the Financial
Obligations Ratio,” Federal Reserve Bulletin, vol. 91, September 2005, pp. 473-486.
7 Despite the increase in credit access and usage, higher risk consumers may not have borrowed as much as desired
given that their borrowing costs were relatively more expensive. See Wendy M. Edelberg, “Risk-based Pricing of
Interest Rates in Household Loan Markets,” Finance and Economics Discussion Series 2003-62. Washington: Board of
Governors of the Federal Reserve System, 2003.
households grew more responsive to the interest rate movements and preferred cards that would
allow them to benefit from market rate declines. On the other hand, it is at least equally likely that
lenders may have offered more variable rate cards to borrowers to benefit from market rate
increases. Hence, these developments suggest increases in both the supply and demand for
revolving credit, resulting in growth of the revolving credit market.
The most recent 2004 survey suggests the following changes from 2001.8 Approximately 74.9%
of the U.S. families surveyed in 2004 had credit cards, and 58% of those families carried a
balance. In 2001, 76.2% of families had credit cards, and 55% of those families carried a balance.
These findings over a three-year period do not indicate a substantial change in credit card holding
or borrowing rates. SCF data, however, do indicate that borrowing levels increased
simultaneously as households had greater access to revolving credit at lower rates. In 2004, the
median credit limit was $13,500, which represents a 26.2% increase from 2001. The median
interest rate on the household credit card with the largest balance was 11.5%, down by 3.5% from
real (inflation-adjusted) terms of 10% from 2001.
Despite higher credit limits and lower interest rates by 2004, the median outstanding debt level
relative to the median credit card limit declined. The use of credit cards at levels below card
limits suggests that borrowers have access to amounts of revolving credit to sufficiently cover
their borrowing needs. The proportion of the median household-balance relative to the median
level of credit available was 16.3% in 2004, which is 2.4% lower than 2001. Given that overall
consumer indebtedness rose during this period, one possible interpretation of this result is that
households relied more on other types of loans, such as mortgage or home equity loans, where the
interest costs often are lower and tax deductible. In fact, the share of mortgage debt relative to
other U.S. household liabilities rose by 8.6% while the share of other types of consumer lending 10
declined by 17.1% between 1990 and 2006.
Despite a smaller increase in revolving debt relative to mortgage debt, credit card delinquency
rates have risen. A Federal Reserve statistical release shows that, as of November 2007, the
percentage of delinquent credit card loans has been greater than the delinquency percentages of 11
any other type of bank loans since the fourth quarter of 1995. The delinquency rate averaged
about 4.4% over this period, compared to 2.0% for residential mortgage (including multi-family
and home equity) loans and 1.8% for commercial real estate loans. Although credit card
delinquency rates began to decline after the first quarter in 2002, they have been rising since the
first quarter of 2006.
Credit card delinquency rates for commercial banks, however, are not representative of the
delinquency experience for the entire revolving credit industry, since only approximately 40% of
8 See Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore, “Recent Changes in U.S. Family Finances: Evidence
from the 2001 and 2004 Survey of Consumer Finances,” Federal Reserve Bulletin, vol. 92, February 2006.
9 According to the business cycle dating committee at the National Bureau of Economic Research, the U.S. experienced
a recession that began April 2001 and lasted through November 2001.
10 See CRS Report RL34538, Rising Household Debt: Context and Implications, by Brian W. Cashell.
11 The Federal Reserve Board uses data from the Consolidated Reports of Conditions and Income, compiled by the
Federal Financial Institutions Examination Council (FFIEC), to calculate a statistical release entitled “Charge-off and
Delinquency Rates on Loans and Leases at Commercial Banks.” Loans and leases are considered delinquent after 30
days, and charge-offs are the value of these loans and leases (net of recoveries) removed from bank balance sheets and
charged against loss reserves. See http://www.federalreserve.gov/releases/chargeoff.
credit card loan originations remain on bank balance sheets. It is difficult to identify a single
numerical measure to evaluate the health of this sector given the dramatic increase in credit card 12
receivables that are now funded or financed via securitization in modern financial markets.
Despite measurement issues, higher delinquency rates ultimately translate into higher borrowing
costs in this sector. The next section provides the institutional background to illustrate why this
relationship may exist.
Credit cards were initially issued by department stores in the 1950s as a more efficient way to 13
increase customer convenience and manage their accounts. Stores selling big ticket items such
as major appliances eventually allowed customers to decide whether to pay in full or in
installments subject to a finance charge. Once commercial banks recognized the profit potential
from providing open-ended, unsecured financing to consumers, the general-purpose credit card 14
became more popular towards the late 1960s. Of course, since this occurred prior to the rise of
securitization, which will be discussed in more detail below, local banks set the rates on the credit
cards they issued.
During the late 1970s and early 1980s, the rise in inflation made unsecured lending unprofitable,
especially since state regulations limited the interest rates banks could charge. Credit card lenders
responded by charging annual fees and restricting the number of credit cards issued to supplement
the income loss. Banks also began moving their credit card operations to states with high or no 15
interest rate ceilings. Inflation diminished towards the end of the 1980s; this development along
with less restrictive interest rate caps, reduced the need to charge annual fees. In addition to
falling inflation rates, the growth of banking on a national scale resulted in increased competition,
which contributed to a drop in revolving credit interest rates below the 18% to 19% levels 16
maintained through most of the 1980s and early 1990s. Whenever the Federal Reserve decided
to lower the federal funds rate, card-issuing banks also had the option to pass their lower
borrowing costs onto cardholders, which would translate into lower credit card rates.
The funding of revolving credit through securitization, which first began in 1987, also helped 17
reduce the cost of credit. Securitization occurs when financial institutions that originate credit 18
card loans choose not to retain the loans on their balance sheets. Loans originated in the primary
market, where the credit card purchaser and the loan originator conduct business, are often sold in
12 See Mark Furletti, “Measuring Credit Card Industry Chargeoffs: A Review of Sources and Methods,” Payment
Cards Center Discussion Paper, Federal Reserve Bank of Philadelphia, September 2003.
13 For more information on the historical development of the credit card market, see Glenn B. Canner, “Developments
in the Pricing of Credit Card Services,” Federal Reserve Bulletin, September 1992.
14 A charge card must be paid in full every month, unlike a credit card.
15 See Glenn B. Canner and Charles A. Luckett, “Developments in the Pricing of Credit Card Services,” Federal
Reserve Bulletin, September 1992.
16 See Glenn B. Canner and Charles A. Luckett, “The Profitability of Credit Card Operations of Depository
Institutions,” Federal Reserve Bulletin, June 1999.
17 See the Risk Management Credit Card Securitization Manual, The Federal Deposit Insurance Corporation, at
18 The term “bank” may be used interchangeably to mean any type of financial institution that originates a credit card
with a specified loan amount.
the secondary market, where the loan originator and an investor conduct business.19 The
securitization of assets helps originators manage liquidity and credit risk, which then may
translate into lower interest rates for cardholders. Given that approximately 60% of credit card
loans are securitized, a more detailed discussion of the process is provided.
Although loans may be funded using deposits or surplus capital, securitization may be a lower 20
cost funding alternative for lenders. When depository institutions fund loans with deposits, the
terms of the assets (loans), specifically the timing of the receivables, may not match perfectly the
terms of the liabilities (deposits) that must be repaid. Depository institutions, therefore, are
required to hold certain amounts of capital reserves against such timing mis-matches and in the
event the assets do not perform as expected. An opportunity cost, however, is incurred when
capital held for regulatory safety reasons is not used for other, more profitable, lending activities
or investments. Moreover, non-bank or non-depository institutions may enjoy a competitive
funding cost advantage, since they are not subject to the same regulatory capital requirements as
depository institutions. Even if greater capital requirements were not an issue, as in the case of
non-bank institutions, originators would still incur servicing and monitoring costs if loans are
funded from balance sheet activities. Hence, securitization allows for the off-balance-sheet
funding of loans, which may lead to a reduction of funding costs and an elimination (to the
depository institution) of risks associated with on-balance-sheet funding. These cost savings may
or may not be passed on to cardholders in the form of lower credit card rates. Credit card interest 21
rates, however, have become more responsive to issuers’ costs of funds in recent years.
The modern securitization process begins with a credit card issuer or loan originator who, after
approving and making loans with unsecured lines of credit for a specified amount to numerous 22
applicants, decides to securitize these assets. Next, the assets, which in this case are the loan
receivables or repayment streams from the credit card loans, are sold to a trust that will be 23
referred to as a special purpose entity (SPE). SPEs are created as trusts, typically by financial
institutions with a large amount of credit card originations, for two reasons. First, originators may
sell assets to trusts without paying taxes on the sale of those assets. Second, the investors’ rights
to cash flows generated from the underlying assets are protected if the originator were to become
19 For a more detailed explanation of the securitization process, see Mark Furletti, “Overview of Credit Card Asset-
Backed Securities,” Payment Cards Center Discussion Paper, Federal Reserve Bank of Philadelphia, December 2002.
20 See Charles T. Carlstrom and Katherine A. Samolyk, “Securitization: More than Just a Regulatory Artifact,”
Economic Commentary, Federal Reserve Bank of Cleveland, May 1992.
21 See Glenn B. Canner and Charles A. Luckett, “The Profitability of Credit Card Operations of Depository
Institutions,” Federal Reserve Bulletin, June 1999. A publicly available index is typically used to express a component
of the lending costs to the borrower and may be used to calculate the coupon payment accruing to a credit card asset-
backed security investor. Hence, the use of a market index improves transparency for both the borrower and the
investor, who is the ultimate lender. A market index plus a margin reflects the total borrowing cost or total investment
return. The size of the margin or credit premium is tied to the default risk characteristics of cardholders included in the
pool, which may be funded by credit card fees. For more information on the pricing of credit card asset-backed
securities, see Mark Furletti, “An Overview of Credit Card Asset-Backed Securities,” Payment Cards Center
Discussion Paper, Federal Reserve Bank of Philadelphia, December 2002.
22 For a more detailed overview of the underwriting and loan approval process, see the Credit Card Activities Manual,
The Federal Deposit Insurance Corporation, at http://www.fdic.gov/regulations/examinations/credit_card/.
23 See Gary Gorton and Nicholas S. Souleles, “Special Purpose Vehicles and Securitization,” Working Paper No. 05-
21, published by the Research Department of the Federal Reserve Bank of Philadelphia.
insolvent or file bankruptcy. Hence, the SPE may be defined as “bankruptcy remote.” Given the
associated tax and legal advantages, SPEs may not carry out any other activities unrelated to the
specific purpose for which they were created. The SPE’s specific purpose is typically to transform
individual receivables into new financial securities with specific risk and return characteristics, 24
the next step of the securitization process. Securities backed by credit card loans can be created
for any desired maturity, since new receivables are continually added to the pool as older
receivables are paid off by borrowers.
When transforming the individual credit card loans into new issues of asset-backed securities
(ABSs), SPEs may subdivide them into various tranches, or groups of securities with specific risk
and return characteristics. The ultimate lenders or purchasers of such assets are typically large
investors, such as hedge funds, pension funds, or other financial institutions, who purchase
securities from the different tranches. A common tranche arrangement, for example, is a senior-
junior tranching structure. The senior tranche may be designated as the one that pays its investors
first, but the yield may be lower than the junior tranche, which is designated to pay its investors
last. When the securitizer decides to sell the tranches in the secondary market, the senior tranche
will appeal to investors that prefer lower risk, quick paying investments, while the junior tranche
will appeal to investors that prefer to take higher risks for the possibility of earning a higher yield.
The senior-junior tranching structure is only one of the numerous disbursement structures
securitizers use to entice investors. This particular tranching structure, however, is used 25
throughout this report for the sake of illustration.
The tranching structure is used to satisfy the specific risk, return, and investment grade needs of
investors in the secondary market. When the SPE can effectively identify and create ABS
tranches satisfying specific needs, it can appeal to more investors and attract more credit to fund
credit card loan originations in the primary market. For example, suppose the SPE is currently
using the senior-junior tranching structure described above. The junior tranche would consist of
the cash flow remaining after both the principal and yield to senior tranche holders and any losses
associated with default were paid. The holder of the junior tranche, therefore, keeps whatever
cash remains. This repayment structure reduces the credit risk for senior tranche holders, since
junior tranche holders incur most of the credit risk. The senior tranche receives payment first,
followed by the junior tranche; conversely, the junior tranche initially suffers the losses first,
followed by the senior tranche. Of course, the junior tranche holder receives a higher yield or rate
of return in exchange for assuming higher risk. The investors in the senior tranche would be
adversely affected only if default costs exceed the value of payments that would have accrued to 26
the junior tranche investors. Hence, a tranching structure may also serve as a credit
24 In many cases, two SPEs may be involved in the securitization process. The first SPE receiving the assets from the
originator subsequently transfers these receivables to a second SPE that does the actual repackaging and creates the
new credit-card backed securities, which are then sold to investors. Each SPE would be created in response to an
accounting and/or legal issue that would make it difficult for cash in-flows and out-flows to occur without financial
and/or legal consequences impacting the ability to issue, sell, and re-invest the securities.
25 Note that only the loan receivables are collected and securitized. Hence, the sum of all cash payments received is
disbursed according to SPE tranching guidelines, but individual loans do not have to be assigned to any particular
26 The “liquidity crisis” of August 2007 was triggered by senior tranche holders reassessing the riskiness of their
exposure to financial problems that exceeded expectations. See CRS Report RL34182, Financial Crisis? The Liquidity
Crunch of August 2007, by Darryl E. Getter et al. Rather than rely solely upon a tranching structure, investors may also
choose to purchase bond insurance, which may serve as additional credit enhancement.
enhancement, or a method of reducing the credit risk of senior securities, which may attract more
investors, in particular those restricted to purchasing high quality investment grade securities.
Rather than sell all of the ABS tranches to third party investors, the loan originator may also want
to act as an investor in its own asset-backed securities. Whenever the originator chooses to keep
one or more tranches in its own portfolio, the retained tranche is referred to as excess spread.
Suppose an originator retains a junior tranche, which now is subsequently referred to as the
excess spread, then the originator is also providing credit enhancement to senior tranches issued
by the SPE. Again, the junior tranche consists of the cash flow remaining after the principal and
yield to senior tranche holders, and any losses associated with default, are paid. A holder of the
excess spread tranche, therefore, has a strong financial incentive to effectively minimize defaults,
which translates into lower funding costs or more investors as explained below.
Lending activity must be considered a viable investment by investors regardless if the loans are
funded on or off the balance sheets of originators. If funded on-balance sheet, loans may be
backed by capital, or the asset values may be hedged using swaps or other derivatives. If lending
activities are funded off-balance sheet, the pools of receivables are rated by credit-rating agencies,
and maintaining a positive excess spread becomes important for attracting funding for future ABS
issues. The excess spread should yield what investors would consider a viable return, in particular
if the excess spread tranche is being used as a credit enhancement for senior ABS tranches. This
section discusses risks that may lead to a reduction in the profitability of credit card lending.
The yield or profit from credit card receivables is dependent upon whether borrowers make
minimum payments or pay off their balances every month. Consumers have the option during
each billing cycle to pay the minimum balance, pay off the entire loan, or pay something in
between. When credit cards are used for convenience transactions rather than for borrowing, this
does not generate any investor yield. In addition, early amortization, which occurs when the
outstanding balance of a credit card account is suddenly paid off, also reduces yield. (Early
amortization also occurs when a credit card is paid off and the balance is transferred to another
card issued by a competing card issuer.) A reduction in yield ultimately makes investing in credit
card receivables less appealing to investors, a development which itself increases the funding
costs to provide these loans in the future.
A revolving credit loan is higher in credit or default risk relative to other forms of bank lending.
For credit card receivables that have not been securitized, these types of loans involve much
higher operating costs and greater risks of default per dollar of receivables than do other types of 27
lending. For securitized credit card receivables, the default risk of these loans generates
uncertainty surrounding the cash flowing into the excess spread. In both cases, defaults increase
future funding costs.
27 Glenn B. Canner, “Developments in the Pricing of Credit Card Services,” Federal Reserve Bulletin, vol. 78 no. 9,
September 1992. A more detailed discussion about the costs of credit card operations is also included.
The risk in revolving credit lending is derived from several factors. First, the loan is unsecured,
which means the card holder has put forth no collateral assets that can be used to repay the loan in
the event of default. Second, the card holder has the option to use the card when unemployed or
lacking sufficient cash flow to cover routine expenses and payment obligations. The borrower
may suddenly become highly leveraged (up to the credit card limit) without any prior notice.
Without knowing whether or not the cardholder intends to pay off the balance at the end of the
billing cycle, every transaction made with a credit card is potentially a new loan, and the
outstanding principal balance can change at any time. Next, a credit card is also far more
susceptible to fraud than other types of loan. Should unauthorized charges be made on a lost or 28
stolen card, the Fair Credit Billing Act limits the liability for cardholders to $50. Hence,
unrecoverable fraudulent charges may translate into sizeable losses for originators or investors.
