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Introduction to Credit cards part 2

Agenda

In this topic we will talk about the costs

accrued in a credit card portfolio.

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The outline is as follows:

• Costs incurred by the credit issuing

company
• Credit Card Protection Act of 2009
• How has the CARD Act performed?
• Securities market

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Let us look at the costs that a credit issuing

company will incur:

• Interest expenses - The banks

generally borrow the money they have
to lend to their customers. As they
receive very low interest loans from
other firms, they may borrow as much
as the customers require while lending
the capital to other borrowers at higher
rates.

Let’s say the card issuer charges 15% lent

to users and it costs 5% of the money to
lend. Now assuming the balance sits with
the cardholder for a year, the issuer earns
10% on that loan. This 10% difference is the
net interest spread and the 5% is the
interest expense.

• Operating costs - This is the cost of

running the credit card portfolio,
including everything from paying
executives who run the company, to
printing the plastics, to mailing the
statements, etc. Depending on the
issuer, marketing programs are also a
significant portion of the expenses.

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• Charge-offs - When a consumer

becomes severely delinquent on a debt,
often at the point of six months without
payment, the creditor may declare the
debt to be charged-off. It will then be
listed as such on the credit bureau’s
report. A charge-off is considered to be
written off as uncollectable. To banks,
bad debt and even fraud are simply part
of the cost of doing business. However,
the debt is still legally valid and the
creditor can attempt to collect the full
amount for the time period under state
law which can be anything from three
to seven years. This could be done by
internal collections staff or more likely
an outside collections agency.

• Rewards - Many credit card customers

receive rewards such as frequent flyer
points, gift certificates or cash back as
an incentive to use the card. Rewards
are generally tied to purchasing an item
or service on the card which may or
may not include balance transfers, cash
advances or other special uses.
Depending on the type of card, rewards
will generally cost the issuer between
0.25 % and 2% of the spread.

Networks such as Visa and MasterCard have

increased their fee to allow issuers to fund
their rewards system.

Some issuers discourage redemption by forcing

the cardholder to call customer service for
rewards. On the website, redeeming rewards
is usually a feature that is very well-hidden by
the issuers. With a fractured and competitive
environment, rewards can dramatically cut
profits. That’s why reward points and related
incentives must be carefully managed to
ensure a profitable portfolio.

• Fraud - In relative numbers, the values

lost in bank card frauds are minor and
will not exceed maybe 1- 2% of the

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portfolio. When a card is stolen or an

unauthorized duplicate made, most
card issuers will refund all or most of
the charges that the customer is billed
due to fraudulent use.

• Promotion - Promotional purchase is

any purchase on which separate terms
and conditions are set on each
individual transaction. Different types
of promotion could be: no interest no
pay, no interest with pay, deferred
interest, no pay, etc. Promotional
offers are often time bound.

• Interchange value, interchange fees -

In addition to fees paid by the credit
card holder, merchants must also pay
fees to the chard issuing bank and the
card association. These fees are
typically 1 – 3 % of each sale but vary
not only from merchant to merchant
(large merchants can negotiate lower
rates), but also from card to card.

• Interest on outstanding balances -

Interest fees vary widely from card
issuer to card issuer. Often they have
teaser rates in effect for initial periods
of time, as low as 0% for, say, six
months, whereas regular rates can be
as high as 40% for the annum.

What are the major fees that get charged

from the customer?

• Late payment fees.

• Charges that result in exceeding the
credit limit, called over limit fees.
• Return check or payment processing
fee.
• Cash advances.
• Transactions in a foreign currency,
membership fee or annual fee, etc.

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Now let’s take a look at the Credit Card

Protection Act of 2009

This act was passed in the US and was signed

into law by President Obama in May of 2009.
IT requires the consumers to opt-in to over
limit charges. Some card issuers have
therefore commenced solicitations requesting
customers to opt-in to over limit charges,
presenting this as a benefit as it may avoid the
possibility of a future transaction being
declined.

The other issuers have simply just

discontinued the practice of charging over
limit fees.

The CARD Act has really changed industry

practices in four significant ways:
1. The longstanding practice of hiking
interest rates on existing credit card
accounts has been dramatically
curtailed.
2. The amount of late fees consumers are
paying has been substantially reduced.
3. Over limit fees have virtually
disappeared in the credit card industry.
4. And consumers report that their credit
costs are clearer.

This CARD Act has brought about serious

reform for the credit card market in the USA.

In February 2010 many of the tenants came

into effect. As already mentioned, the
industry practice changed in some very
significant ways. However, a lot more needs to
be done.

So has it been a loss for all the banks?

Not really, because this law doesn’t cap card

interest rates.

It just says that you cannot arbitrarily hike

interest rates but it does not cap credit card

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interest rates. Banks can still raise our interest

rates.

The 45-day notice of a rate hike is actually

misleading.

Banks can begin charging you the higher rate

on new purchases as soon as 14 days after
they've mailed you a notice about it

The law can’t truly prevent marketing to

college students either, and here’s where
credit card companies can charge high interest
rates. The law does not curb it.

There are some loopholes which still need to

be curtailed especially in terms of the credit
card statement.

But the good thing is that the credit card

statement is much easier to read now than it
was earlier.

