    Credit Cards: Increased Complexity in Rates and Fees Heightens
    Need for More Effective Disclosures to Consumers (12-SEP-06,
    GAO-06-929).

    With credit card penalty rates and fees now common, the Federal
    Reserve has begun efforts to revise disclosures to better inform
    consumers of these costs. Questions have also been raised about
    the relationship among penalty charges, consumer bankruptcies,
    and issuer profits. GAO examined (1) how card fees and other
    practices have evolved and how cardholders have been affected,
    (2) how effectively these pricing practices are disclosed to
    cardholders, (3) the extent to which penalty charges contribute
    to cardholder bankruptcies, and (4) card issuers' revenues and
    profitability. Among other things, GAO analyzed disclosures from
    popular cards; obtained data on rates and fees paid on cardholder
    accounts from 6 large issuers; employed a usability consultant to
    analyze and test disclosures; interviewed a sample of consumers
    selected to represent a range of education and income levels; and
    analyzed academic and regulatory studies on bankruptcy and card
    issuer revenues.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-929
        ACCNO:   A60724
      TITLE:     Credit Cards: Increased Complexity in Rates and Fees
    Heightens Need for More Effective Disclosures to Consumers
         DATE:   09/12/2006
      SUBJECT:   Bankruptcy
    	     Consumer education
    	     Consumer protection
    	     Credit
    	     Credit sales
    	     Data collection
    	     Debt
    	     Federal regulations
    	     Fees
    	     Fines (penalties)
    	     Information disclosure
    	     Interest rates
    	     Late payments
    	     Lending institutions
    	     Policy evaluation
    	     Statistical data
    	     Surveys

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    GAO-06-929

         * Report to the Ranking Minority Member, Permanent Subcommittee on
           Investigations, Committee on Homeland Security and Governmental
           Affairs, U.S. Senate
              * September 2006
         * CREDIT CARDS
              * Increased Complexity in Rates and Fees Heightens Need for More
                Effective Disclosures to Consumers
         * Contents
              * Results in Brief
              * Background
              * Credit Card Fees and Issuer Practices That Can Increase
                Cardholder Costs Have Expanded, but a Minority of Cardholders
                Appear to Be Affected
                   * Issuers Have Developed More Complex Credit Card Pricing
                     Structures
                        * Multiple Interest Rates May Apply to a Single Account
                          and May Change Based on Market Fluctuations
                        * Credit Cards Increasingly Have Assessed Higher Penalty
                          Fees
                        * Cards Now Frequently Include a Range of Other Fees
                   * Issuers Have Introduced Various Practices that Can
                     Significantly Affect Cardholder Costs
                        * Interest Rate Changes
                        * Payment Allocation Method
                        * Balance Computation Method
                   * New Practices Appear to Affect a Minority of Cardholders
                        * Issuers Say Practices Benefit More Cardholders, but
                          Critics Say Some Practices Harm Consumers
                        * Most Active Accounts Are Assessed Lower Rates Than in
                          the Past
                        * Minority of Cardholders Appear to Be Affected by
                          Penalty Charges Assessed by the Largest U.S. Issuers
              * Weaknesses in Credit Card Disclosures Appear to Hinder Cardholder
                Understanding of Fees and Other Practices That Can Affect Their
                Costs
                   * Mandatory Disclosure of Credit Card Terms and Conditions Is
                     the Primary Means Regulators Use for Ensuring Competitive
                     Credit Card Pricing
                   * Credit Card Disclosures Typically Provided to Many Consumers
                     Have Various Weaknesses
                        * Disclosures Written at Too High a Level
                        * Poor Organization and Formatting
                        * Excessive Complexity and Volume of Information
                   * Consumer Confusion Indicated That Disclosures Were Not
                     Communicating Credit Card Cost Information Clearly
                   * Federal Reserve Effort to Revise Regulations Presents
                     Opportunity to Improve Disclosures
                        * Regulations and Guidance May Contribute to Weaknesses
                          in Current Disclosures
                        * Suggestions for Improving Disclosures Included
                          Obtaining Input from Consumers
              * Although Credit Card Penalty Fees and Interest Could Increase
                Indebtedness, the Extent to Which They Have Contributed to
                Bankruptcies Was Unclear
                   * Researchers Cited Various Factors as Explanations for Rise
                     in Consumer Bankruptcies
                        * Increase in Household Indebtedness
                        * Other Explanations
                   * The Extent to Which Credit Card Penalty Interest and Fees
                     Contribute to Consumer Bankruptcies Remains Controversial in
                     the Absence of Comprehensive Data
                        * Opinions on the Link between Credit Card Practices and
                          Bankruptcies Vary
                        * Penalty Interest and Fees Can Affect Cardholders'
                          Ability to Reduce Outstanding Balances
                        * In Some Court Cases, Cardholders Paid Significant
                          Amounts of Penalty Interest and Fees
                        * Data for Some Bankrupt Cardholders Shows Little in
                          Interest and Fees Owed, but Comprehensive Data Were Not
                          Available
              * Although Penalty Interest and Fees Likely Have Grown as a Share
                of Credit Card Revenues, Large Card Issuers' Profitability Has
                Been Stable
                   * Publicly Disclosed Data on Revenues and Profits from Penalty
                     Interest and Fees Are Limited
                   * Majority of Card Issuer Revenues Came from Interest Charges
                   * Fees Represented the Remainder of Issuer Revenues
                        * Penalty Fees Had Increased
                        * Issuers Also Collect Revenues from Processing Merchant
                          Card Transactions
                   * Large Credit Card Issuer Profitability Has Been Stable
              * Conclusions
              * Recommendation for Executive Action
              * Agency Comments and Our Evaluation
         * Objectives, Scope and Methodology
              * Methodology for Identifying the Evolution of Pricing Structures
              * Methodology for Assessing Effectiveness of Disclosures
              * Methodology for Determining How Penalty Charges Contribute to
                Bankruptcy
              * Methodology for Determining How Penalty Charges Contribute to
                Issuer Revenues
         * Consumer Bankruptcies Have Risen Along with Debt
              * Debt Levels Have Also Risen
              * Increased Access to Credit Cards by Lower-income Households
                Raised Concerns
              * Levels of Financial Distress Have Remained Stable among
                Households
              * Some Researchers Find Other Factors May Trigger Consumer
                Bankruptcies and that Credit Cards Role Varied
         * Factors Contributing to the Profitability of Credit Card Issuers
              * Credit Card Operations Also Have Higher Rates of Loan Losses and
                Operating Expenses
              * Effect of Penalty Interest and Fees on Credit Card Issuer
                Profitability
         * Comments from the Federal Reserve Board
         * GAO Contact and Staff Acknowledgments
         * PDF6-Ordering Information.pdf
              * Order by Mail or Phone

    Report to the Ranking Minority Member, Permanent Subcommittee on
    Investigations, Committee on Homeland Security and Governmental Affairs,
    U.S. Senate

    September 2006

    CREDIT CARDS

    Increased Complexity in Rates and Fees Heightens Need for More Effective
    Disclosures to Consumers

    Contents

    Tables

    Figures

    September 12, 2006Letter

    The Honorable Carl Levin Ranking Minority Member Permanent Subcommittee on
    Investigations Committee on Homeland Security and Governmental Affairs
    United States Senate

    Dear Senator Levin:

    Over the past 25 years, the prevalence and use of credit cards in the
    United States has grown dramatically. Between 1980 and 2005, the amount
    that U.S. consumers charged to their cards grew from an estimated $69
    billion per year to more than $1.8 trillion, according to one firm that
    analyzes the card industry.1 This firm also reports that the number of
    U.S. credit cards issued to consumers now exceeds 691 million. The
    increased use of credit cards has contributed to an expansion in household
    debt, which grew from $59 billion in 1980 to roughly $830 billion by the
    end of 2005.2 The Board of Governors of the Federal Reserve System
    (Federal Reserve) estimates that in 2004, the average American household
    owed about $2,200 in credit card debt, up from about $1,000 in 1992.3

    Generally, a consumer's cost of using a credit card is determined by the
    terms and conditions applicable to the card-such as the interest rate(s),
    minimum payment amounts, and payment schedules, which are typically
    presented in a written cardmember agreement-and how a consumer uses

    a card.4 The Federal Reserve, under the Truth in Lending Act (TILA), is
    responsible for creating and enforcing requirements relating to the
    disclosure of terms and conditions of consumer credit, including those
    applicable to credit cards.5 The regulation that implements TILA's
    requirements is the Federal Reserve's Regulation Z.6 As credit card use
    and debt have grown, representatives of consumer groups and issuers have
    questioned the extent to which consumers understand their credit card
    terms and conditions, including issuers' practices that-even if permitted
    under applicable terms and conditions-could increase consumers' costs of
    using credit cards. These practices include the application of fees or
    relatively high penalty interest rates if cardholders pay late or exceed
    credit limits. Issuers also can allocate customers' payments among
    different components of their outstanding balances in ways that maximize
    total interest charges. Although card issuers have argued that these
    practices are appropriate because they compensate for the greater risks
    posed by cardholders who make late payments or exhibit other risky
    behaviors, consumer groups say that the fees and practices are harmful to
    the financial condition of many cardholders and that card issuers use them
    to generate profits.

    You requested that we review a number of issues related to credit card
    fees and practices, specifically of the largest issuers of credit cards in
    the United States. This report discusses (1) how the interest, fees, and
    other practices that affect the pricing structure of cards from the
    largest U.S. issuers have evolved and cardholders' experiences under these
    pricing structures in recent years; (2) how effectively the issuers
    disclose the pricing structures of cards to their cardholders (3) whether
    credit card debt and penalty interest and fees contribute to cardholder
    bankruptcies; and (4) the extent to which penalty interest and fees
    contribute to the revenues and profitability of issuers' credit card
    operations.

    To identify the pricing structures of cards-including their interest
    rates, fees, and other practices-we analyzed the cardmember agreements, as
    well as materials used by the six largest issuers as of December 31, 2004,
    for 28 popular cards used to solicit new credit card customers from 2003
    through 2005.7 To determine the extent to which these issuers' cardholders
    were assessed interest and fees, we obtained data from each of the six
    largest issuers about their cardholder accounts and their operations. To
    protect each issuer's proprietary information, a third-party organization,
    engaged by counsel to the issuers, aggregated these data and then provided
    the results to us. Although the six largest issuers whose accounts were
    included in this survey and whose cards we reviewed may include some
    subprime accounts, we did not include information in this report relating
    to cards offered by credit card issuers that engage primarily in subprime
    lending.8 To assess the effectiveness of the disclosures that issuers
    provide to cardholders in terms of their usability or readability, we
    contracted with a consulting firm that specializes in assessing the
    readability and usability of written and other materials to analyze a
    representative selection of the largest issuers' cardmember agreements and
    solicitation materials, including direct mail applications and letters,
    used for opening an account (in total, the solicitation materials for four
    cards and cardmember agreements for the same four cards).9 The consulting
    firm compared these materials to recognized industry guidelines for
    readability and presentation and conducted testing to assess how well
    cardholders could use the materials to identify and understand information
    about these credit cards. While the materials used for the readability and
    usability assessments appeared to be typical of the large issuers'
    disclosures, the results cannot be generalized to materials that were not
    reviewed. We also conducted structured interviews to learn about the
    card-using behavior and knowledge of various credit card terms and
    conditions of 112 consumers recruited by a market research organization to
    represent a range of adult income and education levels. However, our
    sample of cardholders was too small to be statistically representative of
    all cardholders, thus the results of our interviews cannot be generalized
    to the population of all U.S. cardholders. We also reviewed comment
    letters submitted to the Federal Reserve in response to its comprehensive
    review of Regulation Z's open-end credit rules, including rules pertaining
    to credit card disclosures.10 To determine the extent to which credit card
    debt and penalty interest and fees contributed to cardholder bankruptcies,
    we analyzed studies, reports, and bank regulatory data relating to credit
    card debt and consumer bankruptcies, as well as information reported to us
    as part of the data request to the six largest issuers. To determine the
    extent to which penalty interest and fees contributes to card issuers'
    revenues and profitability, we analyzed publicly available sources of
    revenue and profitability data for card issuers, including information
    included in reports filed with the Securities and Exchange Commission and
    bank regulatory reports, in addition to information reported to us as part
    of the data request to the six largest issuers.11 In addition, we spoke
    with representatives of other U.S. banks that are large credit card
    issuers, as well as representatives of consumer groups, industry
    associations, academics, organizations that collect and analyze
    information on the credit card industry, and federal banking regulators.
    We also reviewed research reports and academic studies of the credit card
    industry.

    We conducted our work from June 2005 to September 2006 in Boston; Chicago;
    Charlotte, North Carolina; New York City; San Francisco; Wilmington,
    Delaware; and Washington, D.C., in accordance with generally accepted
    government auditing standards. Appendix I describes the objectives, scope,
    and methodology of our review in more detail.

    Results in Brief

    Since about 1990, the pricing structures of credit cards have evolved to
    encompass a greater variety of interest rates and fees that can increase
    cardholder's costs; however, cardholders generally are assessed lower
    interest rates than those that prevailed in the past, and most have not
    been assessed penalty fees. For many years after being introduced, credit
    cards generally charged fixed single rates of interest of around 20
    percent, had few fees, and were offered only to consumers with high credit
    standing. After 1990, card issuers began to introduce cards with a greater
    variety of interest rates and fees, and the amounts that cardholders can
    be charged have been growing. For example, our analysis of 28 popular
    cards and other information indicates that cardholders could be charged

    o up to three different interest rates for different transactions, such as
    one rate for purchases and another for cash advances, with rates for
    purchases that ranged from about 8 percent to about 19 percent;

    o penalty fees for certain cardholder actions, such as making a late
    payment (an average of almost $34 in 2005, up from an average of about $13
    in 1995) or exceeding a credit limit (an average of about $31 in 2005, up
    from about $13 in 1995); and

    o a higher interest rate-some charging over 30 percent-as a penalty for
    exhibiting riskier behavior, such as paying late.

    Although consumer groups and others have criticized these fees and other
    practices, issuers point out that the costs to use a card can now vary
    according to the risk posed by the cardholder, which allows issuers to
    offer credit with lower costs to less-risky cardholders and credit to
    consumers with lower credit standing, who likely would have not have
    received a credit card in the past. Although cardholder costs can vary
    significantly in this new environment, many cardholders now appear to have
    cards with interest rates less than the 20 percent rate that most cards
    charged prior to 1990. Data reported by the top six issuers indicate that,
    in 2005, about 80 percent of their active U.S. accounts were assessed
    interest rates of less than 20 percent-with more than 40 percent having
    rates of 15 percent or less.12 Furthermore, almost half of the active
    accounts paid little or no interest because the cardholder generally paid
    the balance in full. The issuers also reported that, in 2005, 35 percent
    of their active U.S. accounts were assessed late fees and 13 percent were
    assessed over-limit fees.

    Although credit card issuers are required to provide cardholders with
    information aimed at facilitating informed use of credit and enhancing
    consumers' ability to compare the costs and terms of credit, we found that
    these disclosures have serious weaknesses that likely reduced consumers'
    ability to understand the costs of using credit cards. Because the pricing
    of credit cards, including interest rates and fees, is not generally
    subject to federal regulation, the disclosures required under TILA and
    Regulation Z are the primary means under federal law for protecting
    consumers against inaccurate and unfair credit card practices.13 However,
    the assessment by our usability consultant found that the disclosures in
    the customer solicitation materials and cardmember agreements provided by
    four of the largest credit card issuers were too complicated for many
    consumers to understand. For example, although about half of adults in the
    United States read at or below the eighth-grade level, most of the credit
    card materials were written at a tenth- to twelfth-grade level. In
    addition, the required disclosures often were poorly organized, burying
    important information in text or scattering information about a single
    topic in numerous places. The design of the disclosures often made them
    hard to read, with large amounts of text in small, condensed typefaces and
    poor, ineffective headings to distinguish important topics from the
    surrounding text. Perhaps as a result of these weaknesses, the cardholders
    tested by the consultant often had difficulty using these disclosures to
    locate and understand key rates or terms applicable to the cards.
    Similarly, our interviews with 112 cardholders indicated that many failed
    to understand key terms or conditions that could affect their costs,
    including when they would be charged for late payments or what actions
    could cause issuers to raise rates. The disclosure materials that
    consumers found so difficult to use resulted from issuers' attempts to
    reduce regulatory and liability exposure by adhering to the formats and
    language prescribed by federal law and regulations, which no longer suit
    the complex features and terms of many cards. For example, current
    disclosures require that less important terms, such as minimum finance
    charge or balance computation method, be prominently disclosed, whereas
    information that could more significantly affect consumers' costs, such as
    the actions that could raise their interest rate, are not as prominently
    disclosed. With the goal of improving credit card disclosures, the Federal
    Reserve has begun obtaining public and industry input as part of a
    comprehensive review of Regulation Z. Industry participants and others
    have provided various suggestions to improve disclosures, such as placing
    all key terms in one brief document and other details in a much longer
    separate document, and both our work and that of others illustrated that
    involving consultants and consumers can help develop disclosure materials
    that are more likely to be effective. Federal Reserve staff told us that
    they have begun to involve consumers in the preparation of potentially new
    and revised disclosures. Nonetheless, Federal Reserve staff recognize the
    challenge of presenting the variety of information that consumers may need
    to understand the costs of their cards in a clear way, given the
    complexity of credit card products and the different ways in which
    consumers use credit cards.

    Although paying penalty interest and fees can slow cardholders' attempts
    to reduce their debt, the extent to which credit card penalty fees and
    interest have contributed to consumer bankruptcies is unclear. The number
    of consumers filing for bankruptcy has risen more than sixfold over the
    past 25 years-a period when the nation's population grew by 29 percent-to
    more than 2 million filings in 2005, but debate continues over the reasons
    for this increase. Some researchers attribute the rise in bankruptcies to
    the significant increase in household debt levels that also occurred over
    this period, including the dramatic increase in outstanding credit card
    debt. However, others have found that relatively steady household debt
    burden ratios over the last 15 years indicate that the ability of
    households to make payments on this expanded indebtedness has kept pace
    with growth in their incomes. Similarly, the percentage of households that
    appear to be in financial distress-those with debt payments that exceed 40
    percent of their income-did not change much during this period, nor did
    the proportion of lower-income households with credit card balances.
    Because debt levels alone did not appear to clearly explain the rise in
    bankruptcies, some researchers instead cited other explanations, such as a
    general decline in the stigma associated with bankruptcies or the
    increased costs of major life events-such as health problems or divorce-to
    households that increasingly rely on two incomes. Although critics of the
    credit card industry have cited the emergence of penalty interest rates
    and growth in fees as leading to increased financial distress, no
    comprehensive data exist to determine the extent to which these charges
    contributed to consumer bankruptcies. Any penalty charges that cardholders
    pay would consume funds that could have been used to repay principal, and
    we obtained anecdotal information on a few court cases involving consumers
    who incurred sizable penalty charges that contributed to their financial
    distress. However, credit card issuers said that they have little
    incentive to cause their customers to go bankrupt. The six largest issuers
    reported to us that of their active accounts in 2005 pertaining to
    cardholders who had filed for bankruptcy before their account became 6
    months delinquent, about 10 percent of the outstanding balances on those
    accounts represented unpaid interest and fees. However, issuers told us
    that their data system and recordkeeping limitations prevented them from
    providing us with data that would more completely illustrate a
    relationship between penalty charges and bankruptcies, such as the amount
    of penalty charges that bankrupt cardholders paid in the months prior to
    filing for bankruptcy or the amount of penalty charges owed by cardholders
    who went bankrupt after their accounts became more than 6 months
    delinquent.

    Although penalty interest and fees have likely increased as a portion of
    issuer revenues, the largest issuers have not experienced greatly
    increased profitability over the last 20 years. Determining the extent to
    which penalty interest charges and fees contribute to issuers' revenues
    and profits was difficult because issuers' regulatory filings and other
    public sources do not include such detail. Using data from bank
    regulators, industry analysts, and information reported by the five
    largest issuers, we estimate that the majority-about 70 percent in recent
    years-of issuer revenues came from interest charges, and the portion
    attributable to penalty rates appears to have been growing. The remaining
    issuer revenues came from penalty fees-which had generally grown and were
    estimated to represent around 10 percent of total issuer revenues-as well
    as fees that issuers receive for processing merchants' card transactions
    and other sources. The profits of the largest credit-card-issuing banks,
    which are generally the most profitable group of lenders, have generally
    been stable over the last 7 years.

    This report recommends that, as part of its effort to increase the
    effectiveness of disclosure materials, the Federal Reserve should ensure
    that such disclosures, including model forms and formatting requirements,
    more clearly emphasize those terms that can significantly affect
    cardholder costs, such as the actions that can cause default or other
    penalty pricing rates to be imposed. We provided a draft of this report to
    the Federal Reserve, the Office of the Comptroller of the Currency (OCC),
    the Federal Deposit Insurance Corporation (FDIC), the Federal Trade
    Commission, the National Credit Union Administration, and the Office of
    Thrift Supervision for comment. In its written comments, the Federal
    Reserve agreed that current credit card pricing structures have added to
    the complexity of card disclosures and indicated that it is studying
    alternatives for improving both the content and format of disclosures,
    including involving consumer testing and design consultants.

    Background

    Credit card use has grown dramatically since the introduction of cards
    more than 5 decades ago. Cards were first introduced in 1950, when Diners
    Club established the first general-purpose charge card that allowed its
    cardholders to purchase goods and services from many different merchants.
    In the late 1950s, Bank of America began offering the first widely
    available general purpose credit card, which, unlike a charge card that
    requires the balance to be paid in full each month, allows a cardholder to
    make purchases up to a credit limit and pay the balance off over time. To
    increase the number of consumers carrying the card and to reach retailers
    outside of Bank of America's area of operation, other banks were given the
    opportunity to license Bank of America's credit card. As the network of
    banks issuing these credit cards expanded internationally, administrative
    operations were spun off into a separate entity that evolved into the Visa
    network. In contrast to credit cards, debit cards result in funds being
    withdrawn almost immediately from consumers' bank accounts (as if they had
    a written a check instead). According to CardWeb.com, Inc., a firm that
    collects and analyzes data relating to the credit card industry, the
    number of times per month that credit or debit cards were used for
    purchases or other transactions exceeded 2.3 billion in May 2003, the last
    month for which the firm reported this data.

    The number of credit cards in circulation and the extent to which they are
    used has also grown dramatically. The range of goods and services that can
    be purchased with credit cards has expanded, with cards now being used to
    pay for groceries, health care, and federal and state income taxes. As
    shown in figure 1, in 2005, consumers held more than 691 million credit
    cards and the total value of transactions for which these cards were used
    exceeded $1.8 trillion.

    Figure 1: Credit Cards in Use and Charge Volume, 1980-2005

    The largest issuers of credit cards in the United States are commercial
    banks, including many of the largest banks in the country. More than 6,000
    depository institutions issue credit cards, but, over the past decade, the
    majority of accounts have become increasingly concentrated among a small
    number of large issuers. Figure 2 shows the largest bank issuers of credit
    cards by their total credit card balances outstanding as of December 31,
    2004 (the most recent data available) and the proportion they represent of
    the overall total of card balances outstanding.

    Figure 2: The 10 Largest Credit Card Issuers by Credit Card Balances
    Outstanding as of December 31, 2004

    TILA is the primary federal law pertaining to the extension of consumer
    credit. Congress passed TILA in 1968 to provide for meaningful disclosure
    of credit terms in order to enable consumers to more easily compare the
    various credit terms available in the marketplace, to avoid the uninformed
    use of credit, and to protect themselves against inaccurate and unfair
    credit billing and credit card practices. The regulation that implements
    TILA's requirements is Regulation Z, which is administered by the Federal
    Reserve.

    Under Regulation Z, card issuers are required to disclose the terms and
    conditions to potential and existing cardholders at various times. When
    first marketing a card directly to prospective cardholders, written or
    oral applications or solicitations to open credit card accounts must
    generally disclose key information relevant to the costs of using the
    card, including the applicable interest rate that will be assessed on any
    outstanding balances and several key fees or other charges that may apply,
    such as the
    fee for making a late payment.14 In addition, issuers must provide
    consumers with an initial disclosure statement, which is usually a
    component of the issuer's cardmember agreement, before the first
    transaction is made with a card. The cardmember agreement provides more
    comprehensive information about a card's terms and conditions than would
    be provided as part of the application or a solicitation letter.

    In some cases, the laws of individual states also can affect card issuers'
    operations. For example, although many credit card agreements permit
    issuers to make unilateral changes to the agreement's terms and
    conditions, some state laws require that consumers be given the right to
    opt out of changes. However, as a result of the National Bank Act, and its
    interpretation by the U.S. Supreme Court, the interest and fees charged by
    a national bank on credit card accounts is subject only to the laws of the
    state in which the bank is chartered, even if its lending activities occur
    outside of its charter state.15 As a result, the largest banks have
    located their credit card operations in states with laws seen as more
    favorable for the issuer with respect to credit card lending.

    Various federal agencies oversee credit card issuers. The Federal Reserve
    has responsibility for overseeing issuers that are chartered as state
    banks and are also members of the Federal Reserve System. Many card
    issuers are chartered as national banks, which OCC supervises. Other
    regulators of bank issuers are FDIC, which oversees state-chartered banks
    with federally insured deposits that are not members of the Federal
    Reserve System; the Office of Thrift Supervision, which oversees federally
    chartered and state-chartered savings associations with federally insured
    deposits; or the National Credit Union Administration, which oversees
    federally-chartered and state-chartered credit unions whose member
    accounts are federally insured. As part of their oversight, these
    regulators review card issuers' compliance with TILA and ensure that an
    institution's credit card operations do not pose a threat to the
    institutions' safety and soundness. The Federal Trade Commission generally
    has responsibility for enforcing TILA and other consumer protection laws
    for credit card issuers that are not depository institutions.

    Credit Card Fees and Issuer Practices That Can Increase Cardholder Costs
    Have Expanded, but a Minority of Cardholders Appear to Be Affected

    Prior to about 1990, card issuers offered credit cards that featured an
    annual fee, a relatively high, fixed interest rate, and low penalty fees,
    compared with average rates and fees assessed in 2005. Over the past 15
    years, typical credit cards offered by the largest U.S. issuers evolved to
    feature more complex pricing structures, including multiple interest rates
    that vary with market fluctuations. The largest issuers also increased the
    number, and in some cases substantially increased the amounts, of fees
    assessed on cardholders for violations of the terms of their credit
    agreement, such as making a late payment. Issuers said that these changes
    have benefited a greater number of cardholders, whereas critics contended
    that some practices unfairly increased cardholder costs. The largest six
    issuers provided data indicating that most of their cardholders had
    interest rates on their cards that were lower than the single fixed rates
    that prevailed on cards prior to the 1990s and that a small proportion of
    cardholders paid high penalty interest rates in 2005. In addition,
    although most cardholders did not appear to be paying penalty fees, about
    one-third of the accounts with these largest issuers paid at least one
    late fee in 2005.

    Issuers Have Developed More Complex Credit Card Pricing Structures

    The interest rates, fees, and other practices that represent the pricing
    structure for credit cards have become more complex since the early 1990s.
    After first being introduced in the 1950s, for the next several decades,
    credit cards commonly charged a single fixed interest rate around 20
    percent-as the annual percentage rate (APR)-which covered most of an
    issuer's expenses associated with card use.16 Issuers also charged
    cardholders an annual fee, which was typically between $20 and $50
    beginning in about 1980, according to a senior economist at the Federal
    Reserve Board. Card issuers generally offered these credit cards only to
    the most creditworthy U.S. consumers. According to a study of credit card
    pricing done by a member of the staff of one of the Federal Reserve Banks,
    few issuers in the late 1980s and early 1990s charged cardholders fees as
    penalties if they made late payments or exceeded the credit limit set by
    the issuer.17 Furthermore, these fees, when they were assessed, were
    relatively small. For example, the Federal Reserve Bank staff member's
    paper notes that the typical late fee charged on cards in the 1980s ranged
    from $5 to $10.

    Multiple Interest Rates May Apply to a Single Account and May Change Based
    on Market Fluctuations

    After generally charging just a single fixed interest rate before 1990,
    the largest issuers now apply multiple interest rates to a single card
    account balance and the level of these rates can vary depending on the
    type of transaction in which a cardholder engages. To identify recent
    pricing trends for credit cards, we analyzed the disclosures made to
    prospective and existing cardholders for 28 popular credit cards offered
    during 2003, 2004, and 2005 by the six largest issuers (based on credit
    card balances outstanding at the end of 2004).18 At that time, these
    issuers held almost 80 percent of consumer debt owed to credit card
    issuers and as much as 61 percent of total U.S. credit card accounts. As a
    result, our analysis of these 28 cards likely describes the card pricing
    structure and terms that apply to the majority of U.S. cardholders.
    However, our sample of cards did not include subprime cards, which
    typically have higher cost structures to compensate for the higher risks
    posed by subprime borrowers.

    We found that all but one of these popular cards assessed up to three
    different interest rates on a cardholder's balance. For example, cards
    assessed separate rates on

    o balances that resulted from the purchase or lease of goods and services,
    such as food, clothing, and home appliances;

    o balances that were transferred from another credit card, which
    cardholders may do to consolidate balances across cards to take advantage
    of lower interest rates; and

    o balances that resulted from using the card to obtain cash, such as a
    withdrawal from a bank automated teller machine.

    In addition to having separate rates for different transactions, popular
    credit cards increasingly have interest rates that vary periodically as
    market interest rates change. Almost all of the cards we analyzed charged
    variable rates, with the number of cards assessing these rates having
    increased over the most recent 3-year period. More specifically, about 84
    percent of cards we reviewed (16 of 19 cards) assessed a variable interest
    rate in 2003, 91 percent (21 of 23 cards) in 2004, and 93 percent (25 of
    27 cards) in 2005.19 Issuers typically determine these variable rates by
    taking the prevailing level of a base rate, such as the prime rate, and
    adding a fixed percentage amount.20 In addition, the issuers usually reset
    the interest rates on a monthly basis.

    Issuers appear to have assessed lower interest rates in recent years than
    they did prior to about 1990. Issuer representatives noted that issuers
    used to generally offer cards with a single rate of around 20 percent to
    their cardholders, and the average credit card rates reported by the
    Federal Reserve were generally around 18 percent between 1972 and 1990.
    According to the survey of credit card plans, conducted every 6 months by
    the Federal Reserve, more than 100 card issuers indicated that these
    issuers charged interest rates between 12 and 15 percent on average from
    2001 to 2005. For the 28 popular cards we reviewed, the average interest
    rate that would be assessed for purchases was 12.3 percent in 2005, almost
    6 percentage points lower than the average rates that prevailed until
    about 1990. We found that the range of rates charged on these cards was
    between about 8 and 19 percent in 2005. The average rate on these cards
    climbed slightly during this period, having averaged about 11.5 percent in
    2003 and about 12 percent in 2004, largely reflecting the general upward
    movement in prime rates. Figure 3 shows the general decline in credit card
    interest rates, as reported by the Federal Reserve, between about 1991 and
    2005 compared with the prime rate over this time. As these data show,
    credit card interest rates generally were stable regardless of the level
    of market interest rates until around 1996, at which time changes in
    credit card rates approximated changes in market interest rates. In
    addition, the spread between the prime rate and credit card rates was
    generally wider in the period before the 1980s than it has been since
    1990, which indicates that since then cardholders are paying lower rates
    in terms of other market rates.

    Figure 3: Credit Card Interest Rates, 1972-2005

    Recently, many issuers have attempted to obtain new customers by offering
    low, even zero, introductory interest rates for limited periods. According
    to an issuer representative and industry analyst we interviewed, low
    introductory interest rates have been necessary to attract cardholders in
    the current competitive environment where most consumers who qualify for a
    credit card already have at least one. Of the 28 popular cards that we
    analyzed, 7 cards (37 percent) offered prospective cardholders a low
    introductory rate in 2003, but 20 (74 percent) did so in 2005-with most
    rates set at zero for about 8 months. According to an analyst who studies
    the credit card industry for large investors, approximately 25 percent of
    all purchases are made with cards offering a zero percent interest rate.

    Increased competition among issuers, which can be attributed to several
    factors, likely caused the reductions in credit card interest rates. In
    the early 1990s, new banks whose operations were solely focused on credit
    cards entered the market, according to issuer representatives. Known as
    monoline banks, issuer representatives told us these institutions competed
    for cardholders by offering lower interest rates and rewards, and expanded
    the availability of credit to a much larger segment of the population.
    Also, in 1988, new requirements were implemented for credit card
    disclosures that were intended to help consumers better compare pricing
    information on credit cards. These new requirements mandated that card
    issuers use a tabular format to provide information to consumers about
    interest rates and some fees on solicitations and applications mailed to
    consumers. According to issuers, consumer groups, and others, this format,
    which is popularly known as the Schumer box, has helped to significantly
    increase consumer awareness of credit card costs.21 According to a study
    authored by a staff member of a Federal Reserve Bank, consumer awareness
    of credit card interest rates has prompted more cardholders to transfer
    card balances from one issuer to another, further increasing competition
    among issuers.22 However, another study prepared by the Federal Reserve
    Board also attributes declines in credit card interest rates to a sharp
    drop in issuers' cost of funds, which is the price issuers pay other
    lenders to obtain the funds that are then lent to cardholders.23 (We
    discuss issuers' cost of funds later in this report.)

    Our analysis of disclosures also found that the rates applicable to
    balance transfers were generally the same as those assessed for purchases,
    but the rates for cash advances were often higher. Of the popular cards
    offered by the largest issuers, nearly all featured rates for balance
    transfers that were substantially similar to their purchase rates, with
    many also offering low introductory rates on balance transfers for about 8
    months. However, the rates these cards assessed for obtaining a cash
    advance were around 20 percent on average. Similarly to rates for
    purchases, the rates for cash advances on most cards were also variable
    rates that would change periodically with market interest rates.

    Credit Cards Increasingly Have Assessed Higher Penalty Fees

    Although featuring lower interest rates than in earlier decades, typical
    cards today now include higher and more complex fees than they did in the
    past for making late payments, exceeding credit limits, and processing
    returned payments. One penalty fee, commonly included as part of credit
    card terms, is the late fee, which issuers assess when they do not receive
    at least the minimum required payment by the due date indicated in a
    cardholder's monthly billing statement. As noted earlier, prior to 1990,
    the level of late fees on cards generally ranged from $5 to $10. However,
    late fees have risen significantly. According to data reported by
    CardWeb.com, Inc., credit card late fees rose from an average of $12.83 in
    1995 to $33.64 in 2005, an increase of over 160 percent. Adjusted for
    inflation, these fees increased about 115 percent on average, from $15.61
    in 1995 to $33.64 in 2005.24 Similarly, Consumer Action, a consumer
    interest group that conducts an annual survey of credit card costs, found
    late fees rose from an average of $12.53 in 1995 to $27.46 in 2005, a 119
    percent increase (or 80 percent after adjusting for inflation).25 Figure 4
    shows trends in average late fee assessments reported by these two groups.

    Figure 4: Average Annual Late Fees Reported from Issuer Surveys, 1995-2005
    (unadjusted for inflation)

    Notes: Consumer Action data did not report values for 1996 and 1998.

    CardWeb.com, Inc. data are for financial institutions with more than $100
    million in outstanding receivables.

    In addition to increased fees a cardholder may be charged per occurrence,
    many cards created tiered pricing that depends on the balance held by the
    cardholder.26 Between 2003 and 2005, all but 4 of the 28 popular cards
    that we analyzed used a tiered fee structure. Generally, these cards
    included three tiers, with the following range of fees for each tier:

    o $15 to $19 on accounts with balances of $100 or $250;

    o $25 to $29 on accounts with balances up to about $1,000; and

    o $34 to $39 on accounts with balances of about $1,000 or more.

    Tiered pricing can prevent issuers from assessing high fees to cardholders
    with comparatively small balances. However, data from the Federal
    Reserve's Survey of Consumer Finances, which is conducted every 3 years,
    show that the median total household outstanding balance on U.S. credit
    cards was about $2,200 in 2004 among those that carried balances. When we
    calculated the late fees that would be assessed on holders of the 28 cards
    if they had the entire median balance on one card, the average late fee
    increased from $34 in 2003 to $37 in 2005, with 18 of the cards assessing
    the highest fee of $39 in 2005.

    Issuers also assess cardholders a penalty fee for exceeding the credit
    limit set by the issuer. In general, issuers assess over-limit fees when a
    cardholder exceeds the credit limit set by the card issuer. Similar to
    late fees, over-limit fees also have been rising and increasingly involve
    a tiered structure. According to data reported by CardWeb.com, Inc., the
    average over-limit fees that issuers assessed increased 138 percent from
    $12.95 in 1995 to $30.81 in 2005. Adjusted for inflation, average
    over-limit fees reported by CardWeb.com increased from $15.77 in 1995 to
    $30.81 in 2005, representing about a 95 percent increase.27 Similarly,
    Consumer Action found a 114 percent increase in this period (or 76
    percent, after adjusting for inflation). Figure 5 illustrates the trend in
    average over-limit fees over the past 10 years from these two surveys.

    Figure 5: Average Annual Over-limit fees Reported from Issuer Surveys,
    1995-2005 (unadjusted for inflation)

    Notes: Consumer Action did not report values for 1996 and 1998.

    CardWeb.com, Inc. data are for financial institutions with more than $100
    million in outstanding receivables.

    The cards we analyzed also increasingly featured tiered structures for
    over-limit fees, with 29 percent (5 of 17 cards) having such structures in
    2003, and 53 percent (10 of 19 cards) in 2005. Most cards that featured
    tiered over-limit fees assessed the highest fee on accounts with balances
    greater than $1,000. But not all over-limit tiers were based on the amount
    of the cardholder's outstanding balance. Some cards based the amount of
    the over-limit fee on other indicators, such as the amount of the
    cardholder's credit limit or card type. For the six largest issuers'
    popular cards with over-limit fees, the average fee that would be assessed
    on accounts that carried the median U.S. household credit card balance of
    $2,200 rose from $32 in 2003 to $34 in 2005. Among cards that assessed
    over-limit fees in 2005, most charged an amount between $35 and $39.

    Not all of the 28 popular large-issuer cards included over-limit fees and
    the prevalence of such fees may be declining. In 2003, 85 percent, or 17
    of 20 cards, had such fees, but only 73 percent, or 19 of 26 cards, did in
    2005. According to issuer representatives, they are increasingly
    emphasizing competitive strategies that seek to increase the amount of
    spending that their existing cardholders do on their cards as a way to
    generate revenue. This could explain a movement away from assessing
    over-limit fees, which likely discourage cardholders who are near their
    credit limit from spending.

    Cards also varied in when an over-limit fee would be assessed. For
    example, our analysis of the 28 popular large-issuer cards showed that, of
    the 22 cards that assessed over-limit fees, about two-thirds (14 of 22)
    would assess an over-limit fee if the cardholder's balance exceeded the
    credit limit within a billing cycle, whereas the other cards (8 of 22)
    would assess the fee only if a cardholder's balance exceeded the limit at
    the end of the billing cycle. In addition, within the overall limit, some
    of the cards had separate credit limits on the card for how much a
    cardholder could obtain in cash or transfer from other cards or creditors,
    before similarly triggering an over-limit fee.

    Finally, issuers typically assess fees on cardholders for submitting a
    payment that is not honored by the issuer or the cardholder's paying bank.
    Returned payments can occur when cardholders submit a personal check that
    is written for an amount greater than the amount in their checking account
    or submit payments that cannot be processed. In our analysis of 28 popular
    cards offered by the six largest issuers, we found the average fee charged
    for such returned payments remained steady between 2003 and 2005 at about
    $30.

    Cards Now Frequently Include a Range of Other Fees

    Since 1990, issuers have appended more fees to credit cards. In addition
    to penalties for the cardholder actions discussed above, the 28 popular
    cards now often include fees for other types of transactions or for
    providing various services to cardholders. As shown in table 1, issuers
    assess fees for such services as providing cash advances or for making a
    payment by telephone. According to our analysis, not all of these fees
    were disclosed in the materials that issuers generally provide to
    prospective or existing cardholders. Instead, card issuers told us that
    they notified their customers of these fees by other means, such as
    telephone conversations.

    Table 1: Various Fees for Services and Transactions, Charged in 2005 on
    Popular Large-Issuer Cards

           Fee type           Assessed for:       Number of     Average or range
                                                  cards that       of amounts
                                                 assessed fee  generally assessed
                                                   in 2005        (if charged)
    Cash advance      Obtaining cash or cash  26 of 27      3% of cash advance
                         equivalent item using                 amount or $5
                         credit card or                        minimum
                         convenience checks
    Balance transfer  Transferring all or     15 of 27      3% of transfer
                         part of a balance from                amount or $5 to
                         another creditor                      $10 minimum
    Foreign           Making purchases in a   19 of 27      3% of transaction
    transaction       foreign country or                    amount (in U.S.
                         currency                              dollars)
    Returned          Using a convenience     20 of 27      $31
    convenience check check that the issuer
                         declines to honor
    Stop payment      Requesting to stop      20 of 27      $26
                         payment on a
                         convenience check
                         written against the
                         account
    Telephone payment Arranging a single      N/Aa          $5-$15
                         payment through a
                         customer service agent
    Duplicate copy of Obtaining a copy of a   N/Aa          $2-$13 per item
    account records   billing statement or
                         other record
    Rush delivery of  Requesting that a card  N/Aa          $10-$20
    credit card       be sent by overnight
                         delivery

    Source: GAO.

    Note: Cash equivalent transactions include the purchase of items such as
    money orders, lottery tickets and casino chips. Convenience checks are
    personalized blank checks that issuers provide cardholders that can be
    written against the available credit limit of a credit card account.

    aWe were unable to determine the number of cards that assessed telephone
    payment, duplicate copy, or rush delivery fees in 2005 because these fees
    are not required by regulation to be disclosed with either mailed
    solicitation letters or initial disclosure statements. We obtained
    information about the level of these fees from a survey of the six largest
    U.S. issuers.

    While issuers generally have been including more kinds of fees on credit
    cards, one category has decreased: most cards offered by the largest
    issuers do not require cardholders to pay an annual fee. An annual fee is
    a fixed fee that issuers charge cardholders each year they continue to own
    that card. Almost 75 percent of cards we reviewed charged no annual fee in
    2005 (among those that did, the range was from $30 to $90). Also, an
    industry group representative told us that approximately 2 percent of
    cards featured annual fee requirements. Some types of cards we reviewed
    were more likely to apply an annual fee than others. For example, cards
    that offered airline tickets in exchange for points that accrue to a
    cardholder for using the card were likely to apply an annual fee. However,
    among the 28 popular cards that we reviewed, not all of the cards that
    offered rewards charged annual fees.

    Recently, some issuers have introduced cards without certain penalty fees.
    For example, one of the top six issuers has introduced a card that does
    not charge a late fee, over-limit fee, cash-advance fee, returned payment
    fee, or an annual fee. Another top-six issuer's card does not charge the
    cardholder a late fee as long as one purchase is made during the billing
    cycle. However, the issuer of this card may impose higher interest rates,
    including above 30 percent, if the cardholder pays late or otherwise
    defaults on the terms of the card.

    Issuers Have Introduced Various Practices that Can Significantly Affect
    Cardholder Costs

    Popular credit cards offered by the six largest issuers involve various
    issuer practices that can significantly affect the costs of using a credit
    card for a cardholder. These included practices such as raising a card's
    interest rates in response to cardholder behaviors and how payments are
    allocated across balances.

    Interest Rate Changes

    One of the practices that can significantly increase the costs of using
    typical credit cards is penalty pricing. Under this practice, the interest
    rate applied to the balances on a card automatically can be increased in
    response to behavior of the cardholder that appears to indicate that the
    cardholder presents greater risk of loss to the issuer. For example,
    representatives for one large issuer told us they automatically increase a
    cardholder's interest rate if a cardholder makes a late payment or exceeds
    the credit limit. Card disclosure documents now typically include
    information about default rates, which represent the maximum penalty rate
    that issuers can assess in response to cardholders' violations of the
    terms of the card. According to an industry specialist at the Federal
    Reserve, issuers first began the practice of assessing default interest
    rates as a penalty for term violations in the late 1990s. As of 2005, all
    but one of the cards we reviewed included default rates. The default rates
    were generally much higher than rates that otherwise applied to purchases,
    cash advances, or balance transfers. For example, the average default rate
    across the 28 cards was 27.3 percent in 2005-up from the average of 23.8
    percent in 2003-with as many as 7 cards charging rates over 30 percent.
    Like many of the other rates assessed on these cards in 2005, default
    rates generally were variable rates. Increases in average default rates
    between 2003 and 2005 resulted from increases both in the prime rate,
    which rose about 2 percentage points during this time, and the average
    fixed amount that issuers added. On average, the fixed amount that issuers
    added to the index rate in setting default rate levels increased from
    about 19 percent in 2003 to 22 percent in 2005.

    Four of the six largest issuers typically included conditions in their
    disclosure documents that could allow the cardholder's interest rate to be
    reduced from a higher penalty rate. For example some issuers would lower a
    cardholders' rate for not paying late and otherwise abiding by the terms
    of the card for a period of 6 or 12 consecutive months after the default
    rate was imposed. However, at least one issuer indicated that higher
    penalty rates would be charged on existing balances even after six months
    of good behavior. This issuer assessed lower nonpenalty rates only on new
    purchases or other new balances, while continuing to assess higher penalty
    rates on the balance that existed when the cardholder was initially
    assessed a higher penalty rate. This practice may significantly increase
    costs to cardholders even after they've met the terms of their card
    agreement for at least six months.

    The specific conditions under which the largest issuers could raise a
    cardholder's rate to the default level on the popular cards that we
    analyzed varied. The disclosures for 26 of the 27 cards that included
    default rates in 2005 stated that default rates could be assessed if the
    cardholders made late payments. However, some cards would apply such
    default rates only after multiple violations of card terms. For example,
    issuers of 9 of the cards automatically would increase a cardholder's
    rates in response to two late payments. Additionally, for 18 of the 28
    cards, default rates could apply for exceeding the credit limit on the
    card, and 10 cards could also impose such rates for returned payments.
    Disclosure documents for 26 of the 27 cards that included default rates
    also indicated that in response to these violations of terms, the interest
    rate applicable to purchases could be increased to the default rate. In
    addition, such violations would also cause issuers to increase the rates
    applicable to cash advances on 16 of the cards, as well as increase rates
    applicable to balance transfers on 24 of the cards.

    According to a paper by a Federal Reserve Bank researcher, some issuers
    began to increase cardholders' interest rates in the early 2000s for
    actions they took with other creditors.28 According to this paper, these
    issuers would increase rates when cardholders failed to make timely
    payments to other creditors, such as other credit card issuers, utility
    companies, and mortgage lenders. Becoming generally known as "universal
    default," consumer groups criticized these practices. In 2004, OCC issued
    guidance to the banks that it oversees, which include many of the largest
    card
    issuers, which addressed such practices.29 While OCC noted that the
    repricing might be an appropriate way for banks to manage their credit
    risk, they also noted that such practices could heighten a bank's
    compliance and reputation risks. As a result, OCC urged national banks to
    fully and prominently disclose in promotional materials the circumstances
    under which a cardholder's interest rates, fees, or other terms could be
    changed and whether the bank reserved the right to change these
    unilaterally. Around the time of this guidance, issuers generally ceased
    automatically repricing cardholders to default interest rates for risky
    behavior exhibited with other creditors. Of the 28 popular large issuer
    cards that we reviewed, three cards in 2005 included terms that would
    allow the issuer to automatically raise a cardholder's rate to the default
    rate if they made a late payment to another creditor.

    Although the six largest U.S. issuers appear to have generally ceased
    making automatic increases to a default rate for behavior with other
    creditors, some continue to employ practices that allow them to seek to
    raise a cardholder's interest rates in response to behaviors with other
    creditors. During our review, representatives of four of these issuers
    told us that they may seek to impose higher rates on a cardholder in
    response to behaviors related to other creditors but that such increases
    would be done as a change-in-terms, which can require prior notification,
    rather than automatically.30 Regulation Z requires that the affected
    cardholders be notified in writing of any such proposed changes in rate
    terms at least 15 days before such change becomes effective.31 In
    addition, under the laws of the states in which four of the six largest
    issuers are chartered, cardholders would have to be given the right to opt
    out of the change.32 However, issuer representatives told us that few
    cardholders exercise this right. The ability of cardholders to opt out of
    such increases also has been questioned. For example, one legal essay
    noted that some cardholders may not be able to reject the changed terms of
    their cards if the result would be a requirement to pay off the balance
    immediately.33 In addition, an association for community banks that
    provided comments to the Federal Reserve as part of the ongoing review of
    card disclosures noted that 15 days does not provide consumers sufficient
    time to make other credit arrangements if the new terms were undesirable.

    Payment Allocation Method

    The way that issuers allocate payments across balances also can increase
    the costs of using the popular cards we reviewed. In this new credit
    environment where different balances on a single account may be assessed
    different interest rates, issuers have developed practices for allocating
    the payments cardholders make to pay down their balance. For 23 of the 28
    popular larger-issuer cards that we reviewed, cardholder payments would be
    allocated first to the balance that is assessed the lowest rate of
    interest.34 As a result, the low interest balance would have to be fully
    paid before any of the cardholder's payment would pay down balances
    assessed higher rates of interest. This practice can prolong the length of
    time that issuers collect finance charges on the balances assessed higher
    rates of interest.

    Balance Computation Method

    Additionally, some of the cards we reviewed use a balance computation
    method that can increase cardholder costs. On some cards, issuers have
    used a double-cycle billing method, which eliminates the interest-free
    period of a consumer who moves from nonrevolving to revolving status,
    according to Federal Reserve staff. In other words, in cases where a
    cardholder, with no previous balance, fails to pay the entire balance of
    new purchases by the payment due date, issuers compute interest on the
    original balance that previously had been subject to an interest-free
    period. This method is illustrated in figure 6.

    Figure 6: How the Double-Cycle Billing Method Works

    Note: We calculated finance charges assuming a 13.2 percent APR, 30-day
    billing cycle, and that the cardholder's payment is credited on the first
    day of cycle 2. We based our calculations on an average daily balance
    method and daily compounding of finance charges.

    In our review of 28 popular cards from the six largest issuers, we found
    that two of the six issuers used the double-cycle billing method on one or
    more popular cards between 2003 and 2005. The other four issuers indicated
    they would only go back one cycle to impose finance charges.

    New Practices Appear to Affect a Minority of Cardholders

    Representatives of issuers, consumer groups, and others we interviewed
    generally disagreed over whether the evolution of credit card pricing and
    other practices has been beneficial to consumers. However, data provided
    by the six largest issuers show that many of their active accounts did not
    pay finance charges and that a minority of their cardholders were affected
    by penalty charges in 2005.

    Issuers Say Practices Benefit More Cardholders, but Critics Say Some
    Practices Harm Consumers

    The movement towards risk-based pricing for cards has allowed issuers to
    offer better terms to some cardholders and more credit cards to others.
    Spurred by increased competition, many issuers have adopted risk-based
    pricing structures in which they assess different rates on cards depending
    on the credit quality of the borrower. Under this pricing structure,
    issuers have offered cards with lower rates to more creditworthy
    borrowers, but also have offered credit to consumers who previously would
    not have been considered sufficiently creditworthy. For example, about 70
    percent of families held a credit card in 1989, but almost 75 percent held
    a card by 2004, according to the Federal Reserve Board's Survey of
    Consumer Finances. Cards for these less creditworthy consumers have
    featured higher rates to reflect the higher repayment risk that such
    consumers represented. For example, the initial purchase rates on the 28
    popular cards offered by the six largest issuers ranged from about 8
    percent to 19 percent in 2005.

    According to card issuers, credit cards offer many more benefits to users
    than they did in the past. For example, according to the six largest
    issuers, credit cards are an increasingly convenient and secure form of
    payment. These issuers told us credit cards are accepted at more than 23
    million merchants worldwide, can be used to make purchases or obtain cash,
    and are the predominant form of payment for purchases made on the
    Internet. They also told us that rewards, such as cash-back and airline
    travel, as well as other benefits, such as rental car insurance or lost
    luggage protection, also have become standard. Issuers additionally noted
    that credit cards are reducing the need for cash. Finally, they noted that
    cardholders typically are not responsible for loss, theft, fraud, or
    misuse of their credit cards by unauthorized users, and issuers often
    assist cardholders that are victims of identity theft.

    In contrast, according to some consumer groups and others, the newer
    pricing structures have resulted in many negative outcomes for some
    consumers. Some consumer advocates noted adverse consequences of offering
    credit, especially at higher interest rates, to less creditworthy
    consumers. For example, lower-income or young consumers, who do not have
    the financial means to carry credit card debt, could worsen their
    financial condition.35 In addition, consumer groups and academics said
    that various penalty fees could increase significantly the costs of using
    cards for some consumers. Some also argued that card issuers were overly
    aggressive in their assessment of penalty fees. For instance, a
    representative of a consumer group noted that issuers do not reject
    cardholders' purchases during the sale authorization, even if the
    transaction would put the cardholder over the card's credit limit, and yet
    will likely later assess that cardholder an over-limit fee and also may
    penalize them with a higher interest rate. Furthermore, staff for one
    banking regulator told us that they have received complaints from
    consumers who were assessed over-limit fees that resulted from the balance
    on their accounts going over their credit limit because their card issuer
    assessed them a late fee. At the same time, credit card issuers have
    incentives not to be overly aggressive with their assessment of penalty
    charges. For example, Federal Reserve representatives told us that major
    card issuers with long-term franchise value are concerned that their banks
    not be perceived as engaging in predatory lending because this could pose
    a serious risk to their brand reputation. As a result, they explained that
    issuers may be wary of charging fees that could be considered excessive or
    imposing interest rates that might be viewed as potentially abusive. In
    contrast, these officials noted that some issuers, such as those that
    focus on lending to consumers with lower credit quality, may be less
    concerned about their firm's reputation and, therefore, more likely to
    charge higher fees.

    Controversy also surrounds whether higher fees and other charges were
    commensurate with the risks that issuers faced. Consumer groups and others
    questioned whether the penalty interest rates and fees were justifiable.
    For example, one consumer group questioned whether submitting a credit
    card payment one day late made a cardholder so risky that it justified
    doubling or tripling the interest rate assessed on that account. Also, as
    the result of concerns over the level of penalty fees being assessed by
    banks in the United Kingdom, a regulator there has recently announced that
    penalty fees greater than 12 pounds (about $23) may be challenged as
    unfair unless they can be justified by exceptional factors.36
    Representatives of several of the issuers with whom we spoke told us that
    the levels of the penalty fees they assess generally were set by
    considering various factors. For example, they noted that higher fees help
    to offset the increased risk of loss posed by cardholders who pay late or
    engage in other negative behaviors. Additionally, they noted a 2006 study,
    which compared the assessment of penalty fees that credit card banks
    charged to bankruptcy rates in the states in which their cards were
    marketed, and found that late fee assessments were correlated with
    bankruptcy rates.37 Some also noted that increased fee levels reflected
    increased operating costs; for example, not receiving payments when due
    can cause the issuer to incur increased costs, such as those incurred by
    having to call cardholders to request payment. Representatives for four of
    the largest issuers also told us that their fee levels were influenced by
    what others in the marketplace were charging.

    Concerns also have been expressed about whether consumers adequately
    consider the potential effect of penalty interest rates and fees when they
    use their cards. For example, one academic researcher, who has written
    several papers about the credit card industry, told us that many consumers
    do not consider the effect of the costs that can accrue to them after they
    begin using a credit card. According to this researcher, many consumers
    focus primarily on the amount of the interest rate for purchases when
    deciding to obtain a new credit card and give less consideration to the
    level of penalty charges and rates that could apply if they were to miss a
    payment or violate some other term of their card agreement. An analyst
    that studies the credit card industry for large investors said that
    consumers can obtain low introductory rates but can lose them very easily
    before the introductory period expires.

    Most Active Accounts Are Assessed Lower Rates Than in the Past

    As noted previously, the average credit card interest rate assessed for
    purchases has declined from almost 20 percent, that prevailed until the
    late 1980s, to around 12 percent, as of 2005. In addition, the six largest
    issuers-whose accounts represent 61 percent of all U.S. accounts-reported
    to us that the majority of their cardholders in 2005 had cards with
    interest rates lower than the rate that generally applied to all
    cardholders prior to about 1990. According to these issuers, about 80
    percent of active accounts were assessed interest rates below 20 percent
    as of December 31, 2005, with
    more than 40 percent having rates below 15 percent.38 However, the
    proportion of active accounts assessed rates below 15 percent declined
    since 2003, when 71 percent received such rates. According to issuer
    representatives, a greater number of active accounts were assessed higher
    interest rates in 2004 and 2005 primarily because of changes in the prime
    rate to which many cards' variable rates are indexed. Nevertheless,
    cardholders today have much greater access to cards with lower interest
    rates than existed when all cards charged a single fixed rate.

    A large number of cardholders appear to avoid paying any significant
    interest charges. Many cardholders do not revolve a balance from month to
    month, but instead pay off the balance owed in full at the end of each
    month. Such cardholders are often referred to as convenience users.
    According to one estimate, about 42 percent of cardholders are convenience
    users.39 As a result, many of these cardholders availed themselves of the
    benefits of their cards without incurring any direct expenses. Similarly,
    the six largest issuers reported to us that almost half, or 48 percent, of
    their active accounts did not pay a finance charge in at least 10 months
    in 2005, similar to the 47 percent that did so in 2003 and 2004.

    Minority of Cardholders Appear to Be Affected by Penalty Charges Assessed
    by the Largest U.S. Issuers

    Penalty interest rates and fees appear to affect a minority of the largest
    six issuers' cardholders.40 No comprehensive sources existed to show the
    extent to which U.S. cardholders were paying penalty interest rates, but,
    according to data provided by the six largest issuers, a small proportion
    of their active accounts were being assessed interest rates above 25
    percent-which we determined were likely to represent penalty rates.
    However, this proportion had more than doubled over a two-year period by
    having increased from 5 percent at the end of 2003 to 10 percent in 2004
    and 11 percent in 2005.

    Although still representing a minority of cardholders, cardholders paying
    at least one type of penalty fee were a significant proportion of all
    cardholders. According to the six largest issuers, 35 percent of their
    active accounts had been assessed at least one late fee in 2005. These
    issuers reported that their late fee assessments averaged $30.92 per
    active account. Additionally, these issuers reported that they assessed
    over-limit fees on 13 percent of active accounts in 2005, with an average
    over-limit fee of $9.49 per active account.

    Weaknesses in Credit Card Disclosures Appear to Hinder Cardholder
    Understanding of Fees and Other Practices That Can Affect Their Costs

    The disclosures that issuers representing the majority of credit card
    accounts use to provide information about the costs and terms of using
    credit cards had serious weaknesses that likely reduce their usefulness to
    consumers. These disclosures are the primary means under federal law for
    protecting consumers against inaccurate and unfair credit card practices.
    The disclosures we analyzed had weaknesses, such as presenting information
    written at a level too difficult for the average consumer to understand,
    and design features, such as text placement and font sizes, that did not
    conform to guidance for creating easily readable documents. When
    attempting to use these disclosures, cardholders were often unable to
    identify key rates or terms and often failed to understand the information
    in these documents. Several factors help explain these weaknesses,
    including outdated regulations and guidance. With the intention of
    improving the information that consumers receive, the Federal Reserve has
    initiated a comprehensive review of the regulations that govern credit
    card disclosures. Various suggestions have been made to improve
    disclosures, including testing them with consumers. While Federal Reserve
    staff have begun to involve consumers in their efforts, they are still
    attempting to determine the best form and content of any revised
    disclosures. Without clear, understandable information, consumers risk
    making poor choices about using credit cards, which could unnecessarily
    result in higher costs to use them.

    Mandatory Disclosure of Credit Card Terms and Conditions Is the Primary
    Means Regulators Use for Ensuring Competitive Credit Card Pricing

    Having adequately informed consumers that spur competition among issuers
    is the primary way that credit card pricing is regulated in the United
    States. Under federal law, a national bank may charge interest on any loan
    at a rate permitted by the law of the state in which the bank is
    located.41 In 1978, the U.S. Supreme Court ruled that a national bank is
    "located" in the state in which it is chartered, and, therefore, the
    amount of the interest rates charged by a national bank are subject only
    to the laws of the state in which it is chartered, even if its lending
    activities occur elsewhere.42 As a result, the largest credit card issuing
    banks are chartered in states that either lacked interest rate caps or had
    very high caps from which they would offer credit cards to customers in
    other states. This ability to "export" their chartered states' interest
    rates effectively removed any caps applicable to interest rates on the
    cards from these banks. In 1996, the U.S. Supreme Court determined that
    fees charged on credit extended by national banks are a form of interest,
    allowing issuers to also export the level of fees allowable in their state
    of charter to their customers nationwide, which effectively removed any
    caps on the level of fees that these banks could charge.43

    In the absence of federal regulatory limitations on the rates and fees
    that card issuers can assess, the primary means that U.S. banking
    regulators have for influencing the level of such charges is by
    facilitating competition among issuers, which, in turn, is highly
    dependent on informed consumers. The Truth in Lending Act of 1968 (TILA)
    mandates certain disclosures aimed at informing consumers about the cost
    of credit. In approving TILA, Congress intended that the required
    disclosures would foster price competition among card issuers by enabling
    consumers to discern differences among cards while shopping for credit.
    TILA also states that its purpose is to assure that the consumer will be
    able to compare more readily the various credit terms available to him or
    her and avoid the uninformed use of credit. As authorized under TILA, the
    Federal Reserve has promulgated Regulation Z to carry out the purposes of
    TILA. The Federal Reserve, along with the other federal banking agencies,
    enforces compliance with Regulation Z with respect to the depository
    institutions under their respective supervision.

    In general, TILA and the accompanying provisions of Regulation Z require
    credit card issuers to inform potential and existing customers about
    specific pricing terms at specific times. For example, card issuers are
    required to make various disclosures when soliciting potential customers,
    as well as on the actual applications for credit. On or with card
    applications and solicitations, issuers generally are required to present
    pricing terms, including the interest rates and various fees that apply to
    a card, as well as information about how finance charges are calculated,
    among other things. Issuers also are required to provide cardholders with
    specified disclosures prior to the cardholder's first transaction,
    periodically in billing statements, upon changes to terms and conditions
    pertaining to the account, and upon account renewal. For example, in
    periodic statements, which issuers typically provide monthly to active
    cardholders, issuers are required to provide detailed information about
    the transactions on the account during the billing cycle, including
    purchases and payments, and are to disclose the amount of finance charges
    that accrued on the cardholder's outstanding balance and detail the type
    and amount of fees assessed on the account, among other things.

    In addition to the required timing and content of disclosures, issuers
    also must adhere to various formatting requirements. For example, since
    1989, certain pricing terms must be disclosed in direct mail, telephone,
    and other applications and solicitations and presented in a tabular format
    on mailed applications or solicitations.44 This table, generally referred
    to as the Schumer box, must contain information about the interest rates
    and fees that could be assessed to the cardholder, as well as information
    about how finance charges are calculated, among other things.45 According
    to a Federal Reserve representative, the Schumer box is designed to be
    easy for consumers to read and use for comparing credit cards. According
    to a consumer group representative, an effective regulatory disclosure is
    one that stimulates competition among issuers; the introduction of the
    Schumer box in the late 1980s preceded the increased price competition in
    the credit card market in the early 1990s and the movement away from
    uniform credit card products.

    Not all fees that are charged by card issuers must be disclosed in the
    Schumer box. Regulation Z does not require that issuers disclose fees
    unrelated to the opening of an account. For example, according to the
    Official Staff Interpretations of Regulation Z (staff interpretations),
    nonperiodic fees, such as fees charged for reproducing billing statements
    or reissuing a lost or stolen card, are not required to be disclosed.
    Staff interpretations, which are compiled and published in a supplement to
    Regulation Z, are a means of guiding issuers on the requirements of
    Regulation Z.46 Staff interpretations also explain that various fees are
    not required in initial disclosure statements, such as a fee to expedite
    the delivery of a credit card or, under certain circumstances, a fee for
    arranging a single payment by telephone. However, issuers we surveyed told
    us they inform cardholders about these other fees at the time the
    cardholders request the service, rather than in a disclosure document.

    Although Congress authorized solely the Federal Reserve to adopt
    regulations to implement the purposes of TILA, other federal banking
    regulators, under their authority to ensure the safety and soundness of
    depository institutions, have undertaken initiatives to improve the credit
    card disclosures made by the institutions under their supervision. For
    example, the regulator of national banks, OCC, issued an advisory letter
    in 2004 alerting banks of its concerns regarding certain credit card
    marketing and account management practices that may expose a bank to
    compliance and reputation risks. One such practice involved the marketing
    of promotional interest rates and conditions under which issuers reprice
    accounts to higher interest rates.47 In its advisory letter, OCC
    recommended that issuers disclose any limits on the applicability of
    promotional interest rates, such as the duration of the rates and the
    circumstances that could shorten the promotional rate period or cause
    rates to increase. Additionally, OCC advised issuers to disclose the
    circumstances under which they could increase a consumer's interest rate
    or fees, such as for failure to make timely payments to another creditor.

    Credit Card Disclosures Typically Provided to Many Consumers Have Various
    Weaknesses

    The disclosures that credit card issuers typically provide to potential
    and new cardholders had various weaknesses that reduced their usefulness
    to consumers. These weaknesses affecting the disclosure materials included
    the typical grade level required to comprehend them, their poor
    organization and formatting of information, and their excessive detail and
    length.

    Disclosures Written at Too High a Level

    The typical credit card disclosure documents contained content that was
    written at a level above that likely to be understandable by many
    consumers. To assess the readability of typical credit card disclosures,
    we contracted with a private usability consultant to evaluate the two
    primary disclosure documents for four popular, widely-held cards (one each
    from four large credit card issuers). The two documents were (1) a direct
    mail solicitation letter and application, which must include information
    about the costs and fees associated with the card; and (2) the cardmember
    agreement that contains the full range of terms and conditions applicable
    to the card.48 Through visual inspection, we determined that this set of
    disclosures appeared representative of the disclosures for the 28 cards we
    reviewed from the six largest issuers that accounted for the majority of
    cardholders in the United States. To determine the level of education
    likely needed for someone to understand these disclosures, the usability
    consultant used computer software programs that applied three widely used
    readability formulas to the entire text of the disclosures. These formulas
    determined the readability of written material based on quantitative
    measures, such as average number of syllables in words or numbers of words
    in sentences. For more information about the usability consultant's
    analyses, see appendix I.

    On the basis of the usability consultant's analysis, the disclosure
    documents provided to many cardholders likely were written at a level too
    high for the average individual to understand. The consultant found that
    the disclosures on average were written at a reading level commensurate
    with about a tenth- to twelfth-grade education. According to the
    consultant's analysis, understanding the disclosures in the solicitation
    letters would require an eleventh-grade level of reading comprehension,
    while understanding the cardmember agreements would require about a
    twelfth-grade education. A consumer advocacy group that tested the reading
    level needed to understand credit card disclosures arrived at a similar
    conclusion. In a comment letter to the Federal Reserve, this consumer
    group noted it had measured a typical passage from a change-in-terms
    notice on how issuers calculate finance charges using one of the
    readability formulas and that this passage required a twelfth-grade
    reading level.

    These disclosure documents were written such that understanding them
    required a higher reading level than that attained by many U.S.
    cardholders. For example, a nationwide assessment of the reading level of
    the U.S. population cited by the usability consultant indicated that
    nearly half of the adult population in the United States reads at or below
    the eighth-grade level.49 Similarly, to ensure that the information that
    public companies are required to disclose to prospective investors is
    adequately understandable, the Securities and Exchange Commission (SEC)
    recommends that such disclosure materials be written at a sixth- to
    eighth-grade level.50

    In addition to the average reading level, certain portions of the typical
    disclosure documents provided by the large issuers required even higher
    reading levels to be understandable. For example, the information that
    appeared in cardmember agreements about annual percentage rates, grace
    periods, balance computation, and payment allocation methods required a
    minimum of a fifteenth-grade education, which is the equivalent of 3 years
    of college education. Similarly, text in the documents describing the
    interest rates applicable to one issuer's card were written at a
    twenty-seventh-grade level. However, not all text in the disclosures
    required such high levels. For example, the consultant found that the
    information about fees that generally appeared in solicitation letters
    required only a seventh- and eighth-grade reading level to be
    understandable. Solicitation letters likely required lower reading levels
    to be understandable because they generally included more information in a
    tabular format than cardmember agreements.

    Poor Organization and Formatting

    The disclosure documents the consultant evaluated did not use designs,
    including effective organizational structures and formatting, that would
    have made them more useful to consumers. To assess the adequacy of the
    design of the typical large issuer credit card solicitation letters and
    cardmember agreements, the consultant evaluated the extent to which these
    disclosures adhered to generally accepted industry standards for effective
    organizational structures and designs intended to make documents easy to
    read. In the absence of best practices and guidelines specifically for
    credit card disclosures, the consultant used knowledge of plain language,
    publications design guidelines, and industry best practices and also
    compared the credit card disclosure documents to the guidelines in the
    Securities and Exchange Commission's plain English handbook. The usability
    consultant used these standards to identify aspects of the design of the
    typical card disclosure documents that could cause consumers using them to
    encounter problems.

    On the basis of this analysis, the usability consultant concluded that the
    typical credit card disclosures lacked effective organization. For
    example, the disclosure documents frequently placed pertinent information
    toward the end of sentences. Figure 7 illustrates an example taken from
    the cardmember agreement of one of the large issuers that shows that a
    consumer would need to read through considerable amounts of text before
    reaching the important information, in this case the amount of the annual
    percentage rate (APR) for purchases. Best practices would dictate that
    important information-the amount of the APR-be presented first, with the
    less important information-the explanation of how the APR is
    determined-placed last.

    Figure 7: Example of Important Information Not Prominently Presented in
    Typical Credit Card Disclosure Documents

    In addition, the disclosure documents often failed to group relevant
    information together. Although one of the disclosure formats mandated by
    law-the Schumer box-has been praised as having simplified the presentation
    of complex information, our consultant observed that the amount of
    information that issuers typically presented in the box compromised the
    benefits of using a tabular format. Specifically, the typical credit card
    solicitation letter, which includes a Schumer box, may be causing
    difficulties for consumers because related information generally is not
    grouped appropriately, as shown in figure 8.

    Figure 8: Example of How Related Information Was Not Being Grouped
    Together in Typical Credit Card Disclosure Documents

    As shown in figure 8, information about the APR that would apply to
    purchases made with the card appeared in three different locations. The
    first row includes the current prevailing rate of the purchase APR; text
    that describes how the level of the purchase APR could vary according to
    an underlying rate, such as the prime rate, is included in the third row;
    and text describing how the issuer determines the level of this underlying
    rate is included in the footnotes. According to the consultant, grouping
    such related information together likely would help readers to more easily
    understand the material.

    In addition, of the four issuers whose materials were analyzed, three
    provided a single document with all relevant information in a single
    cardmember agreement, but one issuer provided the information in separate
    documents. For example, this issuer disclosed specific information about
    the actual amount of rates and fees in one document and presented
    information about how such rates were determined in another document.
    According to the readability consultant, disclosures in multiple documents
    can be more difficult for the reader to use because they may require more
    work to find information.

    Formatting weaknesses also likely reduced the usefulness of typical credit
    card disclosure documents. The specific formatting issues were as follows:

    o Font sizes. According to the usability consultant's analysis, many of
    the disclosure documents used font sizes that were difficult to read and
    could hinder consumers' ability to find information. For example, the
    consultant found extensive use of small and condensed typeface in
    cardmember agreements and in footnotes in solicitation materials when best
    practices would suggest using a larger, more legible font size. Figure 9
    contains an illustration of how the disclosures used condensed text that
    makes the font appear smaller than it actually is. Multiple consumers and
    consumer groups who provided comments to the Federal Reserve noted that
    credit card disclosures were written in a small print that reduces a
    consumer's ability to read or understand the document. For example, a
    consumer who provided comments to the Federal Reserve referred to the text
    in card disclosures as "mice type." This example also illustrates how
    notes to the text, which should be less important, were the same size and
    thus given the same visual emphasis as the text inside the box. Consumers
    attempting to read such disclosures may have difficulty determining which
    information is more important.

    Figure 9: Example of How Use of Small Font Sizes Reduces Readability in
    Typical Credit Card Disclosure Documents

    Note: Graphic shown is the actual size it appears in issuer disclosure
    documents. Graphic is intentionally portioned off to focus attention to
    headings.

    o Ineffective font placements. According to the usability consultant, some
    issuers' efforts to distinguish text using different font types sometimes
    had the opposite effect. The consultant found that the disclosures from
    all four issuers emphasized large amounts of text with all capital letters
    and sometimes boldface. According to the consultant, formatting large
    blocks of text in capitals makes it harder to read because the shapes of
    the words disappear, forcing the reader to slow down and study each letter
    (see figure 10). In a comment letter to the Federal Reserve, an industry
    group recommended that boldfaced or capitalized text should be used
    discriminately, because in its experience, excessive use of such font
    types caused disclosures to lose all effectiveness. SEC's guidelines for
    producing clear disclosures contain similar suggestions.

    Figure 10: Example of How Use of Ineffective Font Types Reduces
    Readability in Typical Credit Card Disclosure Documents

    o Selecting text for emphasis. According to the usability consultant, most
    of the disclosure documents unnecessarily emphasized specific terms.
    Inappropriate emphasis of such material could distract readers from more
    important messages. Figure 11 contains a passage from one cardmember
    agreement that the readability consultant singled out for its emphasis of
    the term "periodic finance charge," which is repeated six times in this
    example. According to the consultant, the use of boldface and capitalized
    text calls attention to the word, potentially requiring readers to work
    harder to understand the entire passage's message.

    Figure 11: Example of How Use of Inappropriate Emphasis Reduces
    Readability in Typical Credit Card Disclosure Documents

    o Use of headings. According to the usability consultant, disclosure
    documents from three of the four issuers analyzed contained headings that
    were difficult to distinguish from surrounding text. Headings, according
    to the consultant, provide a visual hierarchy to help readers quickly
    identify information in a lengthy document. Good headers are easy to
    identify and use meaningful labels. Figure 12 illustrates two examples of
    how the credit card disclosure documents failed to use headings
    effectively.

    Figure 12: Example of Ineffective and Effective Use of Headings in Typical
    Credit Card Disclosure Documents

    In the first example, the headings contained an unnecessary string of
    numbers that the consultant found would make locating a specific topic in
    the text more difficult. As a result, readers would need to actively
    ignore the string of numbers until the middle of the line to find what
    they wanted. The consultant noted that such numbers might be useful if
    this document had a table of contents that referred to the numbers, but it
    did not. In the second example, the consultant noted that a reader's
    ability to locate information using the headings in this document was
    hindered because the headings were not made more visually distinct, but
    instead were aligned with other text and printed in the same type size as
    the text that followed. As a result, these headings blended in with the
    text. Furthermore, the consultant noted that because the term "Annual
    Percentage Rates" was given the same visual treatment as the two headings
    in the example, finding headings quickly was made even more difficult. In
    contrast, figure 12 also shows an example that the consultant identified
    in one of the disclosure documents that was an effective use of headings.

    o Presentation techniques. According to the usability consultant, the
    disclosure documents analyzed did not use presentation techniques, such as
    tables, bulleted lists, and graphics, that could help to simplify the
    presentation of complicated concepts, especially in the cardmember
    agreements. Best practices for document design suggest using tables and
    bulleted lists to simplify the presentation of complex information.
    Instead, the usability consultant noted that all the cardmember agreements
    reviewed almost exclusively employed undifferentiated blocks of text,
    potentially hindering clear communication of complex information, such as
    the multiple-step procedures issuers use for calculating a cardholder's
    minimum required payment. Figure 13 below presents two samples of text
    from different cardmember agreements describing how minimum payments are
    calculated. According to the consultant, the sample that used a bulleted
    list was easier to read than the one formatted as a paragraph. Also, an
    issuer stated in a letter to the Federal Reserve that their consumers have
    welcomed the issuer's use of bullets to format information, emphasizing
    the concept that the visual layout of information either facilitates or
    hinders consumer understanding.

    Figure 13: Example of How Presentation Techniques Can Affect Readability
    in Typical Credit Card Disclosure Documents

    Excessive Complexity and Volume of Information

    The content of typical credit card disclosure documents generally was
    overly complex and presented in too much detail, such as by using
    unfamiliar or complex terms to describe simple concepts. For example, the
    usability consultant identified one cardmember agreement that used the
    term "rolling consecutive twelve billing cycle period" instead of saying
    "over the course of the next 12 billing statements" or "next 12 months"-if
    that was appropriate. Further, a number of consumers, consumer advocacy
    groups, and government and private entities that have provided comments to
    the Federal Reserve agreed that typical credit card disclosures are
    written in complex language that hinders consumers' understanding. For
    example, a consumer wrote that disclosure documents were "loaded with
    booby traps designed to trip consumers, and written in intentionally
    impenetrable and confusing language." One of the consumer advocacy groups
    stated the disclosures were "full of dense, impenetrable legal jargon that
    even lawyers and seasoned consumer advocates have difficulty
    understanding." In addition, the consultant noted that many of the
    disclosures, including solicitation letters and cardmember agreements,
    contained overly long and complex sentences that increase the effort a
    reader must devote to understanding the text. Figure 14 contains two
    examples of instances in which the disclosure documents used uncommon
    words and phrases to express simple concepts.

    Figure 14: Examples of How Removing Overly Complex Language Can Improve
    Readability in Typical Credit Card Disclosure Documents

    In addition, the disclosure documents regularly presented too much or
    irrelevant detail. According to the usability consultant's analysis, the
    credit card disclosures often contained superfluous information. For
    example, figure 15 presents an example of text from one cardmember
    agreement that described the actions the issuer would take if its normal
    source for the rate information used to set its variable rates-The Wall
    Street Journal-were to cease publication. Including such an arguably
    unimportant detail lengthens and makes this disclosure more complex.
    According to SEC best practices for creating clear disclosures, disclosure
    documents are more effective when they adhere to the rule that less is
    more. By omitting unnecessary details from disclosure documents, the
    usability consultant indicated that consumers would be more likely to read
    and understand the information they contain.

    Figure 15: Example of Superfluous Detail in Typical Credit Card Disclosure
    Documents

    Consumer Confusion Indicated That Disclosures Were Not Communicating
    Credit Card Cost Information Clearly

    Many of the credit cardholders that were tested and interviewed as part of
    our review exhibited confusion over various fees, practices, and other
    terms that could affect the cost of using their credit cards. To
    understand how well consumers could use typical credit card disclosure
    documents to locate and understand information about card fees and other
    practices, the usability consultant with whom we contracted used a sample
    of cardholders to perform a usability assessment of the disclosure
    documents from the four large issuers. As part of this assessment, the
    consultant conducted one-on-one sessions with a total of 12 cardholders so
    that each set of disclosures, which included a solicitation letter and a
    cardmember agreement, was reviewed by 3 cardholders.51 Each of these
    cardholders were asked to locate information about fee levels and rates,
    the circumstances in which they would be imposed, and information about
    changes in card terms. The consultant also tested the cardholders' ability
    to explain various practices used by the issuer, such as the process for
    determining the amount of the minimum monthly payment, by reading the
    disclosure documents. Although the results of the usability testing cannot
    be used to make generalizations about all cardholders, the consultant
    selected cardholders based on the demographics of the U.S. adult
    population, according to age, education level, and income, to ensure that
    the cardholders tested were representative of the general population. In
    addition, as part of this review, we conducted one-on-one interviews with
    112 cardholders to learn about consumer behavior and knowledge about
    various credit card terms and practices.52 Although we also selected these
    cardholders to reflect the demographics of the U.S. adult population, with
    respect to age, education level, and income, the results of these
    interviews cannot be generalized to the population of all U.S.
    cardholders.53

    Based on the work with consumers, specific aspects of credit card terms
    that apparently were not well understood included:

    o Default interest rates. Although issuers can penalize cardholders for
    violating the terms of the card, such as by making late payments or by
    increasing the interest rates in effect on the cardholder's account to
    rates as high as 30 percent or more, only about half of the cardholders
    that the usability consultant tested were able to use the typical credit
    card disclosure documents to successfully identify the default rate and
    the circumstances that would trigger rate increases for these cards. In
    addition, the usability consultant observed the cardholders could not
    identify this information easily. Many also were unsure of their answers,
    especially when rates were expressed as a "prime plus" number, indicating
    the rate varied based on the prime rate. Locating information in the
    typical cardmember agreement was especially difficult for cardholders, as
    only 3 of 12 cardholders were able to use such documents to identify the
    default interest rate applicable to the card. More importantly, only about
    half of the cardholders tested using solicitation letters were able to
    accurately determine what actions could potentially cause the default rate
    to be imposed on these cards.

    o Other penalty rate increases. Although card issuers generally reserve
    the right to seek to raise a cardholder's rate in other situations, such
    as when a cardholder makes a late payment to another issuer's credit card,
    (even if the cardholder has not defaulted on the cardmember agreement),
    about 71 percent of the 112 cardholders we interviewed were unsure or did
    not believe that issuers could increase their rates in such a case. In
    addition, about two-thirds of cardholders we interviewed were unaware or
    did not believe that a drop in their credit score could cause an issuer to
    seek to assess higher interest rates on their account.54

    o Late payment fees. According to the usability assessment, many of the
    cardholders had trouble using the disclosure documents to correctly
    identify what would occur if a payment were to be received after the due
    date printed in the billing statement. For example, nearly half of the
    cardholders were unable to use the cardmember agreement to determine
    whether a payment would be considered late based on the date the issuer
    receives the payment or the date the payment was mailed or postmarked.
    Additionally, the majority of the 112 cardholders we interviewed also
    exhibited confusion over late fees: 52 percent indicated that they have
    been surprised when their card company applied a fee or penalty to their
    account.

    o Using a credit card to obtain cash. Although the cardholders tested by
    the consultant generally were able to use the disclosures to identify how
    a transaction fee for a cash advance would be calculated, most were unable
    to accurately use this information to determine the transaction fee for
    withdrawing funds, usually because they neglected to consider the minimum
    dollar amount, such as $5 or $10, that would be assessed.

    o Grace periods. Almost all 12 cardholders in the usability assessment had
    trouble using the solicitation letters to locate and define the grace
    period, the period during which the a cardholder is not charged interest
    on a balance. Instead, many cardholders incorrectly indicated that the
    grace period was instead when their lower, promotional interest rates
    would expire. Others incorrectly indicated that it was the amount of time
    after the monthly bill's due date that a cardholder could submit a payment
    without being charged a late fee.

    o Balance computation method. Issuers use various methods to calculate
    interest charges on outstanding balances, but only 1 of the 12 cardholders
    the usability consultant tested correctly described average daily balance,
    and none of the cardholders were able to describe two-cycle average daily
    balance accurately. At least nine letters submitted to the Federal Reserve
    in connection with its review of credit card disclosures noted that few
    consumers understand balance computation methods as stated in disclosure
    documents.

    Perhaps as a result of weaknesses previously described, cardholders
    generally avoid using the documents issuers provide with a new card to
    improve their understanding of fees and practices. For example, many of
    the cardholders interviewed as part of this report noted that the length,
    format, and complexity of disclosures led them to generally disregard the
    information contained in them. More than half (54 percent) of the 112
    cardholders we interviewed indicated they read the disclosures provided
    with a new card either not very closely or not at all. Instead, many
    cardholders said they would call the issuer's customer service
    representatives for information about their card's terms and conditions.
    Cardholders also noted that the ability of issuers to change the terms and
    conditions of a card at any time led them to generally disregard the
    information contained in card disclosures. Regulation Z allows card
    issuers to change the terms of credit cards provided that issuers notify
    cardholders in writing within 15 days of the change. As a result, the
    usability consultant observed some participants were dismissive of the
    information in the disclosure documents because they were aware that
    issuers could change anything.

    Federal Reserve Effort to Revise Regulations Presents Opportunity to
    Improve Disclosures

    With liability concerns and outdated regulatory requirements seemingly
    explaining the weaknesses in card disclosures, the Federal Reserve has
    begun efforts to review its requirements for credit card disclosures.
    Industry participants have advocated various ways in which the Federal
    Reserve can act to improve these disclosures and otherwise assist
    cardholders.

    Regulations and Guidance May Contribute to Weaknesses in Current
    Disclosures

    Several factors may help explain why typical credit card disclosures
    exhibit weaknesses that reduce their usefulness to cardholders. First,
    issuers make decisions about the content and format of their disclosures
    to limit potential legal liability. Issuer representatives told us that
    the disclosures made in credit card solicitations and cardmember
    agreements are written for legal purposes and in language that consumers
    generally could not understand. For example, representatives for one large
    issuer told us they cannot always state information in disclosures clearly
    because the increased potential that simpler statements would be
    misinterpreted would expose them to litigation. Similarly, a participant
    of a symposium on credit card disclosures said that disclosures typically
    became lengthier after the issuance of court rulings on consumer credit
    issues. Issuers can attempt to reduce the risk of civil liability based on
    their disclosures by closely following the formats that the Federal
    Reserve has provided in its model forms and other guidance. According to
    the regulations that govern card disclosures, issuers acting in good faith
    compliance with any interpretation issued by a duly authorized official or
    employee of the Federal Reserve are afforded protection from liability.55

    Second, the regulations governing credit card disclosures have become
    outdated. As noted earlier in this report, TILA and Regulation Z that
    implements the act's provisions are intended to ensure that consumers have
    adequate information about potential costs and other applicable terms and
    conditions to make appropriate choices among competing credit cards. The
    most recent comprehensive revisions to Regulation Z's open-end credit
    rules occurred in 1989 to implement the provisions of the Fair Credit and
    Charge Card Act. As we have found, the features and cost structures of
    credit cards have changed considerably since then. An issuer
    representative told us that current Schumer box requirements are not as
    useful in presenting the more complicated structures of many current
    cards. For example, they noted that it does not easily accommodate
    information about the various cardholder actions that could trigger rate
    increases, which they argued is now important information for consumers to
    know when shopping for credit. As a result, some of the specific
    requirements of Regulation Z that are intended to ensure that consumers
    have accurate information instead may be diminishing the usefulness of
    these disclosures.

    Third, the guidance that the Federal Reserve provides issuers may not be
    consistent with guidelines for producing clear, written documents. Based
    on our analysis, many issuers appear to adhere to the formats and model
    forms that the Federal Reserve staff included in the Official Staff
    Interpretations of Regulation Z, which are prepared to help issuers comply
    with the regulations. For example, the model forms present text about how
    rates are determined in footnotes. However, as discussed previously, not
    grouping related information undermines the usability of documents. The
    Schumer box format requires a cardholder to look in several places, such
    as in multiple rows in the table and in notes to the table, for
    information about related aspects of the card. Similarly, the Federal
    Reserve's model form for the Schumer box recommends that the information
    about the transaction fee and interest rate for cash advances be disclosed
    in different areas.

    Finally, the way that issuers have implemented regulatory guidance may
    have contributed to the weaknesses typical disclosure materials exhibited.
    For example, in certain required disclosures, the terms "annual percentage
    rate" and "finance charge," when used with a corresponding amount or
    percentage rate, are required to be more conspicuous than any other
    required disclosures.56 Staff guidance suggests that such terms may be
    made more conspicuous by, for example, capitalizing these terms when other
    disclosures are printed in lower case or by displaying these terms in
    larger type relative to other disclosures, putting them in boldface print
    or underlining them.57 Our usability consultant's analysis found that card
    disclosure documents that followed this guidance were less effective
    because they placed an inappropriate emphasis on terms. As shown
    previously in figure 11, the use of bold and capital letters to emphasize
    the term "finance charge" in the paragraph unnecessarily calls attention
    to that term, potentially distracting readers from information that is
    more important. The excerpt shown in figure 11 is from an initial
    disclosure document which, according to Regulation Z, is subject to the
    "more conspicuous" rule requiring emphasis of the terms "finance charge"
    and "annual percentage rate."

    Suggestions for Improving Disclosures Included Obtaining Input from
    Consumers

    With the intention of improving credit card disclosures, the Federal
    Reserve has begun efforts to develop new regulations. According to its
    2004 notice seeking public comments on Regulation Z, the Federal Reserve
    hopes to address the length, complexity, and superfluous information of
    disclosures and produce new disclosures that will be more useful in
    helping consumers compare credit products.58 After the passage of the
    Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
    (Bankruptcy Act) in October of that year, which included amendments to
    TILA, the Federal Reserve sought additional comments from the public to
    prepare to implement new disclosure requirements including disclosures
    intended to advise consumers of the consequences of making only minimum
    payments on credit cards.59 According to Federal Reserve staff, new credit
    card disclosure regulations may not be in effect until sometime in 2007 or
    2008 because of the time required to conduct consumer testing, modify the
    existing regulations, and then seek comment on the revised regulation.

    Industry participants and others have provided input to assist the Federal
    Reserve in this effort. Based on the interviews we conducted, documents we
    reviewed, and our analysis of the more than 280 comment letters submitted
    to the Federal Reserve, issuers, consumer groups, and others provided
    various suggestions to improve the content and format of credit card
    disclosures, including:

    o Reduce the amount of information disclosed. Some industry participants
    said that some of the information currently presented in the Schumer box
    could be removed because it is too complicated to disclose meaningfully or
    otherwise lacks importance compared to other credit terms that are
    arguably more important when choosing among cards. Such information
    included the method for computing balances and the amount of the minimum
    finance charge (the latter because it is typically so small, about 50
    cents in 2005).

    o Provide a shorter document that summarizes key information. Some
    industry participants advocated that all key information that could
    significantly affect a cardholder's costs be presented in a short document
    that consumers could use to readily compare across cards, with all other
    details included in a longer document. For example, although the Schumer
    box includes several key pieces of information, it does not include other
    information that could be as important for consumer decisions, such as
    what actions could cause the issuer to raise the interest rate to the
    default rate.

    o Revise disclosure formats to improve readability. Various suggestions
    were made to improve the readability of card disclosures, including making
    more use of tables of contents, making labels and headings more prominent,
    and presenting more information in tables instead of in text. Disclosure
    documents also could use consistent wording that could allow for better
    comparison of terms across cards.

    Some issuers and others also told us that the new regulations should allow
    for more flexibility in card disclosure formats. Regulations mandating
    formats and font sizes were seen as precluding issuers from presenting
    information in more effective ways. For example, one issuer already has
    conducted market research and developed new formats for the Schumer box
    that it says are more readable and contain new information important to
    choosing cards in today's credit card environment, such as cardholder
    actions that would trigger late fees or penalty interest rate increases.

    In addition to suggestions about content, obtaining the input of
    consumers, and possibly other professionals, was also seen as an important
    way to make any new disclosures more useful. For example, participants in
    a Federal Reserve Bank symposium on credit card disclosures recommended
    that the Federal Reserve obtain the input of marketers, researchers, and
    consumers as part of developing new disclosures. OCC staff suggested that
    the Federal Reserve also employ qualitative research methods such as
    in-depth interviews with consumers and others and that it conduct
    usability testing.

    Consumer testing can validate the effectiveness or measure the
    comprehension of messages and information, and detect document design
    problems. Many issuers are using some form of market research to test
    their disclosure materials and have advocated improving disclosures by
    seeking the input of marketers, researchers, and consumers.60 SEC also has
    recently used consumer focus groups to test the format of new disclosures
    related to mutual funds. According to an SEC staff member who participated
    in this effort, their testing provided them with valuable information on
    what consumers liked and disliked about some of the initial forms that the
    regulator had drafted. In some cases, they learned that information that
    SEC staff had considered necessary to include was not seen as important by
    consumers. As a result, they revised the formats for these disclosures
    substantially to make them simpler and may use graphics to present more
    information rather than text.61 According to Federal Reserve staff, they
    have begun to involve consumers in the development of new credit card
    disclosures. According to Federal Reserve staff, they have already
    conducted some consumer focus groups. In addition, they have contracted
    with a design consultant and a market research firm to help them develop
    some disclosure formats that they can then use in one-on-one testing with
    consumers. However, the Federal Reserve staff told us they recognize the
    challenge of designing disclosures that include all key information in a
    clear manner, given the complexity of credit card products and the
    different ways in which consumers use credit cards.

    Although Credit Card Penalty Fees and Interest Could Increase
    Indebtedness, the Extent to Which They Have Contributed to Bankruptcies
    Was Unclear

    The number of consumers filing for bankruptcy has risen more than six-fold
    over the past 25 years, and various factors have been cited as possible
    explanations. While some researchers have pointed to increases in total
    debt or credit card debt in particular, others found that debt burdens and
    other measures of financial distress had not increased and thus cite other
    factors, such as a general decline in the stigma of going bankrupt or the
    potentially increased costs of major life events such as health problems
    or divorce. Some critics of the credit card industry have cited penalty
    interest and fees as leading to increased financial distress; however, no
    comprehensive data existed to determine the extent to which these charges
    were contributing to consumer bankruptcies. Data provided by the six
    largest card issuers indicated that unpaid interest and fees represented a
    small portion of the amounts owed by cardholders that filed for
    bankruptcy; however, these data alone were not sufficient to determine any
    relationship between the charges and bankruptcies filed by cardholders.

    Researchers Cited Various Factors as Explanations for Rise in Consumer
    Bankruptcies

    According to U.S. Department of Justice statistics, consumer bankruptcy
    filings generally rose steadily from about 287,000 in 1980 to more than 2
    million as of December 31, 2005, which represents about a 609 percent

    increase over the last 25 years.62 Researchers have cited a number of
    factors as possible explanations for the long-term trend.

    Increase in Household Indebtedness

    The total debt of American households is composed of mortgages on real
    estate, which accounts for about 80 percent of the total, and consumer
    credit debt, which includes revolving credit, such as balances owed on
    credit cards, and nonrevolving credit, primarily consisting of auto loans.
    According to Federal Reserve statistics, consumers' use of debt has
    expanded over the last 25 years, increasing more than sevenfold from $1.4
    trillion in 1980 to about $11.5 trillion in 2005. Some researchers pointed
    to this rise in overall indebtedness as contributing to the rise in
    bankruptcies. For example, a 2000 Congressional Budget Office summary of
    bankruptcy research noted that various academic studies have argued that
    consumer bankruptcies are either directly or indirectly caused by heavy
    consumer indebtedness.

    Rather than total debt, some researchers and others argue that the rise in
    bankruptcies is related to the rise in credit card debt in particular.
    According to the Federal Reserve's survey of consumer debt, the amount of
    credit card debt reported as outstanding rose from about $237 billion to
    more than $802 billion-a 238 percent increase between 1990 and 2005.63 One
    academic researcher noted that the rise in bankruptcies and charge-offs by
    banks in credit card accounts grew along with the increase in credit card
    debt during the 1973 to 1996 period he examined.64 According to some
    consumer groups, the growth of credit card debt is one of the primary
    explanations of the increased prevalence of bankruptcies in the United
    States. For example, one group noted in a 2005 testimony before Congress
    that growth of credit card debt-particularly among lower and moderate
    income households, consumers with poor credit scores, college students,
    older Americans, and minorities-was contributing to the rise in
    bankruptcies.65

    However, other evidence indicates that increased indebtedness has not
    severely affected the financial condition of U.S. households in general.
    For example:

    o Some researchers note that the ability of households to make payments on
    debt appears to be keeping pace. For example, total household debt levels
    as a percentage of income has remained relatively constant since the
    1980s. According to the Federal Reserve, the aggregate debt burden
    ratio-which covers monthly aggregate required payments of all households
    on mortgage debt and both revolving and non-revolving consumer loans
    relative to the aggregate monthly disposable income of all households-for
    U.S. households has been above 13 percent in the last few years but
    generally fluctuated between 11 percent and 14 percent from 1990 to 2005,
    similar to the levels observed during the 1980s. According to one
    researcher, although the debt burden ratio has risen since the 1980s, the
    increase has been gradual and therefore cannot explain the six-fold
    increase in consumer bankruptcy filings over the same period.

    o Credit card debt remains a small portion of overall household debt, even
    among households with the lowest income levels. According to the Federal
    Reserve, credit card balances as a percentage of total household debt have
    declined from 3.9 percent of total household debt in 1995 to just 3.0
    percent as of 2004.

    o The proportion of households that could be considered to be in financial
    distress does not appear to be increasing significantly. According to the
    Federal Reserve Board's Survey of Consumer Finances, the proportion of
    households that could be considered to be in financial distress-those that
    report debt-to-income ratios exceeding 40 percent and that have had at
    least one delinquent payment within the last 60 days-was relatively stable
    between 1995 and 2004. Further, the proportion of the lowest-income
    households exhibiting greater levels of distress was lower in 2004 than it
    was in the 1990s.

    Other Explanations

    With the effect of increased debt unclear, some researchers say that other
    factors may better explain the surge in consumer bankruptcy filings over
    the past 25 years. For example, the psychological stigma of declaring
    bankruptcy may have lessened. One academic study examined a range of
    variables that measured the credit risk (risk of default) of several
    hundred thousand credit card accounts and found that because the
    bankruptcy rate for the accounts was higher than the credit-risk variables
    could explain, the higher rate must be the result of a reduced level of
    stigma associated with filing.66 However, others have noted that reliably
    measuring stigma is difficult. Some credit card issuers and other industry
    associations also have argued that the pre-2005 bankruptcy code was too
    debtor-friendly and created an incentive for consumers to borrow beyond
    the ability to repay and file for bankruptcy.

    In addition to the possibly reduced stigma, some academics, consumer
    advocacy groups, and others noted that the normal life events that reduce
    incomes or increase expenses for households may have a more serious effect
    today. Events that can reduce household incomes include job losses, pay
    cuts, or having a full-time position converted to part-time work. With
    increasing health care costs, medical emergencies can affect household
    expenses and debts more significantly than in the past, and, with more
    families relying on two incomes, so can divorces. As a result, one
    researcher explains that while these risks have always faced households,
    their effect today may be more severe, which could explain higher
    bankruptcy rates.67

    Researchers who assert that life events are the primary explanation for
    bankruptcy filings say that the role played by credit cards can vary. They
    acknowledged that credit card debt can be a contributing factor to a
    bankruptcy filing if a person's income is insufficient to meet all
    financial obligations, including payments to credit card issuers. For
    example, some individuals experiencing an adverse life event use credit
    cards to provide additional funds to satisfy their financial obligations
    temporarily but ultimately exhaust their ability to meet all obligations.
    However, because the number of people that experience financially
    troublesome life events likely exceeds the number of people who file for
    bankruptcy, credit cards in other cases may serve as a critical temporary
    source of funding they needed to avert a filing until that person's income
    recovers or expenses diminish. (Appendix II provides additional detail
    about the factors that may have affected the rise in consumer bankruptcy
    filings and its relationship with credit card debt.)

    The Extent to Which Credit Card Penalty Interest and Fees Contribute to
    Consumer Bankruptcies Remains Controversial in the Absence of
    Comprehensive Data

    With very little information available on the financial condition of
    individuals filing for bankruptcy, assessing the role played by credit
    card debt, including penalty interest and fees, is difficult. According to
    Department of Justice officials who oversee bankruptcy trustees in most
    bankruptcy courts, the documents submitted as part of a bankruptcy filing
    show the total debt owed to each card issuer but not how much of this
    total consists of unpaid principal, interest, or fees. Similarly, these
    Justice officials told us that the information that credit card issuers
    submit when their customers reaffirm the debts owed to them-known as
    proofs of claim-also indicate only the total amount owed. Likewise, the
    amount of any penalty interest or fees owed as part of an outstanding
    credit card balance is generally not required to be specified when a
    credit card issuer seeks to obtain a court judgment that would require
    payment from a customer as part of a collection case.

    Opinions on the Link between Credit Card Practices and Bankruptcies Vary

    Although little comprehensive data exist, some consumer groups and others
    have argued that penalty interest and fees materially harm the financial
    condition of some cardholders, including those that later file for
    bankruptcy. Some researchers who study credit card issues argue that high
    interest rates (applicable to standard purchases) for higher risk
    cardholders, who are also frequently lower-income households, along with
    penalty and default interest rates and fees, contribute to more consumer
    bankruptcy filings. Another researcher who has studied issues relating to
    credit cards and bankruptcy asserted that consumers focus too much on the
    introductory purchase interest rates when shopping for credit cards and,
    as a result, fail to pay close attention to penalty interest rates,
    default clauses, and other fees that may significantly increase their
    costs later. According to this researcher, it is doubtful that penalty
    fees (such as late fees and over-limit fees) significantly affect
    cardholders' debt levels, but accrued interest charges-particularly if a
    cardholder is being assessed a high penalty interest rate-can
    significantly worsen a cardholder's financial distress.

    Some consumer advocacy groups and academics say that the credit card
    industry practice of raising cardholder interest rates for default or
    increased risky behavior likely has contributed to some consumer
    bankruptcy filings. According to these groups, cardholders whose rates are
    raised under such practices can find it more difficult to reduce their
    credit card debt and experience more rapid declines in their overall
    financial conditions as they struggle to make the higher payments that
    such interest rates may entail. As noted earlier in this report, card
    issuers have generally ceased practicing universal default, although
    representatives for four of the six issuers told us that they might
    increase their cardholder's rates if they saw indications that the
    cardholder's risk has increased, such as how well they were making
    payments to other creditors. In such cases, the card issuers said they
    notify the cardholders in advance, by sending a change in terms notice,
    and provide an option to cancel the account but keep the original terms
    and conditions while paying off the balance.

    Some organizations also have criticized the credit card industry for
    targeting lower-income households that they believe may be more likely to
    experience financial distress or file for bankruptcy. One of the
    criticisms these organizations have made is that credit card companies
    have been engaging in bottom-fishing by providing increasing amounts of
    credit to riskier lower-income households that, as a result, may incur
    greater levels of indebtedness than appropriate. For example, an official
    from one consumer advocacy group testified in 2005 that card issuers
    target lower-income and minority households and that this democratization
    of credit has had serious negative consequences for these households,
    placing them one financial emergency away from having to file for
    bankruptcy.68 Some consumer advocacy group officials and academics noted
    that card issuers market high-cost cards, with higher interest rates and
    fees, to customers with poor credit histories-called subprime
    customers-including some just coming out of bankruptcy. However, as noted
    earlier, Federal Reserve survey data indicate that the proportion of
    lower-income households-those with incomes below the fortieth
    percentile-exhibiting financial distress has not increased since 1995. In
    addition, in a June 2006 report that the Federal Reserve Board prepared
    for Congress on the relationship between credit cards and bankruptcy, it
    stated that credit card issuers do not solicit customers or extend credit
    to them indiscriminately or without assessing their ability to repay debt
    as issuers review all received applications for risk factors.69

    In addition, representatives of credit card issuers argued that they do
    not offer credit to those likely to become financially bankrupt because
    they do not want to experience larger losses from higher-risk borrowers.
    Because card accounts belonging to cardholders that filed for bankruptcy
    account for a sizeable portion of issuers' charge-offs, card issuers do
    not want to acquire new customers with high credit risk who may
    subsequently file for bankruptcy. However, one academic researcher noted
    that, if card issuers could increase their revenue and profits by offering
    cards to more customers, including those with lower creditworthiness, they
    could reasonably be expected to do so until the amount of expected losses
    from bankruptcies becomes larger than the expected additional revenues
    from the new customers.

    In examining the relationship between the consumer credit industry and
    bankruptcy, the Federal Reserve Board's 2006 report comes to many of the
    same conclusions as the studies of other researchers we reviewed. The
    Federal Reserve Board's report notes that despite large growth in the
    proportion of households with credit cards and the rise in overall credit
    card debt in recent decades, the debt-burden ratio and other potential
    measures of financial distress have not significantly changed over this
    period. The report also found that, while data on bankruptcy filings
    indicate that most filers have accumulated consumer debt and the
    proportion of filings and rise in revolving consumer debt have risen in
    tandem, the decision to file for bankruptcy is complex and tends to be
    driven by distress arising from life events such as job loss, divorce, or
    uninsured illness.

    Penalty Interest and Fees Can Affect Cardholders' Ability to Reduce
    Outstanding Balances

    While the effect of credit card penalty interest charges and fees on
    consumer bankruptcies was unclear, such charges do reduce the ability of
    cardholders to reduce their overall indebtedness. Generally, any penalty
    charges that cardholders pay would consume funds that could have been used
    to repay principal. Figure 16 below, compares two hypothetical cardholders
    with identical initial outstanding balances of $2,000 that each make
    monthly payments of $100. The figure shows how the total amounts of
    principal are paid down by each of these two cardholders over the course
    of 12 months, if penalty interest and fees apply. Specifically, cardholder
    A (1) is assessed a late payment fee in three of those months and (2) has
    his interest rate increased to a penalty rate of 29 percent after 6
    months, while cardholder B does not experience any fees or penalty
    interest charges. At the end of 12 months, the penalty and fees results in
    cardholder A paying down $260 or 27 percent less of the total balance owed
    than does cardholder B who makes on-time payments for the entire period.

    Figure 16: Hypothetical Impact of Penalty Interest and Fee Charges on Two
    Cardholders

    In Some Court Cases, Cardholders Paid Significant Amounts of Penalty
    Interest and Fees

    In reviewing academic literature, hearings, and comment letters to the
    Federal Reserve, we identified some court cases, including some involving
    the top six issuers, that indicated that cardholders paid large amounts of
    penalty interest and fees. For example:

    o In a collections case in Ohio, the $1,963 balance on one cardholder's
    credit card grew by 183 percent to $5,564 over 6 years, despite the
    cardholder making few new purchases. According to the court's records,
    although the cardholder made payments totaling $3,492 over this period,
    the holder's balance grew as the result of fees and interest charges.
    According to the court's determinations, between 1997 and 2003, the
    cardholder was assessed a total of $9,056, including $1,518 in over-limit
    fees, $1,160 in late fees, $369 in credit insurance, and $6,009 in
    interest charges and other fees. Although the card issuer had sued to
    collect, the judge rejected the issuer's collection demand, noting that
    the cardholder was the victim of unreasonable, unconscionable practices.70

    o In a June 2004 bankruptcy case filed in the U.S. Bankruptcy Court for
    the Eastern District of Virginia, the debtor objected to the proofs of
    claim filed by two companies that had been assigned the debt outstanding
    on two of the debtor's credit cards. One of the assignees submitted
    monthly statements for the credit card account it had assumed. The court
    noted that over a two-year period (during which balance on the account
    increased from $4,888 to $5,499), the debtor made only $236 in purchases
    on the account, while making $3,058 in payments, all of which had gone to
    pay finance charges, late charges, over-limit fees, bad check fees and
    phone payment fees.71

    o In a bankruptcy court case  filed in July 2003 in North Carolina, 18
    debtors filed objections to the claims by one card issuer of the amounts
    owed on their credit cards.72 In response to an inquiry by the judge, the
    card issuer provided data for these accounts that showed that, in the
    aggregate, 57 percent of the amounts owed by these 18 accounts at time of
    their bankruptcy filings represented interest charges and fees. However,
    the high percentage of interest and fees on these accounts may stem from
    the size of these principal balances, as some were as low as $95 and none
    was larger than $1,200.

    Regulatory interagency guidance published in 2003 for all depository
    institutions that issue credit cards may have reduced the potential for
    cardholders who continue to make minimum payments to experience increasing
    balances.73 In this guidance, regulators suggested that card issuers
    require minimum repayment amounts so that cardholders' current balance
    would be paid off-amortized-over a reasonable amount of time. In the past,
    some issuers' minimum monthly payment formulas were such that a full
    payment may have resulted in little or no principal being paid down,
    particularly if the cardholder also was assessed any fees during a billing
    cycle. In such cases, these cardholders' outstanding balances would
    increase (or negatively amortize). In response to this guidance, some card
    issuers we interviewed indicated that they have been changing their
    minimum monthly payment formulas to ensure that credit card balances will
    be paid off over a reasonable period by including at least some amount of
    principal in each payment due.

    Representatives of card issuers also told us that the regulatory guidance,
    issued in 2003, addressing credit card workout programs-which allow a
    distressed cardholder's account to be closed and repaid on a fixed
    repayment schedule-and other forbearance practices, may help cardholders
    experiencing financial distress avoid fees. In this guidance, the
    regulators stated that (1) any workout program offered by an issuer should
    be designed to have cardholders repay credit card debt within 60 months
    and (2) to meet this time frame, interest rates and penalty fees may have
    to be substantially reduced or eliminated so that principal can be repaid.
    As a result, card issuers are expected to stop imposing penalty fees and
    interest charges on delinquent card accounts or hardship card accounts
    enrolled in repayment workout programs. According to this guidance,
    issuers also can negotiate settlement agreements with cardholders by
    forgiving a portion of the amount owed. In exchange, a cardholder can be
    expected to pay the remaining balance either in a lump-sum payment or by
    amortizing the balance over a several month period. Staff from OCC and an
    association of credit counselors told us that, since the issuance of this
    guidance, they have noticed that card issuers are increasingly both
    reducing and waiving fees for cardholders who get into financial
    difficulty. OCC officials also indicated that issuers prefer to facilitate
    repayment of principal when borrowers adopt debt management plans and tend
    to reduce or waive fees so the accounts can be amortized. On the other
    hand, FDIC staff indicated that criteria for waiving fees and penalties
    are not publicly disclosed to cardholders. These staff noted that most fee
    waivers occurs after cardholders call and complain to the issuer and are
    handled on a case-by-case basis.

    Data for Some Bankrupt Cardholders Shows Little in Interest and Fees Owed,
    but Comprehensive Data Were Not Available

    Card issuers generally charge-off credit card loans that are no longer
    collectible because they are in default for either missing a series of
    payments or filing for bankruptcy. According to the data provided by the
    six largest issuers, the number of accounts that these issuers
    collectively had to charge off as a result of the cardholders filing for
    bankruptcy ranged from about 1.3 million to 1.6 million annually between
    2003 and 2005. Collectively, these represented about 1 percent of the six
    issuers' active accounts during this period. Also, about 60 percent of the
    accounts were 2 or more months delinquent at the time of the charge-off.
    Most of the cardholders whose accounts were charged off as the result of a
    bankruptcy owed small amounts of fees and interest charges at the time of
    their bankruptcy filing. According to the data the six issuers provided,
    the average account that they charged off in 2005 owed approximately
    $6,200 at the time that bankruptcy was filed. Of this amount, the issuers
    reported that on average 8 percent represented unpaid interest charges; 2
    percent unpaid fees, including any unpaid penalty charges; and about 90
    percent principal.

    However, these data do not provide complete information about the extent
    to which the financial condition of the cardholders may have been affected
    by penalty interest and fee charges. First, the amounts that these issuers
    reported to us as interest and fees due represent only the unpaid amounts
    that were owed at the time of bankruptcy. According to representatives of
    the issuers we contacted, each of their firms allocates the amount of any
    payment received from their customers first to any outstanding interest
    charges and fees, then allocates any remainder to the principal balance.
    As a result, the amounts owed at the time of bankruptcy would not reflect
    any previously paid fees or interest charges. According to representatives
    of these issuers, data system and recordkeeping limitations prevented them
    from providing us the amounts of penalty interest and fees assessed on
    these accounts in the months prior to the bankruptcy filings.

    Furthermore, the data do not include information on all of the issuers'
    cardholders who went bankrupt, but only those whose accounts the issuers
    charged off as the result of a bankruptcy filing. The issuers also charge
    off the amounts owed by customers who are delinquent on their payments by
    more than 180 days, and some of those cardholders may subsequently file
    for bankruptcy. Such accounts may have accrued larger amounts of unpaid
    penalty interest and fees than the accounts that were charged off for
    bankruptcy after being delinquent for less than 180 days, because they
    would have had more time to be assessed such charges. Representatives of
    the six issuers told us that they do not maintain records on these
    customers after they are charged off, and, in many cases, they sell the
    accounts to collection firms.

    Although Penalty Interest and Fees Likely Have Grown as a Share of Credit
    Card Revenues, Large Card Issuers' Profitability Has Been Stable

    Determining the extent to which penalty interest charges and fees
    contribute to issuers' revenues and profits was difficult because issuers'
    regulatory filings and other public sources do not include such detail.
    According to bank regulators, industry analysts, and information reported
    by the five largest issuers, we estimate that the majority of issuer
    revenues-around 70 percent in recent years-came from interest charges, and
    the portion attributable to penalty rates appears to be growing. Of the
    remaining issuer revenues, penalty fees had increased and were estimated
    to represent around 10 percent of total issuer revenues. The remainder of
    issuer revenues came from fees that issuers receive for processing
    merchants' card transactions and other types of consumer fees. The largest
    credit card-issuing banks, which are generally the most profitable group
    of lenders, have not greatly increased their profitability over the last
    20 years.

    Publicly Disclosed Data on Revenues and Profits from Penalty Interest and
    Fees Are Limited

    Determining the extent to which penalty interest and fee charges are
    contributing to card issuer revenues and profits is difficult because
    limited information is available from publicly disclosed financial
    information. Credit card-issuing banks are subject to various regulations
    that require them to publicly disclose information about their revenues
    and expenses. As insured commercial banks, these institutions must file
    reports of their financial condition, known as call reports, each quarter
    with their respective federal regulatory agency. In call reports, the
    banks provide comprehensive balance sheets and income statements
    disclosing their earnings, including those from their credit card
    operations. Although the call reports include separate lines for interest
    income earned, this amount is not further segregated to show, for example,
    income from the application of penalty interest rates. Similarly, banks
    report their fee income on the call reports, but this amount includes
    income from all types of fees, including those related to fiduciary
    activities, and trading assets and liabilities and is not further
    segregated to show how much a particular bank has earned from credit card
    late fees, over-limit fees, or insufficient payment fees.

    Another limitation of using call reports to assess the effect of penalty
    charges on bank revenues is that these reports do not include detailed
    information on credit card balances that a bank may have sold to other
    investors through a securitization. As a way of raising additional funds
    to lend to cardholders, many issuers combine the balances owed on large
    groups of their accounts and sell these receivables as part of pools of
    securitized assets to investors. In their call reports, the banks do not
    report revenue received from cardholders whose balances have been sold
    into credit card interest and fee income categories.74 The banks report
    any gains or losses incurred from the sale of these pooled credit card
    balances on their call reports as part of noninterest income. Credit card
    issuing banks generally securitize more than 50 percent of their credit
    card balances.

    Although many card issuers, including most of the top 10 banks, are public
    companies that must file various publicly available financial disclosures
    on an ongoing basis with securities regulators, these filings also do not
    disclose detailed information about penalty interest and fees. We reviewed
    the public filings by the top five issuers and found that none of the
    financial statements disaggregated interest income into standard interest
    and penalty interest charges. In addition, we found that the five banks'
    public financial statements also had not disaggregated their fee income
    into penalty fees, service fees, and interchange fees. Instead, most of
    these card issuers disaggregated their sources of revenue into two broad
    categories-interest and noninterest income.

    Majority of Card Issuer Revenues Came from Interest Charges

    Although limited information is publicly disclosed, the majority of credit
    card revenue appears to have come from interest charges. According to
    regulators, information collected by firms that analyze the credit card
    industry, and data reported to us by the five of the six largest issuers,
    the proportion of net interest revenues to card issuers' total revenues is
    as much as 71 percent. For example, five of the six largest issuers that
    provided data to us reported that the proportion of their total U.S. card
    operations income derived from interest charges ranged from 69 to 71
    percent between 2003 and 2005.75

    Figure 17: Example of a Typical Bank's Income Statement

    We could not precisely determine the extent to which penalty interest
    charges contribute to this revenue, although the amount of penalty
    interest that issuers have been assessing has increased. In response to
    our request, the six largest issuers reported the proportions of their
    total cardholder accounts that were assessed various rates of interest for
    2003 to 2005. On the basis of our analysis of the popular cards issued by
    these largest issuers, all were charging, on average, default interest
    rates of around 27 percent. According to the data these issuers provided,
    the majority of cardholders paid interest rates below 20 percent, but the
    proportion of their cardholders that paid interest rates at or above 25
    percent-which likely represent default rates-has risen from 5 percent in
    2003 to 11 percent in 2005. As shown in Figure 18, the proportion of
    cardholders paying between 15 and 20 percent has also increased, but an
    issuer representative told us that this likely was due to variable
    interest rates on cards rising as a result of increases in U.S. market
    interest rates over the last 3 years.

    Figure 18: Proportion of Active Accounts of the Six Largest Card Issuers
    with Various Interest Rates for Purchases, 2003 to 2005

    Although we could not determine the amounts of penalty interest the card
    issuers received, the increasing proportion of accounts assessed rates of
    25 percent suggests a significant increase in interest revenues. For
    example, a cardholder carrying a stable balance of $1,000 and paying 10
    percent interest would pay approximately $100 annually, while a cardholder
    carrying the same stable balance but paying 25 percent would pay $250 to
    the card issuer annually. Although we did not obtain any information on
    the size of balances owed by the cardholders of the largest issuers, the
    proportion of the revenues these issuers received from cardholders paying
    penalty interest rates may also be greater than 11 percent because such
    cardholders may have balances larger than the $2,500 average for 2005 that
    the issuers reported to us.

    Fees Represented the Remainder of Issuer Revenues

    The remaining card issuer revenues largely come from noninterest sources,
    including merchant and consumer fees. Among these are penalty fees and
    other consumer fees, as well as fees that issuers receive as part of
    processing card transactions for merchants.

    Penalty Fees Had Increased

    Although no comprehensive data exist publicly, various sources we
    identified indicated that penalty fees represent around 10 percent of
    issuers' total revenues and had generally increased. We identified various
    sources that gave estimates of penalty fee income as a percentage of card
    issuers' total revenues that ranged from 9 to 13 percent:

    o Analysis of the data the top six issuers provided to us indicated that
    each of these issuers assessed an average of about $1.2 billion in penalty
    fees for cardholders that made late payments or exceeded their credit
    limit in 2005. In total, these six issuers reported assessing $7.4 billion
    for these two penalty fees that year, about 12 percent of the $60.3
    billion in total interest and consumer fees (penalty fees and fees for
    other cardholder services).76

    o According to a private firm that assists credit card banks with buying
    and selling portfolios of credit card balance receivables, penalty fees
    likely represented about 13 percent of total card issuer revenues.
    According to an official with this firm, it calculated this estimate by
    using information from 15 of the top 20 issuers, as well as many smaller
    banks, that together represent up to 80 percent of the total credit card
    industry.77

    o An estimate from an industry research firm that publishes data on credit
    card issuer activities indicated that penalty fees represented about 9
    percent of issuer total revenues.

    Issuers Also Collect Revenues from Processing Merchant Card Transactions

    When a consumer makes a purchase with a credit card, the merchant selling
    the goods does not receive the full purchase price. When the cardholder
    presents the credit card to make a purchase, the merchant transmits the
    cardholder's account number and the amount of the transaction to the
    merchant's bank.78 The merchant's bank forwards this information to the
    card association, such as Visa or Mastercard, requesting authorization for
    the transaction. The card association forwards the authorization request
    to the bank that issued the card to the cardholder. The issuing bank then
    responds with its authorization or denial to the merchant's bank and then
    to the merchant. After the transaction is approved, the issuing bank will
    send the purchase amount, less an interchange fee, to the merchant's bank.
    The interchange fee is established by the card association. Before
    crediting the merchant's account, the merchant's bank will subtract a
    servicing fee. These transaction fees-called interchange fees-are commonly
    about 2 percent of the total purchase price. As shown in figure 19, the
    issuing banks generally earn about $2.00 for every $100 purchased as
    interchange fee revenue. In addition, the card association receives a
    transaction processing fee. The card associations, such as Visa or
    Mastercard, assess the amount of these fees and also conduct other
    important activities, including imposing rules for issuing cards,
    authorizing, clearing and settling transactions, advertising and promoting
    the network brand, and allocating revenues among the merchants, merchant's
    bank, and card issuer.

    Figure 19: Example of a Typical Credit Card Purchase Transaction Showing
    How Interchange Fees Paid by Merchants Are Allocated

    In addition to penalty fees and interchange fees, the remaining
    noninterest revenues for card issuers include other consumer fees or other
    fees. Card issuers collect annual fees, cash advance fees, balance
    transfer fees, and other fees from their cardholders. In addition, card
    issuers collect other revenues, such as from credit insurance. According
    to estimates by industry analyst firms, such revenues likely represented
    about 8 to 9 percent of total issuer revenues.

    Large Credit Card Issuer Profitability Has Been Stable

    The profits of credit card-issuing banks, which are generally the most
    profitable group of lenders, have been stable over the last 7 years. A
    commonly used indicator of profitability is the return on assets ratio
    (ROA). This ratio, which is calculated by dividing a company's income by
    its total assets, shows how effectively a business uses its assets to
    generate profits. In annual reports to Congress, the Federal Reserve
    provides data on the profitability of larger credit card issuers-which
    included 17 banks in 2004.79 Figure 20 shows the average ROA using pretax
    income for these large credit card issuers compared with pretax ROA of all
    commercial banks during the period 1986 to 2004. In general, the large
    credit card issuers earned an average return of 3.12 percent over this
    period, which was more than twice as much as the 1.49 percent average
    returns earned by all commercial banks.

    Figure 20: Average Pretax Return on Assets for Large Credit Card Banks and
    All Commercial Banks, 1986 to 2004

    As shown in the figure above, the ROA for larger credit card banks,
    although fluctuating more widely during the 1990s, has generally been
    stable since 1999, with returns in the 3.0 to 3.5 percent range. The
    return on assets for the large card issuers peaked in 1993 at 4.1 percent
    and has declined to 3.55 percent in 2004. In contrast, the profitability
    of all commercial banks has been generally increasing over this period,
    rising more than 140 percent between 1986 and 2004. Similar to the data
    for all larger credit card issuers, data that five of the six largest
    issuers provided to us indicated that their profitability also has been
    stable in the 3 years between 2003 and 2005. These five issuers reported
    that the return on their pretax earnings over their credit card balances
    over this 3-year period ranged from about 3.6 percent to 4.1 percent.

    Because of the high interest rates that issuers charge and variable rate
    pricing, credit card lending generally is the most profitable type of
    consumer lending, despite the higher rate of loan losses that issuers
    incur on cards. Rates charged on credit cards generally are the highest of
    any consumer lending category because they are extensions of credit that
    are not secured by any collateral from the borrower. In contrast, other
    common types of consumer lending, such as automobile loans or home
    mortgages, involve the extension of a fixed amount of credit under fixed
    terms of repayment that are secured by the underlying asset-the car or the
    house-which the lender can repossess in the event of nonpayment by the
    borrower. Collateral and fixed repayment terms reduce the risk of loss to
    the lender, enabling them to charge lower interest rates on such loans. In
    contrast, credit card loans, which are unsecured, available to large and
    heterogeneous populations, and repayable on flexible terms at the
    cardholders' convenience, present greater risks and have commensurately
    higher interest rates. For example, according to Federal Reserve
    statistics, the interest rate charged on cards by lenders generally has
    averaged above 16 percent since 1980, while the average rate charged on
    car loans since then has averaged around 10 percent. Borrowers may be more
    likely to cease making payments on their credit cards if they become
    financially distressed than they would on other loans that are secured by
    an asset they could lose. For example, the percentage of credit card loans
    that banks have had to charge off averaged above 4 percent between 2003
    and 2005; in contrast, charge-offs for other types of consumer loans
    average about 2 percent, with charge-offs for mortgage loans averaging
    less than 1 percent, during those 3 years. (App. III provides additional
    detail about the factors that affect the profitability of credit card
    issuers.)

