Why Credit Card Regulation Is Broken

Last Updated Nov 19, 2009 12:26 PM EST

A credit card (or three or seven) has undeniable benefits. It's
convenient. It means you don't have to carry cash. It allows you to
dine on $98 sea urchin mousse at Le Haute Snobbe as if you could actually
afford it. And it comes with powerful consumer protection; if someone steals
your card, you're liable for no more than $50 in fraudulent charges,
and many card companies waive that amount. Credit cards became so winsome,
however, that issuers felt free to add booby traps that, once tripped, could
snare unwitting users with huge finance charges and penalties. For the most
part, regulators looked the other way — until recently.

How Cards Got Slippery

For years, state usury laws
determined the maximum credit card interest rate their residents could be
charged, usually a maximum of 10 to 20 percent. In 1978, however, the Supreme
Court gave national banks the right to preempt the usury law of the borrower’s
home state
. When inflation sent interest rates up to 20 percent, banks in
states with low usury limits saw their card operations lose money by the
carload. Citibank, searching for relief, moved its card division to South
Dakota and persuaded legislators there to repeal its usury law. In short order,
Utah and Delaware dropped their interest-rate limits, too. After that, national
banks with operations in those states could solicit customers anywhere and
charge whatever rate they wished. State-chartered banks soon became exempt from
state limits as well.

Since then, some banks have
seduced customers with bait-and-switch introductory offers, like a 0 percent
rate that rises by about 10 points a few months later. Issuers have changed
customers’ rates with as little as 14 days’ notice and applied
the new rate to old balances. So a refrigerator you charged at 9.9 percent
could wind up costing 15.6 percent. For the cardholder who paid late two or
three times (sometimes only once) banks invented the default or penalty rate,
now as high as 32 percent, according to ConsumerAction, a nonpartisan advocacy
group. A practice known as universal default allowed an issuer to slap on the
default rate even if you had paid all of that issuer’s bills on time,
if you happened to be late paying another company’s bill.

Adding to
all the complexity, cards in the late 1990s started coming out with multiple
rates — one for purchases, another for transferred balances, and a
third for cash advances. In 1996, the Supreme Court held that fees for late
payments, exceeding limits, cash advances, returned checks, and annual
membership were a form of interest and also immune to state rate limits.
Consumer advocates feared the decision would send fees skyrocketing. They were
right. The effect of all these fees and penalty rates has sometimes been
disastrous. A court found that one elderly Ohio woman living on Social Security
paid Discover $3,400 on her original $1,900 credit-card debt and still owed the
company $5,000 in penalty interest and fees.

How Consumers Are Protected

chief source of credit card consumer protection is the Truth in Lending Act
(TILA), which requires lenders to disclose terms so consumers can compare the
cost of credit. Added protection came in 2000, when credit card companies were
first required to include in every credit offer a “Schumer box
— a summary of a credit card’s cost — named for
New York Senator Charles Schumer, who championed the legislation that led to
the rules.

But simply giving credit card
customers better fine print hasn’t been enough to keep many of them
out of trouble. “It seems clear that improved disclosures alone
cannot solve all of the problems consumers face in trying to manage their
credit card accounts,” said Federal Reserve Board Chairman Ben
Bernanke last December. After soliciting comment and receiving thousands of
complaints from cardholders, the Fed issued a variety of consumer protection
, which take effect in 2010. Among other things, they bar rate increases
in the first year after a credit card account is opened. “The Federal
Reserve’s rules are pretty strong, but they could go further,”
says Joshua Frank, a senior researcher with the Center for Responsible Lending,
a nonprofit advocacy group in Washington (see "Seven
Credit Card Reforms Washington Needs to Make"