Delinquencies may eventually turn into defaults, which are defined as 180 days delinquent. When
borrowers initially fail to make timely credit card payments, the servicer attempts to contact the
borrower within several days of delinquency to arrange payment. The servicer, and not
necessarily the loan originator, is the designated collector of credit card payments (and forwards
them to the SPE if the payment streams are being securitized). After 30 days, which is considered
one complete billing cycle, the servicer must decide whether to cut off credit to the borrower and
send the account to collections. Financial institutions may adopt various different policies for
dealing with delinquencies. If, however, accounts are sent to collections, the Fair Debt Collection
Practices Act (FDCPA) prohibits abusive, deceptive, and improper collection practices of third 2930
party debt collectors. The collections process is regulated by federal guidelines.
If the credit card issuer owns the loans, contractual charge-offs (which are account receivables
deemed uncollectible due to missed payments) must be written off the issuer’s books after 6
billing cycles or 180 days of nonpayment, according to guidances issued by the Federal Financial 31
Institutions Examination Council (FFIEC). When a borrower files for bankruptcy, accounts
must be charged off 60 days after receipt of notification of the filing from the bankruptcy court.
One expert estimated that 60% of charge-offs result from 180 days, or six billing cycles, of 32
missed payments, and 40% of charge-offs are the result of bankruptcy. If the loans are
securitized, delinquency and default costs generated from the accounts may be subtracted from
the proceeds paid to the SPE, which may translate into losses to the excess spread tranche.
When revolving credit is securitized, issuers may find it difficult to attract investors to fund
revolving credit loans without “implicit recourse.” Implicit recourse refers to a perception among
investors that credit card originators will repurchase non-performing loans from ABS-pools and 33
absorb default losses, which may seem to negate the benefits of securitization. A Removal of
28 P.L. 93-495, as codified at 15 U.S.C. 1666j. See http://fdic.gov/regulations/laws/rules/6500-500.html.
29 P.L. 90-321, as codified at 15 U.S.C. 1692 et. seq., and as amended by P.L. 109-351, §§ 801-02, 120 Stat. 1966
(2006). See http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre27.pdf.
30 For a summary of these guidelines, see http://www.ftc.gov/bcp/conline/pubs/credit/fdc.shtm.
31 See the February 10, 1999, FFIEC press release entitled “Federal Financial Institution Regulators Issue Revised
Policy For Classifying Retail Credits,” at http://www.ffiec.gov/press/pr021099.htm.
32 See Furletti, “Measuring Credit Card Industry Chargeoffs: A Review of Sources and Methods.”
33 According to FASB 140 accounting rules, a “true sale” means the seller is no longer responsible for the subsequent
performance of the financial assets sold. If poor performance is transferred back to the originator, then a true
accounting sale of assets did not occur, and the originator should be required to hold capital against the value of the
collateral. The only permissible exception to this recourse provision is when the originator wants to remove a
delinquent account from a pool to offer a workout solution to the borrower. The exception was not designed to simply
Account Provision (ROAP), which is a provision that exists in some credit card securitization
agreements that allows issuers to remove delinquent accounts, or accounts with fraudulent
charges, from an ABS pool, may be exercised. Exercising this option too often, however, may still
imply that the tranche(s) should receive lower credit ratings, which could make it more difficult
to attract some ABS investors.
More convenience users, early amortizations, and defaults reduce the yield on credit card ABSs.
The impact on yield may be even more significant should all of these risks materialize
simultaneously. Slightly more consumers, however, are carrying a balance and the median
balance has increased, as discussed earlier in this report. Consequently, the payoff risk associated
with an increase in convenience users has seen some decline. On the other hand, defaults are
rising. Should defaults continue to accelerate, the increase in funding costs may encourage some
lenders to re-evaluate the profitability of providing revolving credit. One option may be to curtail
revolving lending activities and pursue more profitable business strategies. Another option may
be to employ various repricing practices.
The previous historical discussion noted that fee income, a component of the total cost of
borrower credit, was used to help cover the increasing costs to supply credit during the late 1970s
and early 1980s. The securitization discussion shows how a particular funding method, that
minimizes the liquidity and default risk for credit card originators, may translate into lower rates
for cardholders. Interest rate charges and fees, therefore, change when costs change.