    Conclusions

    Credit cards provide various benefits to their cardholders, including
    serving as a convenient way to pay for goods and services and providing
    additional funds at rates of interest generally lower than those consumers
    would have paid to borrow on cards in the past. However, the penalties for
    late payments or other behaviors involving card use have risen
    significantly in recent years. Card issuers note that their use of
    risk-based pricing structures with multiple interest rates and fees has
    allowed them to offer credit cards to cardholders at costs that are
    commensurate with the risks presented by different types of customers,
    including those who previously might not have been able to obtain credit
    cards. On the whole, a large number of cardholders experience greater
    benefits-either by using their cards for transactions without incurring
    any direct expense or by enjoying generally lower costs for borrowing than
    prevailed in the past-from using credit cards than was previously
    possible, but the habits or financial circumstances of other cardholders
    also could result in these consumers facing greater costs than they did in
    the past.

    The expansion and increased complexity of card rates, fees, and issuer
    practices has heightened the need for consumers to receive clear
    disclosures that allow them to more easily understand the costs of using
    cards. In the absence of any regulatory or legal limits on the interest or
    fees that cards can impose, providing consumers with adequate information
    on credit card costs and practices is critical to ensuring that vigorous
    competition among card issuers produces a market that provides the best
    possible rates and terms for U.S. consumers. Our work indicates that the
    disclosure materials that the largest card issuers typically provided
    under the existing regulations governing credit cards had many serious
    weaknesses that reduced their usefulness to the consumers they are
    intended to help. Although these regulations likely were adequate when
    card rates and terms were less complex, the disclosure materials they
    produce for cards today, which have a multitude of terms and conditions
    that can affect cardholders' costs, have proven difficult for consumers to
    use in finding and understanding important information about their cards.
    Although providing some key information, current disclosures also give
    prominence to terms, such as minimum finance charge or balance computation
    method, that are less significant to consumers' costs and do not
    adequately emphasize terms such as those cardholder actions that could
    cause their card issuer to raise their interest rate to a high default
    rate. Because part of the reason that current disclosure materials may be
    less effective is that they were designed in an era when card rates and
    terms were less complex, the Federal Reserve also faces the challenge of
    creating disclosure requirements that are more flexible to allow them to
    be adjusted more quickly as new card features are introduced and others
    become less common.

    The Federal Reserve, which has adopted these regulations, has recognized
    these problems, and its current review of the open-end credit rules of
    Regulation Z presents an opportunity to improve the disclosures applicable
    to credit cards. Based on our work, we believe that disclosures that are
    simpler, better organized, and use designs and formats that comply with
    best practices and industry standards for readability and usability would
    be more effective. Our work and the experiences of other regulators also
    confirmed that involving experts in readability and testing documents with
    actual consumers can further improve any resulting disclosures. The
    Federal Reserve has indicated that it has begun to involve consumers in
    the design of new model disclosures, but it has not completed these
    efforts to date, and new model disclosures are not expected to be issued
    until 2007 or 2008. Federal Reserve staff noted that they recognize the
    challenge of how best to incorporate the variety of information that
    consumers may need to understand the costs of their cards in clear and
    concise disclosure materials. Until such efforts are complete, consumers
    will continue to face difficulties in using disclosure materials to better
    understand and compare costs of credit cards. In addition, until more
    understandable disclosures are issued, the ability of well-informed
    consumers to spur additional competition among issuers in credit card
    pricing is hampered.

    Definitively determining the extent to which credit card penalty interest
    and fees contribute to personal bankruptcies and the profits and revenues
    of card issuers is difficult given the lack of comprehensive, publicly
    available data. Penalty interest and fees can contribute to the total debt
    owed by cardholders and decrease the funds that a cardholder could have
    used to reduce debt and possibly avoid bankruptcy. However, many consumers
    file for bankruptcy as the result of significant negative life events,
    such as divorces, job losses, or health problems, and the role that credit
    cards play in avoiding or accelerating such filings is not known.
    Similarly, the limited available information on card issuer operations
    indicates that penalty fees and interest are a small but growing part of
    such firms' revenues. With the profitability of the largest card issuers
    generally being stable over recent years, the increased revenues gained
    from penalty interest and fees may be offsetting the generally lower
    amounts of interest that card issuers collect from the majority of their
    cardholders. These results appear to indicate that while most cardholders
    likely are better off, a smaller number of cardholders paying penalty
    interest and fees are accounting for more of issuer revenues than they did
    in the past. This further emphasizes the importance of taking steps to
    ensure that all cardholders receive disclosures that help them clearly
    understand their card costs and how their own behavior can affect those
    costs.

    Recommendation for Executive Action

    As part of its effort to increase the effectiveness of disclosure
    materials used to inform consumers of rates, fees, and other terms that
    affect the costs of using credit cards, the Chairman, Federal Reserve
    should ensure that such disclosures, including model forms and formatting
    requirements, more clearly emphasize those terms that can significantly
    affect cardholder costs, such as the actions that can cause default or
    other penalty pricing rates to be imposed.

    Agency Comments and Our Evaluation

    We provided a draft of this report to the Federal Reserve, OCC, FDIC, the
    Federal Trade Commission, the National Credit Union Administration, and
    the Office of Thrift Supervision for their review and comment. In a letter
    from the Federal Reserve, the Director of the Division of Consumer and
    Community Affairs agreed with the findings of our report that credit card
    pricing has become more complex and that the disclosures required under
    Regulation Z could be improved with the input of consumers. To this end,
    the Director stated that the Board is conducting extensive consumer
    testing to identify the most important information to consumers and how
    disclosures can be simplified to reduce current complexity. Using this
    information, the Director said that the Board would develop new model
    disclosure forms with the assistance of design consultants. If
    appropriate, the Director said the Board may develop suggestions for
    statutory changes for congressional consideration.

    We also received technical comments from the Federal Reserve and OCC,
    which we have incorporated in this report as appropriate. FDIC, the
    Federal Trade Commission, the National Credit Union Administration, and
    the Office of Thrift Supervision did not provide comments.

    As agreed with your offices, unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days
    after the date of this report. At that time, we will send copies of this
    report to the Chairman, Permanent Subcommittee on Investigations, Senate
    Committee on Homeland Security and Governmental Affairs; the Chairman,
    FDIC; the Chairman, Federal Reserve; the Chairman, Federal Trade
    Commission; the Chairman, National Credit Union Administration; the
    Comptroller of the Currency; and the Director, Office of Thrift
    Supervision and to interested congressional committees. We will also make
    copies available to others upon request. The report will be available at
    no charge on the GAO Web site at http://www.gao.gov .

    If you or your staff have any questions regarding this report, please
    contact me at (202) 512-8678 or woodd@gao.gov . Contact points for our
    Offices of Congressional Relations and Public Affairs may be found on the
    last page of this report. Key contributors to this report are listed in
    appendix IV.

    Sincerely yours,

    David G. Wood Director, Financial Markets   and Community Investment

    Appendix I

    Objectives, Scope and Methodology

    Our objectives were to determine (1) how the interest, fees, and other
    practices that affect the pricing structure of cards from the largest U.S.
    issuers have evolved, and cardholders' experiences under these pricing
    structures in recent years; (2) how effectively the issuers disclose the
    pricing structures of cards to their cardholders; (3) whether credit card
    debt and penalty interest and fees contribute to cardholder bankruptcies;
    and (4) the extent to which penalty interest and fees contribute to the
    revenues and profitability of issuers' credit card operations.

    Methodology for Identifying the Evolution of Pricing Structures

    To identify how the pricing structure of cards from the largest U.S.
    issuers has evolved, we analyzed disclosure documents from 2003 to 2005
    for 28 popular cards that were issued by the six largest U.S. card
    issuers, as measured by total outstanding receivables as of December 31,
    2004 (see fig. 2 in the body of this report). These issuers were Bank of
    America; Capital One Bank; Chase Bank USA, N.A.; Citibank (South Dakota),
    N.A.; Discover Financial Services; and MBNA America Bank, N.A.
    Representatives for these six issuers identified up to five of their most
    popular cards and provided us actual disclosure materials, including
    cardmember agreements and direct mail applications and solicitations used
    for opening an account for each card. We calculated descriptive statistics
    for various interest rates and fees and the frequency with which cards
    featured other practices, such as methods for calculating finance charges.
    We determined that these cards likely represented the pricing and terms
    that applied to the majority of U.S. cardholders because the top six
    issuers held almost 80 percent of consumer credit card debt and as much as
    61 percent of total U.S. credit card accounts.

    We did not include in our analysis of popular cards any cards offered by
    credit card issuers that engage primarily in subprime lending. Subprime
    lending generally refers to extending credit to borrowers who exhibit
    characteristics indicating a significantly higher risk of default than
    traditional bank lending customers. Such issuers could have pricing
    structures and other terms significantly different to those of the popular
    cards offered by the top issuers. As a result, our analysis may
    underestimate the range of interest rate and fee levels charged on the
    entire universe of cards. To identify historical rate and fee levels, we
    primarily evaluated the Federal Reserve Board's G.19 Consumer Credit
    statistical release for 1972 to 2005 and a paper written by a Federal
    Reserve Bank
    staff, which included more than 150 cardmember agreements from 15 of the
    largest U.S. issuers in 1997 to 2002.1

    To evaluate cardholders' experiences with credit card pricing structures
    in recent years, we obtained proprietary data on the extent to which
    issuers assessed various interest rate levels and fees for active accounts
    from the six largest U.S. issuers listed above for 2003, 2004, and 2005.
    We obtained data directly from issuers because no comprehensive sources
    existed to show the extent to which U.S. cardholders were paying penalty
    interest rates. Combined, these issuers reported more than 180 million
    active accounts, or about 60 percent of total active accounts reported by
    CardWeb.com, Inc. These accounts also represented almost $900 billion in
    credit card purchases in 2005, according to these issuers. To preserve the
    anonymity of the data, these issuers engaged legal counsel at the law firm
    Latham & Watkins, LLP, to which they provided their data on interest rate
    and fee assessments, which then engaged Argus Information and Advisory
    Services, LLC, a third-party analytics firm, to aggregate the data, and
    then supplied it to us. Although we originally provided a more
    comprehensive data request to these issuers, we agreed to a more limited
    request with issuer representatives as a result of these firms' data
    availability and processing limitations. We discussed steps that were
    taken to attempt to ensure that the data provided to us were complete and
    accurate with representatives of these issuers and the third party
    analytics firm. We also shared a draft of this report with the supervisory
    agencies of these issuers. However, we did not have access to the issuers'
    data systems to fully assess the reliability of the data or the systems
    that housed them. Therefore, we present these data in our report only as
    representations made to us by the six largest issuers.

    Methodology for Assessing Effectiveness of Disclosures

    To determine how effectively card issuers disclose to cardholders the
    rates, fees, and other terms related to their credit cards, we contracted
    with UserWorks, Inc., a private usability consulting firm, which conducted
    three separate evaluations of a sample of disclosure materials. We
    provided the usability consultant with a cardmember agreement and
    solicitation letter for one card from four representative credit card
    issuers-a total of four cards and eight disclosure documents. The first
    evaluation, a readability assessment, used computer-facilitated formulas
    to predict the grade level required to understand the materials.
    Readability formulas measure the elements of writing that can be subjected
    to mathematical calculation, such as average number of syllables in words
    or numbers of words in sentences in the text. The consultant applied the
    following industry-standard formulas to the documents: Flesch Grade Level,
    Frequency of Gobbledygook (FOG), and the Simplified Measure of
    Gobbledygook (SMOG). Using these formulas, the consultant measured the
    grade levels at which the disclosure documents were written overall, as
    well as for selected sections. Secondly, the usability consultant
    conducted an heuristic evaluation that assessed how well these card
    disclosure documents adhered to a recognized set of principles or industry
    best practices. In the absence of best practices specifically applicable
    to credit card disclosures, the consultant used guidelines from the U.S.
    Securities and Exchange Commission's 1998 guidebook Plain English
    Handbook: How to Create Clear SEC Disclosure Documents.

    Finally, the usability consultant tested how well actual consumers were
    able to use the documents to identify and understand information about
    card fees and other practices and used the results to identify problem
    areas. The consultant conducted these tests with 12 consumers.2 To ensure
    sample diversity, the participants were selected to represent the
    demographics of the U.S. adult population in terms of education, income,
    and age. While the materials used for the readability and usability
    assessments appeared to be typical of the large issuers' disclosures, the
    results cannot be generalized to materials that were not reviewed.

    To obtain additional information on consumers' level of awareness and
    understanding of their key credit card terms, we also conducted in-depth,
    structured interviews in December 2005 with a total of 112 adult
    cardholders in three locations: Boston, Chicago, and San Francisco.3 We
    contracted with OneWorld Communications, Inc., a market research
    organization, to recruit a sample of cardholders that generally resembled
    the demographic makeup of the U.S. population in terms of age, education
    levels, and income. However, the cardholders recruited for the interviews
    did not form a random, statistically representative sample of the U.S.
    population and therefore cannot be generalized to the population of all
    U.S. cardholders. Cardholders had to speak English, have owned at least
    one general-purpose credit card for a minimum of 12 months, and have not
    participated in more than one focus group or similar in-person study in
    the 12 months prior to the interview. We gathered information about the
    cardholders' knowledge of credit card terms and conditions, and assessed
    cardholders' use of card disclosure materials by asking them a number of
    open- and closed-ended questions.

    Methodology for Determining How Penalty Charges Contribute to Bankruptcy

    To determine whether credit card debt and penalty interest and fees
    contribute to cardholder bankruptcies, we interviewed Department of
    Justice staff responsible for overseeing bankruptcy courts and trustees
    about the availability of data on credit card penalty charges in materials
    submitted by consumers or issuers as part of bankruptcy filings or
    collections cases. We also interviewed two attorneys that assist consumers
    with bankruptcy filings. In addition, we reviewed studies that analyzed
    credit card and bankruptcy issues published by various academic
    researchers, the Congressional Research Service, and the Congressional
    Budget Office. We did not attempt to assess the reliability of all of
    these studies to the same, full extent. However, because of the prominence
    of some of these data sources, and frequency of use of this data by other
    researchers, as well as the fact that much of the evidence is corroborated
    by other evidence, we determined that citing these studies was
    appropriate.

    We also analyzed aggregated card account data provided by the six largest
    issuers (as previously discussed) to measure the amount of credit card
    interest charges and fees owed at the time these accounts were charged off
    as a result of becoming subject to bankruptcy filing. We also spoke with
    representatives of the largest U.S. credit card issuers, as well as
    representatives of consumer groups and industry associations, and with
    academic researchers that conduct analysis on the credit card industry.

    Methodology for Determining How Penalty Charges Contribute to Issuer
    Revenues

    To determine the extent to which penalty interest and fees contributed to
    the revenues and profitability of issuers' credit card operations, we
    reviewed the extent to which penalty charges are disclosed in bank
    regulatory reports-the call reports-and in public disclosures-such as
    annual reports (10-Ks) and quarterly reports (10-Qs) made by publicly
    traded card issuers. We analyzed data reported by the Federal Reserve on
    the profitability of commercial bank card issuers with at least $200
    million in yearly average assets (loans to individuals plus
    securitizations) and at least 50 percent of assets in consumer lending, of
    which 90 percent must be in the form of revolving credit. In 2004, the
    Federal Reserve reported that 17 banks had card operations with at least
    this level of activity in 2004. We also analyzed information from the
    Federal Deposit Insurance Corporation, which analyzes data for all
    federally insured banks and savings institutions and publishes aggregated
    data on those with various lending activity concentrations, including a
    group of 33 banks that, as of December 2005, had credit card operations
    that exceeded 50 percent of their total assets and securitized
    receivables.

    We also analyzed data reported to us by the six largest card issuers on
    their revenues and profitability of their credit card operations for 2003,
    2004, and 2005. We also reviewed data on revenues compiled by industry
    analysis firms, including Card Industry Directory published by
    Sourcemedia, and R.K. Hammer. Because of the proprietary nature of their
    data, representatives for Sourcemedia and R.K. Hammer were not able to
    provide us with information sufficient for us to assess the reliability of
    their data. However, we analyzed and presented some information from these
    sources because we were able to corroborate their information with each
    other and with data from sources of known reliability, such as regulatory
    data, and we attribute their data to them.

    We also interviewed broker-dealer financial analysts who monitor
    activities by credit card issuers to identify the extent to which various
    sources of income contribute to card issuers' revenues and profitability.
    We attempted to obtain the latest in a series of studies of card issuer
    profitability that Visa, Inc. traditionally has compiled. However, staff
    from this organization said that this report is no longer being made
    publicly available.

    We discussed issues relevant to this report with various organizations,
    including representatives of 13 U.S. credit card issuers and card
    networks, 2 trade associations, 4 academics, 4 federal bank agencies, 4
    national consumer interest groups, 2 broker dealer analysts that study
    credit card issuers for large investors, and a commercial credit-rating
    agency. We also obtained technical comments on a draft of this report from
    representatives of the issuers that supplied data for this study.

    Appendix II

    Consumer Bankruptcies Have Risen Along with Debt

    Consumer bankruptcies have increased significantly over the past 25 years.
    As shown in figure 21 below, consumer bankruptcy filings rose from about
    287,000 in 1980 to more than 2 million as of December 31, 2005, about a
    609 percent increase over the last 25 years.1

    Figure 21: U.S. Consumer Bankruptcy Filings, 1980-2005

    Debt Levels Have Also Risen

    The expansion of consumers' overall indebtedness is one of the
    explanations cited for the significant increase in bankruptcy filings. As
    shown in figure 22, consumers' use of debt has expanded over the last 25
    years, increasing more than 720 percent from about $1.4 trillion in 1980
    to about $11.5 trillion in 2005.

    Figure 22: U.S. Household Debt, 1980-2005

    Some researchers have been commenting on the rise in overall indebtedness
    as a contributor to the rise in bankruptcies for some time. For example,
    in a 1997 congressional testimony, a Congressional Budget Office official
    noted that the increase in consumer bankruptcy filings and the increase in
    household indebtedness appeared to be correlated.2 Also, an academic paper
    that summarized existing literature on bankruptcy found that some consumer
    bankruptcies were either directly or indirectly caused by heavy consumer
    indebtedness, specifically pointing to the high correlation between
    consumer bankruptcies and consumer debt-to-income ratios.3

    Beyond total debt, some researchers and others argue that the rise in
    bankruptcies also was related to the rise in credit debt, in particular.
    As shown in figure 23, the amount of credit card debt reported also has
    risen from $237 billion to about $802 billion-a 238 percent increase
    between 1990 and 2005.4

    Figure 23: Credit Card and Other Revolving and Nonrevolving Debt
    Outstanding, 1990 to 2005

    Increased Access to Credit Cards by Lower-income Households Raised
    Concerns

    Rather than total credit card debt alone, some researchers argued that
    growth in credit card use and indebtedness by lower-income households has
    contributed to the rise in bankruptcies. In the survey of consumer
    finances conducted every 3 years, the Federal Reserve reports on the use
    and indebtedness on credit cards by households overall and also by income
    percentiles. As shown in figure 24 below, the latest Federal Reserve
    survey results indicated the greatest increase of families reporting
    credit card debt occurred among those in the lowest 20 percent of
    household income between 1998 and 2001.

    Figure 24: Percent of Households Holding Credit Card Debt by Household
    Income, 1998, 2001, and 2004

    In the last 15 years, credit card companies have greatly expanded the
    marketing of credit cards, including to households with lower incomes than
    previously had been offered cards. An effort by credit card issuers to
    expand its customer base in an increasingly competitive market
    dramatically increased credit card solicitations. According to one study,
    more than half of credit cards held by consumers are the result of
    receiving
    mail solicitations.5 According to another academic research paper, credit
    card issuers have increased the number of mail solicitations they send to
    consumers by more than five times since 1990, from 1.1 billion to 5.23
    billion in 2004, or a little over 47 solicitations per household. The
    research paper also found that wealthier families receive the highest
    number of solicitations but that low-income families were more likely to
    open them.6 As shown in figure 25 above, the Federal Reserve's survey
    results indicated that the number of lower income households with credit
    cards has also grown the most during 1998 to 2001, reflecting issuers'
    willingness to grant greater access to credit cards to such households
    than in the past.

