Consumer debt mounts, loans default – but lenders prosper

GRETCHEN MORGENSON; The New York Times
Last updated: July 20th, 2008 06:49 AM (PDT)

She worked two jobs so she could afford her small, two-bedroom ranch house in suburban Philadelphia, the Kia she drove to work, and the handbags and knickknacks she liked.

Then last year, back-to-back medical emergencies helped push her over the edge. She could no longer afford either her home payments or her credit card bills. Then she lost her job. Now her home is in foreclosure and her credit profile in ruins.

McLeod, who is 47, readily admits her money problems are largely of her own making. But she had partners in her financial demise. Financial giants Citigroup, Capital One and GE Capital were collecting interest payments totaling more than 40 percent of her pre-tax income and thousands more in fees.

Years of spending more than they earn have left a record number of Americans like McLeod at the financial precipice. They have amassed a mountain of debt that expands because of high interest rates and fees.

And now not just individuals but the entire economy is suffering. Practices that produced record profits for many banks have shaken the nation’s financial system. As Americans default, banks are recording hundreds of billions of dollars in losses, devastating their shareholders.

To reduce the risk of a domino effect, the Bush administration fashioned an emergency rescue plan last week to shore up Fannie Mae and Freddie Mac, the nation’s two largest mortgage finance companies, if necessary.

LOAN PRACTICES CHANGED

The increased availability of credit has contributed mightily to the American economy and has allowed consumers to make big-ticket purchases.

But behind the big increase in consumer debt is a major shift by lenders. In earlier years, actually being repaid by borrowers was crucial to lenders. Now, because so much consumer debt is packaged into securities and sold to investors, repayment of the loans takes on less importance to those lenders than the fees and charges generated when loans are made.

The rates that credit card issuers charge even borrowers with good credit records have risen to 19.1 percent last year from 17.7 percent in 2005 – a difference that adds billions of dollars in interest charges annually to credit card bills.

Average late fees rose to $35 in 2007 from less than $13 in 1994, and fees charged when customers exceed their credit limits more than doubled to $26 a month from $11, according to CardWeb, an online publisher of information on payment and credit cards.

FEES MULTIPLY

Mortgage lenders similarly added or raised fees – like $75 e-mail charges, $100 document preparation costs and $70 courier fees – bringing the average to $700 a mortgage, according to the Department of Housing and Urban Development. These “junk fees” have risen 50 percent in recent years, said Michael A. Kratzer, president of Feedisclosure.com.

“Today the focus for lenders is not so much on consumer loans being repaid, but on the loan as a perpetual earning asset,” said Julie Williams, chief counsel of the Comptroller of the Currency, in a March 2005 speech that received little notice at the time.

Tallying what the lenders have made off McLeod over the years is revealing. In 2007, when she earned $48,000 before taxes, she was charged more than $20,000 in interest on her various loans.

Her first mortgage, originated by the EquiFirst Corp., charged her $14,136 a year, and her second, held by CitiFinancial, added $4,000. Capital One, a credit card company that charged her 28 percent interest on her balances, billed $1,400 in annual interest. GE Money Bank levied 27 percent on the $1,500 or so that McLeod owed on an account she had with a local jewelry store, adding more than $400.

Olde City Mortgage, the company that arranged one of McLeod’s loans, made $6,000 on a single refinancing, and EquiFirst received $890 for a loan origination fee.

McLeod used debt to keep going until she was fired from her job in March for inappropriate e-mail. Since then, she has been selling her coveted handbags and other items on eBay to raise money while waiting to be evicted.

“I think a lot of people in this country have a lot more debt than they let the outside world know,” McLeod said. “I worked in retail for five years. And men, women would open up their wallets to pay and the credit cards that were in some of the wallets just amazed me.”

Ad campaigns and direct mail programs in the last decades have targeted every age group to spend. “Live Richly” was a Citibank message. “Life Takes Visa,” asserts the nation’s largest credit card issuer.

Eliminating negative feelings about indebtedness was the idea behind MasterCard’s “Priceless” campaign, the work of McCann-Erickson Worldwide Advertising, which came out in 1997.

“One of the tricks in the credit card business is that people have an inherent guilt with spending,” said Jonathan Cranin, executive vice president and deputy creative director at the agency when the commercials began. “What you want is to have people feel good about their purchases.”

Mortgage lenders took to cold-calling homeowners to persuade them to refinance. Done to reduce monthly payments, serial refinancings allowed lenders to charge thousands of dollars in loan processing fees, including appraisals, credit checks, title searches and document fees.

CUSTOMERS SUFFERED

Such practices generated dazzling profits for the nation’s financial companies. And since 2005, when the bankruptcy law became more strict, the credit card industry has increased its earnings 25 percent, according to a study by Michael Simkovic, a former James M. Olin fellow in Law and Economics at Harvard Law School.

The “2005 bankruptcy reform benefited credit card companies and hurt their customers,” