Matthew Casey: Getting credit where credit isn’t due

Editor’s note: This is the first of a two-part series on the American credit card industry.

As we continue to muddle through the aftermath of the worst economic collapse in decades, it is clear that several factors conspired to create the current state of affairs. Among the primary culprits: easy credit and human nature.

Credit is a wonderful thing. Used prudently, it allows access to education, property and business investment. However, there can always be too much of a good thing, and credit is no exception.

During the recession of 2001, interest rates were dropped to historic lows to stimulate the economy. The plan may have worked too well.

Prolonged access to cheap money led to reckless economic behavior. Rather than using credit to access capital for investment and sustainable growth, many consumers chose to leverage their futures to finance lifestyles that they otherwise could not afford.

Eventually, unsustainable spending based on debt accrual set off a chain reaction that threatened the global economy. In hindsight, it’s clear that we simply couldn’t help ourselves: as a nation, we are addicted to debt.

There are about 1.5 billion credit cards in use in the United States, and the average American household carries a balance of $8,300. At any given moment, Americans owe about $1 trillion in revolving credit card debt. Given the fragile state of the economy, the risk of this massive debt is enormous.

It wasn’t always like this.

A generation ago, credit card issuers had to comply with state usury laws that capped the interest rates they could charge. Because card issuers couldn’t simply raise rates to compensate for write-offs caused by defaulting customers, they had to be more selective when granting credit.

However, by the late 1970s, rampant inflation caused interest rates to soar. As a result, credit card companies faced a dilemma: they had to borrow money at higher rates than they could legally charge their customers for credit card loans. Inevitably, the losses began to mount.

That changed in 1978, when the United States Supreme Court held that a national bank could charge the highest interest rate permissible where the company was headquartered, regardless of the legally mandated rates in effect where their customers were located.

By 1979, banking interests in South Dakota began lobbying the state legislature to eliminate the state usury law. Soon after the legislature complied, Citibank fled its New York home — and its interest rate cap — for Sioux Falls. Once the move was complete, Citi was free to charge all of its credit card customers whatever interest rate it desired without concern for local regulation.

In short order, usury laws across the country began falling like dominoes as states sought to attract other large banks.

In 1999, a new federal law allowed local banks to charge interest rates equal to the rates charged by any other banks operating in their home state. In effect, all local usury laws were rendered moot with a stroke of Bill Clinton’s pen.

It is undeniable that the elimination of usury laws made credit available to millions of Americans who had no previous access. In 1970, just 16 percent of households held at least one credit card; by 2008, that number approached 80 percent.

But deregulation also eliminated caps on interest and fees. Many consumers now face interest rates of 30 percent or more, figures that were previously confined to the realm of loan sharks.

With an interest rate of 30 percent, if you carry $8,300 in debt, stop using your card and pay just the monthly minimum — say 4 percent of the total debt — it will take you 20 years to pay off your balance, during which time you will incur more than $13,400 in interest.

Predictably, the industry has become extremely profitable, clearing as much as $30 billion annually.

However, the nature of the industry leaves it in a precarious position: deregulation reduced the incentive for banks to limit risk by catering to credit-worthy customers. In addition, many consumers, struggling to get by in a down economy, have few options but to run up their credit card balances.

 Unsurprisingly, there were more than 1 million personal bankruptcies in 2008, and the credit card industry writes-off about 10 percent of its loans as uncollectible.

Another by-product of deregulation was industry consolidation. The top five credit card issuers now control about 90 percent of the market. Given the current status of the economy, having so much owed to so few poses another potential threat to the banking industry.

Surely, those who abuse credit have no one but themselves to blame for living beyond their means. Just as surely, the credit card issuers are to blame for their current predicament by providing easy credit to many who have no business accessing it.

Regardless of who is at fault for the current situation, one thing is clear: all of us will bear the burden. As more consumers default on their debt, banks will attempt to recoup their losses in the form of higher fees and interest for all of their customers — whether they pay their bills on time or not.

Of course, if that doesn’t work, the industry can always look to the American taxpayer to bail them out. After all, we allowed them to become too big to fail.

Read more from Matthew Casey at matthewcasey.net.