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How has the CARD Act performed?

CardRatings.com compared terms on roughly

500 credit card offers from late 2008 and late
2011, and found the following impacts that
may be attributed to the CARD Act:

1. Higher interest rates.

From the end of 2008 through late 2011, the

prime bank rate was unchanged, and
mortgage rates fell. Credit card rates, on the
other hand, rose.

The CardRatings.com study found that annual

percentage rates on new credit card
offers rose by an average of 2.1 percent over
that period. While these higher rates
wouldn’t have immediately affected existing
customers, over time this new rate
environment would start to affect more and
more balances.

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Based on roughly $800 billion in outstanding

U.S. credit card debt over much of the past
two years, this 2.1-percent increase in credit
card rates would translate to an annual
additional consumer cost of $16.8 billion.

2. Heavier burden on customers with

poor credit.

In part, the CARD Act was intended to protect

customers with credit problems. Those
cardholders were subject to the steepest rises
in their credit card rates.

However, it is these same customers who

appear to have been hurt the most by rising
rates over the past few years.

While the lowest rate tier of credit card

offers, for consumers with excellent credit,
rose by only 1.6 percent from late 2008 to
late 2011, the highest rate tier, for
consumers with poor credit, rose by an
average of 3.4 percent over the same period.

3. Ballooning balance transfer fees.

Balance transfer fees have also risen over the

past few years.

For one thing, fewer cards now put a cap on

the maximum balance transfer fee.

Instead, they charge a percentage of the

amount transferred.

In late 2008, 31 percent of credit card offers

had a cap on balance transfer fees. Now, just
4 percent do.

In addition, the average percentage charged

has risen to 3.3 percent from 2.1 percent, a
difference that would cost you $120 more on
a $10,000 balance transfer.

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Can all of these costs be blamed on the CARD

Act?

Given the aftermath of the 2008 credit crunch

and the significant market changes as a result
(including credit card companies reducing credit
lines or cancelling cards outright in order to
manage their risk), it’s impossible to be certain.

But as the most significant change in the industry

between the two time periods that were
compared, the CARD Act seems to bear much of
the responsibility.

Let’s consider the benefits

1. Fewer late fees.

The CARD Act required that billing cycles be

standardized, and that customers be given a
minimum of 21 days to pay a credit card bill.

In one snapshot comparison, the Consumer

Financial Protection Bureau found that
between January and November 2010 monthly
late fees had dropped by $474 million.

This suggests that consumers may be paying

around $5 billion less in late fees every year
compared to before the CARD Act.

2. Fewer over-the-limit fees.

Similar to overdraft fees on your checking

account, over-the-limit fees are charged if
you exceed your credit limit.

The CARD Act banned credit card companies

from charging this type of fee unless you
expressly opt into the program.

If you don’t opt in, transactions which would

exceed your credit limit are simply denied.

Since the new law, many credit card

companies have backed away from over-the-
limit fees. Only 40 percent of credit card
offers feature those fees now, compared with
95 percent before the CARD Act.

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3. Lower over-the-limit fees.

Perhaps because credit card companies now

have to convince you to opt into fees for
exceeding the credit limit, those fees have
become more competitive.

CardRatings.com found that the average

maximum over-the-limit fee is now about
$14, down from $33 in late 2008.

Advocates of the CARD Act would claim one

other benefit: that the law has limited the
circumstances under which interest rates can
be raised in reaction to economic events,
your payment history and your changing
credit status.

To know more about the Card Act, you can go

the Federal Reserve site
http://www.federalreserve.gov/consumerinfo
/wyntk_creditcardrules2.htm

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Now let’s take a look at the securities

market.

So what happens to credit card companies?

Once they book a portfolio, can they never
liquidate it?

As customers continue to revolve the card,

does the portfolio go on forever and ever and
ever?

No, it’s not true. There are pools of securities.

Credit holders never realize that the bank sold

their accounts because nothing appears
different to the credit card holder. If they call
customer service, they are treated exactly the
same as if they were account holders of the
original issuing bank.

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However, what really happens backend is that

the monthly payments are funneled through a
trust rather than the bank and used to make
interest payments to investors. So what banks
really do is that they bundle or pool together
millions of credit card accounts. The money
owed by these card holders is an asset that
would normally sit in the bank’s balance sheet
as a receivable.

Instead of waiting for years for these credit

card holders to repay the money in monthly
instalments, the bank sells these credit card
IOUs to securitized trusts.

These trusts sell an interest in the future

credit card receivable, to large institutional
investors like pension funds, mutual funds,
other banks and insurance companies.

The money or capital that a credit card issuer

is able to get through securitization, is used to
issue additional credit cards or help fund
reward programs or keep interest rates low.
Essentially it’s used back in the portfolio.

To recap,

• Credit cards are a complicated product

and a lot of analytics does happen at
remedial stages in the credit card life
cycle.
• There are some key measures of
portfolio profitability and some costs
which are unique to credit cards.
• The CARD act has gone a long way in
trying to regulate the credit card
market. The US incidentally had the
largest credit card market in the world.
They have gone a long way to regulate
the credit card market, though a lot
more can be done.

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That’s it for this topic. For any queries, do

email us at info@jigsawacademy.com

Thanks!

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