For example, when a borrower is delinquent, exceeds credit limits, or bounces payment checks,
the borrower may now be viewed as a greater credit risk. At that point, lenders may consider the
borrower as a candidate for being re-priced for the credit. Repricing is an extension of risk-based
pricing in that higher risk borrowers shoulder more of the costs associated with having access to
borrowing services. Penalties, increased fees, and increased loan rates are all tools available to
credit suppliers to reprice the increased risk to yield. If cardholders are sensitive to increasing
charges, then repricing may be used to encourage delinquent cardholders to repay their
obligations faster and discourage them from further borrowing.
Repricing, however, can be initiated without any delinquency incident. When this happens, a
borrower may shop for other card issuers that are willing to provide them with credit cards at
lower prices or accept balance transfers. Hence, the lender’s decision to charge higher interest and
fees, whether to compensate for rising default risk or simply to increase profit margins, is likely
to be affected by an assessment of the borrower’s willingness to shop for and find other lower-
allow issuers to absorb losses, for example, by removing early amortization accounts to enhance the performance of
securitized tranches. For more details on this point, see Charles W. Calomiris and Joseph R. Mason, “Credit Card
Securitization and Regulatory Arbitrage,” Working Paper No. 03-7, Federal Reserve Bank of Philadelphia, April 2003.
Repricing practices typically include “hair-trigger” repricing and “universal default”; and, in 34
some cases, “double-cycle billing” practices may have the same effect. Hair-trigger repricing
refers to imposing fees and higher finance charges on cardholders almost immediately after a
payment is late without any grace period. Universal default occurs when a borrower defaults on a
loan serviced by a lender, and other revolving creditors respond by increasing the lending rates on
the loans they are servicing for that particular borrower, even if the borrower has not defaulted on
those loans. Double-cycle billing is the practice of calculating interest over a two-month billing
cycle period, as opposed to a one-month billing cycle, that may result in higher finance charges.
Although double-cycle billing may not often be described as a repricing practice, in particular if
this billing method is universally applied to all customers, the economic impact on cardholders
can be similar to standard repricing strategies. If the consumer misses a payment or switches from
being a convenience user to a revolver, the typical grace period, or a specified time period
payments can be made without incurring any finance charge, is retroactively eliminated under
double-cycle billing. Forfeiture of interest-free grace periods results in higher finance charges;
therefore, risk-based repricing has automatically been captured by the billing method.
Repricing practices are unpopular with borrowers because they are perceived to be changes in the
credit terms that were not part of the original agreement when the card was issued. It is also
possible that borrowers unknowingly agreed to such terms that were very difficult to 35
understand. Loan originators, however, are concerned primarily with the cash flow necessary to
maintain lower funding costs, in particular at a time while defaults are rising. Moreover,
maintaining cash flows sufficient to cover losses accruing to the lower tranche is also important if
the subordinate tranche is being used as a credit enhancement for more senior tranches.
One response might be to eliminate repricing practices. A possible consequence of this response,
however, could result in a reduction in cash flow and possible increase in bank charge-offs or
excess spread tranches with insufficient returns to make this type of lending attractive to future
investors. Economic theory, specifically the law of supply, suggests that firms are less willing to
supply products to the marketplace at lower prices. Hence, credit card issuers could respond in a
variety of ways to pricing restrictions. To recapture the fee income, issuers may increase loan
rates across the board on all borrowers, making it more expensive for both good and delinquent
34 For definitions of terms, see the following references. “Credit Cards: Increased Complexity in Rates and Fees
Heightens Need for More Effective Disclosures to Consumers,” GAO-06-929, Government Accountability Office
(September 2006) located at http://www.gao.gov/new.items/d06929.pdf; Sheila Bair, Chairman, FDIC, Statement on
Improving Credit Card Consumer Protection: Recent Industry And Regulatory Initiatives before the Subcommittee On
Financial Institutions and Consumer Credit of the Financial Services Committee, U.S. House of Representatives, June
7, 2007, at http://www.fdic.gov/news/news/speeches/archives/2007/chairman/spjun0707.html; Mark Furletti, Credit
Card Pricing Developments and Their Disclosure, Federal Reserve Bank of Philadelphia, January 2003, at
http://www.philadelphiafed.org/pcc/papers/2003/CreditCardPricing_012003.pdf; a glossary of revolving credit terms
may be found at http://www.fdic.gov/regulations/examinations/credit_card/glossary.html; and see Testimony Before
the Committee of Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations Regarding
Credit Card Practices: Fee, Interest Rates, and Grace Periods, March 7, 2007, at http://hsgac.senate.gov/public/_files/
35 The Government Accountability Office reported that disclosures of complex risk-based pricing practices in the credit
card industry have become extremely difficult for consumers to understand. See “Credit Cards: Increased Complexity
in Rates and Fees Heightens Need for More Effective Disclosures to Consumers,” GAO-06-929, Government
Accountability Office (September 2006) at http://www.gao.gov/new.items/d06929.pdf.
