Credit card securitization encourages fee-based profit model

One of the major reasons for the current economic downturn is securitization, the process of pooling and selling to investors certain assets which have regular repayment schedules like mortgages and credit card loans.

For example, a mortgage company may pool its 30-year fixed-rate mortgages of homeowners with a credit score of 750 and above, and therefore create a mortgage-backed security with a seemingly safe investment rating of AAA.  For simplicity, let’s say the first two years of payment coupons from all the pooled mortgages adds up to be $200 million.  The mortgage company may sell to a buyer, a money market fund perhaps, the first two years of coupons for $180 million.  While it may seem like a $20 million loss to the seller, it could be a quick gain for a company unwilling to wait two years for their money. Moreover, this deal lessens the seller’s risk.  As for the buyer in this case, such a purchase is a great short-term investment, especially one with such a high rating and unlikelihood of default. Some investors even go as far as selling bonds based on these assets in the secondary market.

The system works beautifully as long as people pay their debts. However, pandemonium occurs when a large number of homeowners, as in this example, default on their payments due to a job loss, an excessive lifestyle, a medical emergency, etc.  As a result of massive defaults, mortgage-backed securities (those pools of mortgages mentioned earlier) become “toxic” as they quickly lose value.  In addition, falling home values further decrease the value of the securities. Everyone involved takes a hit.  

Credit card securitization

Credit card securitization works in a similar way except for one major difference that fuels the new fee-based profit model.  The biggest difference is that credit card companies don’t completely sell-off their relationship with the debtor to the buyer; instead, they still have means to profit from that debt.  Credit card expert Adam Levetin, a law professor at Georgetown University, explains the major difference: “While card issuers sell off most of the default risk, they keep any upside that comes from inflating their fees and rates… If the higher fees and rates cause more defaults, it is investors who bear the loss. If the higher fees result in more income, however, it is the card issuer, not the investors, who benefit.”  Simply put, credit card securitization can be extremely profitable –and at a much lower risk for issuers.

As a result of the popularity of credit card securitization, companies have implemented all types of new fees.  There is the cash advance fee, balance-transfer fee, late-payment fee, over-the-limit fee, additional card fee, expedited payment fee, etc. The list goes on.  Levetin cites the following statistic that makes the case quite clear: “The rise of these fees has a 99 percent correlation with the growth of securitization.”

In conclusion, credit card securitization is the culprit for outrageous fees and an increasing number of angry consumers.  Last year, revenue from these fees totaled $12 billion.  When considering the long list of fees, the actual interest rate that consumers pay is unbelievably high. So, while rising interest rates, decreasing credit limits, and increasing horrific customer service are obvious and immediate concerns, the underlying model of credit card securitization must be changed.  Otherwise, consumers will continue to be extorted.       

Comments

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"Spell record issuers delude off most of the option risk, they enter any side that comes from inflating their fees and rates… If the higher fees and rates make more defaults, it is investors who assume the casualty. If the higher fees finish in many income, nevertheless, it is the card issuer, not the investors, who good.

Thanks

Keep it up!!!!!!!!!!!!!
Have a great day.

====================== Taylar Tom

[fassd.com]

Most high interest credit cards are usually easy to get and really the interest rate only matters if you roll over your balances from month to month. People that have had bankruptcies, judgments or just have a bad credit rating, for what ever reason are the most common applicants for high interest credit cards.

[Holly]

12 billion in fees.....and they are in trouble????

Is there any audit procedure (internal and/or external)? How can they be in trouble...with fees like that, above and beyond what they collect on what they loaned...where's the problem? Could it be the high paid CEO's???? Bonsus, Executive trips??

Give me a break.... and they are putting a "hardship" on the consumer???? What??? Your kidding....right???

[Larry K.]

Can't the government outlaw the securitization process?

[Carole May]

Well now that we have the stimulus package, and they've addressed the foreclosure issue, I think it's time we all put pressure on Washington to do something about these credit cards. There is power in numbers. Forget email. We need to flood every office with snail mail so they get buried in complaints from consumers. Then they will have to listen.

[Laura B.]

Yup. This helps me digest all of this craziness. We're in a BIG mess, folks!!

[Andrew Lewis]

This is one of the best explanations of the crisis I've heard. I wonder if inflated home values and appraisals have anything to do with the rapid decrease in value of these mortgage-backed securities. It seems to me that prices have dropped so much in part because of the inflated home prices. There needs to be a way to ensure that home values are not inflated so much that investors lose a lot of money. But when the securities are so esoteric and resold so many times, it is probably more of a headache to check on the values of the collateral even if you wanted to. Thanks, Kevin. I'll share with friends.