    Levels of Financial Distress Have Remained Stable among Households

    The ability of households to make the payments on their debt appeared to
    be keeping pace with their incomes as their total household debt burden
    levels-which measure their payments required on their debts as percentage
    of household incomes-have remained relatively constant since the 1980s. As
    shown below in figure 25, Federal Reserve statistics show that the
    aggregate debt burden ratio for U.S. households has generally fluctuated
    between 10.77 percent to 13.89 percent between 1990 to 2005, which are
    similar to the levels for this ratio that were observed during the 1980s.
    Also shown in figure 25 are the Federal Reserve's statistics on the
    household financial obligations ratio, which compares the total payments
    that a household must make for mortgages, consumer debt, auto leases,
    rent, homeowners insurance, and real estate taxes to its after-tax income.
    Although this ratio has risen from around 16 percent in 1980 to over 18
    percent in 2005-representing an approximately 13 percent increase-Federal
    Reserve staff researchers indicated that it does not necessarily indicate
    an increase in household financial stress because
    much of this increase appeared to be the result of increased use of credit
    cards for transactions and more households with cards.7

    Figure 25: U.S. Household Debt Burden and Financial Obligations Ratios,
    1980 to 2005

    In addition, credit card debt remains a small portion of overall household
    debt, including those with the lowest income levels. As shown in table 2,
    credit card balances as a percentage of total household debt actually have
    been declining since the 1990s.

    Table 2: Portion of Credit Card Debt Held by Households

        Type of debt          1995 1998 2001 2004
    Amount of debt of all
    families, distributed
    by type of debt
    Secured home loan      80.7 78.9 81.4 83.7
    Lines of credit not     0.6  0.3  0.5  0.7
    secured by residential                     Installment 12.0 13.1 12.3 11.0
    property                                   loans
    Credit card balances    3.9  3.9  3.4  3.0
    Other                   2.9  3.7  2.3  1.6
    Total                   100  100  100  100

    Source: Federal Reserve.

    Also, as shown in table 3, median credit card balances for the
    lowest-income households has remained stable from 1998 through 2004.

    Table 3: Credit Card Debt Balances Held by Household Income8

                                                               1998   2001   2004
        Median value of holdings for families holding credit
    card debt
    All families                                          $1,900 $2,000 $2,200
    Percentile of income
    Less than 20                                          $1,000 $1,100 $1,000
    20-39.9                                               $1,300 $1,300 $1,900
    40-59.9                                               $2,100 $2,100 $2,200
    60-79.9                                               $2,400 $2,400 $3,000
    80-89.9                                               $2,200 $4,000 $2,700
    90-100                                                $3,300 $3,000 $4,000

    Source: Federal Reserve.

    As shown in figure 26 below, the number of households in the twentieth
    percentile of income or less that reportedly were in financial distress
    has remained relatively stable.

    Figure 26: Households Reporting Financial Distress by Household Income,
    1995 through 2004

    As shown in figure 26 above, more lower-income households generally
    reported being in financial distress than did other households in most of
    the other higher-income groups. In addition, the lowest-income households
    in the aggregate generally did not exhibit greater levels of distress over
    the last 20 years, as the proportion of households that reported distress
    was higher in the 1990s than in 2004.

    Some Researchers Find Other Factors May Trigger Consumer Bankruptcies and
    that Credit Cards Role Varied

    Some academics, consumer advocacy groups, and others have indicated that
    the rise in consumer bankruptcy filings has occurred because the normal
    life events that reduce incomes or increase expenses for households have
    more serious effects today. Events that can reduce household incomes
    include job losses, pay cuts, or conversion of full-time positions to
    part-time work. Medical emergencies can result in increased household
    expenses and debts. Divorces can both reduce income and increase expenses.
    One researcher explained that, while households have faced the same kinds
    of risks for generations, the likelihood of these types of life events
    occurring has increased. This researcher's studies noted that the
    likelihood of job loss or financial distress arising from medical problems
    and the risk of divorce have all increased. Furthermore, more households
    send all adults into the workforce, and, while this increases their
    income, it also doubles their total risk exposure, which increases their
    likelihood of having to file for bankruptcy. According to this researcher,

    about 94 percent of families who filed for bankruptcy would qualify as
    middle class.9

    Although many of the people who file for bankruptcy have considerable
    credit card debt, those researchers that asserted that life events were
    the primary explanation for filings noted that the role played by credit
    cards varied. According to one of these researchers, individuals who have
    filed for bankruptcy with outstanding credit card debt could be classified
    into three groups:

    o Those who had built up household debts, including substantial credit
    card balances, but filed for bankruptcy after experiencing a life event
    that adversely affected their expenses or incomes such that they could not
    meet their obligations.

    o Those who experienced a life event that adversely affected their
    expenses or incomes, and increased their usage of credit cards to avoid
    falling behind on other secured debt payments (such as mortgage debt), but
    who ultimately failed to recover and filed for bankruptcy.

    o Those with very little credit card debt who filed for bankruptcy when
    they could no longer make payments on their secured debt. This represented
    the smallest category of people filing for bankruptcy.

    Appendix III

    Factors Contributing to the Profitability of Credit Card Issuers

    Various factors help to explain why banks that focus on credit card
    lending generally have higher profitability than other lenders. The major
    source of income for credit card issuers comes from interest they earn
    from their cardholders who carry balances-that is, do not payoff the
    entire outstanding balance when due. One factor that contributes to the
    high profitability of credit card operations is that the average interest
    rates charged on credit cards are generally higher than rates charged on
    other types of lending. Rates charged on credit cards are generally the
    highest because they are extensions of credit that are not secured by any
    collateral from the borrower. Unlike credit cards, most other types of
    consumer lending involve the extension of a fixed amount of credit under
    fixed terms of repayment (i.e., the borrower must repay an established
    amount of principal, plus interest each month) and are collateralized-such
    as loans for cars, under which the lender can repossess the car in the
    event the borrower does not make the scheduled loan payments. Similarly,
    mortgage loans that allow borrowers to purchase homes are secured by the
    underlying house. Loans with collateral and fixed repayment terms pose
    less risk of loss, and thus lenders can charge less interest on such
    loans. In contrast, credit card loans, which are unsecured, available to
    large and heterogeneous populations, and can be repaid on flexible terms
    at the cardholders' convenience, present greater risks and have
    commensurately higher interest rates.

    As shown in figure 27, data from the Federal Reserve shows that average
    interest rates charged on credit cards were generally higher than interest
    rates charged on car loans and personal loans. Similarly, average interest
    rates charged on corporate loans are also generally lower than credit
    cards, with the best business customers often paying the prime rate, which
    averaged 6.19 percent during 2005.

    Figure 27: Average Credit Card, Car Loans and Personal Loan Interest Rates

    Moreover, many card issuers have increasingly begun setting the interest
    rates they charge their cardholders using variable rates that change as a
    specified market index rate, such as the prime rate, changes. This allows
    credit card issuers' interest revenues to rise as their cost of funding
    rises during times when market interest rates are increasing. Of the most
    popular cards issued by the largest card issuers between 2004 and 2005
    that we analyzed, more than 90 percent had variable rates that changed
    according to an index rate. For example, the rate that the cardholder
    would pay on these large issuer cards was determined by adding between 6
    and 8 percent to the current prime rate, with a new rate being calculated
    monthly.

    As a result of the higher interest charges assessed on cards and variable
    rate pricing, banks that focus on credit card lending had the highest net
    interest margin compared with other types of lenders. The net interest
    income of a bank is the difference between what it has earned on its
    interest-bearing assets, including the balances on credit cards it has
    issued and the amounts loaned out as part of any other lending activities,
    and its interest expenses. To compare across banks, analysts calculate net
    interest margins, which express each banks' net interest income as a
    percentage of interest-bearing assets. The Federal Deposit Insurance
    Corporation (FDIC) aggregates data for a group of all federally insured
    banks that focus on credit card lending, which it defines as those with
    more than 50 percent of managed assets engaged in credit card operations;
    in 2005, FDIC identified 33 banks with at least this much credit card
    lending activity. As shown in figure 28, the net interest margin of all
    credit card banks, which averaged more than 8 percent, was about two to
    three times as high as other consumer and mortgage lending activities in
    2005. Five of the six largest issuers reported to us that their average
    net interest margin in 2005 was even higher, at 9 percent.

    Figure 28: Net Interest Margin for Credit Card Issuers and Other Consumer
    Lenders in 2005

    Credit Card Operations Also Have Higher Rates of Loan Losses and Operating
    Expenses

    Although profitable, credit card operations generally experience higher
    charge-off rates and operating expenses than those of other types of
    lending. Because these loans are generally unsecured, meaning the borrower
    will not generally immediately lose an asset-such as a car or house-if
    payments are not made, borrowers may be more likely to cease making
    payments on their credit cards if they become financially distressed than
    they would for other types of credit. As a result, the rate of losses that
    credit card issuers experience on credit cards is higher than that
    incurred on other types of credit. Under bank regulatory accounting
    practices, banks must write off the principal balance outstanding on any
    loan when it is determined that the bank is unlikely to collect on the
    debt. For credit cards, this means that banks must deduct, as a loan loss
    from their income, the amount of balance outstanding on any credit card
    accounts for which either no payments have been made within the last 180
    days or the bank has received notice that the cardholder has filed for
    bankruptcy. This procedure is called charging the debt off. Card issuers
    have much higher charge-off rates compared to other consumer lending
    businesses as shown in figure 29.

    Figure 29: Charge-off Rates for Credit Card and Other Consumer Lenders,
    2004 to 2005

    The largest credit card issuers also reported similarly high charge-off
    rates for their credit card operations. As shown in figure 30, five of the
    top six credit card issuers that we obtained data from reported that their
    average charge-off rate was higher than 5.5 percent between 2003 and 2005,
    well above other consumer lenders' average net charge-off rate of 1.44
    percent.

    Figure 30: Charge-off Rates for the Top 5 Credit Card Issuers, 2003 to
    2005

    Credit card issuers also incur higher operating expenses compared with
    other consumer lenders. Operating expense is another one of the largest
    cost items for card issuers and, according to a credit card industry
    research firm, accounts for approximately 37 percent of total expenses in
    2005. The operating expenses of a credit card issuer include staffing and
    the information technology costs that are incurred to maintain
    cardholders' accounts. Operating expense as a proportion of total assets
    for credit card lending is higher because offering credit cards often
    involves various activities that other lending activities do not. For
    example, issuers often incur significant expenses in postage and other
    marketing costs as part of soliciting new customers. In addition, some
    credit cards now provide rewards and loyalty programs that allow
    cardholders to earn rewards such as free airline tickets, discounts on
    merchandise, or cash back on their accounts, which are not generally
    expenses associated with other types of lending. Credit card operating
    expense burden also may be higher because issuers must service a large
    number of relatively small accounts. For example, the six large card
    issuers that we surveyed reported that they each had an average of 30
    million credit card accounts, the average outstanding balance on these
    accounts was about $2,500, and 48 percent of accounts did not revolve
    balances in 2005.

    As a result, the average operating expense, as a percentage of total
    assets for banks, that focus on credit card lending averaged over 9
    percent in 2005, as shown in figure 31, which was well above the 3.44
    percent average for other consumer lenders. The largest issuers operating
    expenses may not be as high as all banks that focus on credit card lending
    because their larger operations give them some cost advantages from
    economies of scale. For example, they may be able to pay lower postage
    rates by being able to segregate the mailings of account statements to
    their cardholders by zip code, thus qualifying for bulk-rate discounts.

    Figure 31: Operating Expense as Percentage of Total Assets for Various
    Types of Lenders in 2005

    Another reason that the banks that issue credit cards are more profitable
    than other types of lenders is that they earn greater percentage of
    revenues from noninterest sources, including fees, than lenders that focus
    more on other types of consumer lending. As shown in figure 32, FDIC data
    indicates that the ratio of noninterest revenues to assets-an indicator of
    noninterest income generated from outstanding credit loans-is about 10
    percent for the banks that focus on credit card lending, compared with
    less than 2.8 percent for other lenders.

    Figure 32: Non-Interest Revenue as Percentage of Their Assets for Card
    Lenders and Other Consumer Lenders

    Effect of Penalty Interest and Fees on Credit Card Issuer Profitability

    Although penalty interest and fees apparently have increased, their effect
    on issuer profitability may not be as great as other factors. For example,
    while more cardholders appeared to be paying default rates of interest on
    their cards, issuers have not been experiencing greater profitability from
    interest revenues. According to our analysis of FDIC Quarterly Banking
    Profile data, the revenues that credit card issuers earn from interest
    generally have been stable over the last 18 years.1 As shown in figure 33,
    net interest margin for all banks that focused on credit card lending has
    ranged between 7.4 percent and 9.6 percent since 1987. Similarly,
    according to the data that five of the top six issuers provided to us,
    their net interest margins have been relatively stable between 2003 and
    2005, ranging from 9.2 percent to 9.6 percent during this period.

    Figure 33: Net Interest Margin for All Banks Focusing on Credit Card
    Lending, 1987-2005

    These data suggest that increases in penalty interest assessments could be
    offsetting decreases in interest revenues from other cardholders. During
    the last few years, card issuers have competed vigorously for market
    share. In doing so, they frequently have offered cards to new cardholders
    that feature low interest rates-including zero percent for temporary
    introductory periods, usually 8 months-either for purchases or sometimes
    for balances transferred from other cards. The extent to which cardholders
    now are paying such rates is not known, but the six largest issuers
    reported to us that the proportion of their cardholders paying interest
    rates below 5 percent-which could be cardholders enjoying temporarily low
    introductory rates-represented about 7 percent of their cardholders
    between 2003 and 2005. To the extent that card issuers have been receiving
    lower interest as the result of these marketing efforts, such declines
    could be masking the effect of increasing amounts of penalty interest on
    their overall interest revenues.

    Although revenues from penalty fees have grown, their effect on overall
    issuer profitability is less than the effect of income from interest or
    other factors. For example, we obtained information from a Federal Reserve
    Bank researcher with data from one of the credit card industry surveys
    that illustrated that the issuers' cost of funds may be a more significant
    factor for their profitability lately. Banks generally obtain the funds
    they use to lend to others through their operations from various sources,
    such as checking or savings deposits, income on other investments, or
    borrowing from other banks or creditors. The average rate of interest they
    pay on these funding sources represents their cost of funds. As shown in
    table 4 below, the total cost of funds (for $100 in credit card balances
    outstanding) for the credit card banks included in this survey declined
    from $8.98 in 1990 to a low of $2.00 in 2004-a decrease of 78 percent.
    Because card issuers' net interest income generally represents a much
    higher percentage of revenues than does income from penalty fees, its
    impact on issuers' overall profitability is greater; thus the reduction in
    the cost of funds likely contributed significantly to the general rise in
    credit card banks' profitability over this time.

    Table 4: Revenues and Profits of Credit Card Issuers in Card Industry
    Directory per $100 of Credit Card Assets

             Revenues and profits              1990       2004     Percent change
    Interest revenues                     $16.42     $12.45               -24%
    Cost of funds                           8.98       2.00                -78
    Net interest income                     7.44      10.45                 40
    Interchange fee revenues                2.15       2.87                 33
    Penalty fee revenues                    0.69       1.40                103
    Annual fee revenues                     1.25       0.42                -66
    Other revenues                          0.18       0.87                383
    Total revenue from operations          11.71      16.01                 37
    Other expenses                          8.17      10.41                 27
    Taxes                                   1.23       1.99                 62
    Net income                              2.30       3.61                 57

    Source: GAO Analysis of Card Industry Directory data.

    Although card issuer revenues from penalty fees have been increasing since
    the 1980s, they remain a small portion of overall revenues. As shown in
    table 4 above, our analysis of the card issuer data obtained from the
    Federal Reserve indicated that the amount of revenues that issuers
    collected from penalty fees for every $100 in credit card balances
    outstanding climbed from 69 cents to $1.40 between 1990 and 2004-an
    increase of 103 percent. During this same period, net interest income
    collected per $100 in card balances outstanding grew from $7.44 to
    $10.45-an increase of about 41 percent. However, the relative size of each
    of these two sources of income indicates that interest income is between 7
    to 8 times more important to issuer revenues than penalty fee income is in
    2004. Furthermore, during this same time, collections of annual fees from
    cardholders declined from $1.25 to 42 cents per every $100 in card
    balances-which means that the total of annual and penalty fees in 2004 is
    about the same as in 1990 and that this decline may also be offsetting the
    increased revenues from penalty fees.

    Appendix IV

    Comments from the Federal Reserve Board

    Appendix V

    GAO Contact and Staff Acknowledgments

    GAO Contact
    Dave Wood (202) 512-8678

    Staff Acknowledgments

    In addition to those named above, Cody Goebel, Assistant Director; Jon
    Altshul; Rachel DeMarcus; Kate Magdelena Gonzalez; Christine Houle;
    Christine Kuduk; Marc Molino; Akiko Ohnuma; Carl Ramirez; Omyra Ramsingh;
    Barbara Roesmann; Kathryn Supinski; Richard Vagnoni; Anita Visser; and
    Monica Wolford made key contributions to this report.

    (250248)

    www.gao.gov/cgi-bin/getrpt? GAO-06-929 .

    To view the full product, including the scope
    and methodology, click on the link above.

    For more information, contact David G. Wood at (202) 512-8678 or
    woodd@gao.gov.

    Highlights of GAO-06-929 , a report to the Ranking Minority Member,
    Permanent Subcommittee on Investigations, Committee on Homeland Security
    and Governmental Affairs, U.S. Senate

    September 2006

    CREDIT CARDS

    Increased Complexity in Rates and Fees Heightens Need for More Effective
    Disclosures to Consumers

    With credit card penalty rates and fees now common, the Federal Reserve
    has begun efforts to revise disclosures to better inform consumers of
    these costs. Questions have also been raised about the relationship among
    penalty charges, consumer bankruptcies, and issuer profits. GAO examined
    (1) how card fees and other practices have evolved and how cardholders
    have been affected, (2) how effectively these pricing practices are
    disclosed to cardholders, (3) the extent to which penalty charges
    contribute to cardholder bankruptcies, and (4) card issuers' revenues and
    profitability. Among other things, GAO analyzed disclosures from popular
    cards; obtained data on rates and fees paid on cardholder accounts from 6
    large issuers; employed a usability consultant to analyze and test
    disclosures; interviewed a sample of consumers selected to represent a
    range of education and income levels; and analyzed academic and regulatory
    studies on bankruptcy and card issuer revenues.

    What GAO Recommends

    As part of revising card disclosures, the Federal Reserve should ensure
    that such disclosure materials more clearly emphasize those terms that can
    significantly affect cardholder costs, such as the actions that can cause
    default or other penalty pricing rates to be imposed. The Federal Reserve
    generally concurred with the report.

    Originally having fixed interest rates around 20 percent and few fees,
    popular credit cards now feature a variety of interest rates and other
    fees, including penalties for making late payments that have increased to
    as high as $39 per occurrence and interest rates of over 30 percent for
    cardholders who pay late or exceed a credit limit. Issuers explained that
    these practices represent risk-based pricing that allows them to offer
    cards with lower costs to less risky cardholders while providing cards to
    riskier consumers who might otherwise be unable to obtain such credit.
    Although costs can vary significantly, many cardholders now appear to have
    cards with lower interest rates than those offered in the past; data from
    the top six issuers reported to GAO indicate that, in 2005, about 80
    percent of their accounts were assessed interest rates of less than 20
    percent, with over 40 percent having rates below 15 percent. The issuers
    also reported that 35 percent of their active U.S. accounts were assessed
    late fees and 13 percent were assessed over-limit fees in 2005.

    Although issuers must disclose information intended to help consumers
    compare card costs, disclosures by the largest issuers have various
    weaknesses that reduced consumers' ability to use and understand them.
    According to a usability expert's review, disclosures from the largest
    credit card issuers were often written well above the eighth-grade level
    at which about half of U.S. adults read. Contrary to usability and
    readability best practices, the disclosures buried important information
    in text, failed to group and label related material, and used small
    typefaces. Perhaps as a result, cardholders that the expert tested often
    had difficulty using the disclosures to find and understand key rates or
    terms applicable to the cards. Similarly, GAO's interviews with 112
    cardholders indicated that many failed to understand key aspects of their
    cards, including when they would be charged for late payments or what
    actions could cause issuers to raise rates. These weaknesses may arise
    from issuers drafting disclosures to avoid lawsuits, and from federal
    regulations that highlight less relevant information and are not well
    suited for presenting the complex rates or terms that cards currently
    feature. Although the Federal Reserve has started to obtain consumer
    input, its staff recognizes the challenge of designing disclosures that
    include all key information in a clear manner.

    Although penalty charges reduce the funds available to repay cardholders'
    debts, their role in contributing to bankruptcies was not clear. The six
    largest issuers reported that unpaid interest and fees represented about
    10 percent of the balances owed by bankrupt cardholders, but were unable
    to provide data on penalty charges these cardholders paid prior to filing
    for bankruptcy. Although revenues from penalty interest and fees have
    increased, profits of the largest issuers have been stable in recent
    years. GAO analysis indicates that while the majority of issuer revenues
    came from interest charges, the portion attributable to penalty rates has
    grown.

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