borrowers to use revolving credit. Their other options may include increasing minimum monthly
payments, reducing credit limits, or reducing the number of credit cards issued to people with 36
On the other hand, credit card issuers may choose not to respond by increasing the costs or
limiting the availability of credit to borrowers. Some financial institutions have recently stated 37
that they will no longer use pricing practices such as double-cycle billing and universal default.
When these announcements were made, there was no indication that subsequent increases in
minimum payments or reductions in credit card issues would occur. Hence, it may be possible for
other institutions to manage their cash flows and delinquencies without relying upon these more 38
controversial pricing practices.
A response by regulators might be to enhance disclosures to borrowers so they are not taken by
surprise when repricing occurs. The Federal Reserve has been engaged in studies that could lead 39
to revision of Regulation Z, concerning the disclosure of consumer credit. These consist of
using consumer focus groups and individuals to determine what types of disclosures are effective
with helping them understand the possible charges they could face. Upon completion of the
interviews, the Federal Reserve expects to propose a format that may be considered more
transparent for consumers to evaluate the credit terms and facilitate their usage of credit cards.
On May 2, 2008, the Board of Governors of the Federal Reserve announced proposed rules 40
regarding credit card pricing practices. The proposals would amend Regulation AA (Unfair Acts
or Practices), Regulation Z (Truth in Lending), and Regulation DD (Truth in Savings). The
purpose of the proposals are to prohibit unfair or deceptive bank practices in connection with
credit card accounts and overdraft services for deposit accounts. For example, one proposed
amendment to Regulation AA would prohibit banks from treating a payment as late until the
consumer has been given a reasonable amount of time to make that payment, and a safe harbor
would be given to banks that send periodic statements at least 21 days prior to the payment due
date. Given that the double-cycle billing method eliminates an interest-free grace period for the
consumer, the proposed rule would also eliminate this billing practice. Banks would only be
allowed to apply rate increases to existing balances only when (1) the interest rate is variable; (2)
a promotional rate expires; or (3) a minimum payment has not been received within 30 days of
the due date.
36 For studies on the regulatory effects of credit card rates and fees, see Diane Ellis, “The Effect of Consumer Interest
Rate Deregulation on Credit Card Volumes, Charge-offs, and the Personal Bankruptcy Rate,” Bank Trends, FDIC
Division of Insurance, March 1998, at http://www.fdic.gov/bank/analytical/bank/bt_9805.html; and Jonathan M.
Orszag and Susan H. Manning, An Economic Assessment of Regulating Credit Card Fees and Interest Rates, a study
commissioned by the American Bankers Association, at http://www.aba.com/aba/documents/press/
37 For example, see “Chase ends double-cycle billing” at http://www.bankrate.com/brm/
story_content.asp?story_uid=20919&prodtype=today; and “Citi Announces Industry Leading Changes to its Credit
Card Practices: To End ‘Universal Default’ & ‘Any Time for Any Reason’ Changes” at http://www.citigroup.com/
38 See Adam J. Levitin, All But Accurate: A Critique of the American Bankers Association Study of Credit Card
Regulation, at http://works.bepress.com/adam_levitin/4/.
39 See http://www.federalreserve.gov/newsevents/press/bcreg/20070523a.htm.
40 Highlights of the proposed rulings can be found at http://www.federalreserve.gov/newsevents/press/bcreg/
The Federal Reserve has also proposed implementing the risk-based pricing provisions in Section 41
311 of the Fair and Accurate Credit Transactions Act of 2003. This rule would require creditors
to notify consumers when an issuer used a credit report to grant credit at a relatively higher
interest rate in comparison to rates offered to most of its customers, who are presumably more
Darryl E. Getter
Specialist in Financial Economics
41 P.L. 108-159. See http://www.treas.gov/offices/domestic-finance/financial-institution/cip/pdf/fact-act.pdf. More
details about the proposed rule may be found at http://www.federalreserve.gov/newsevents/press/bcreg/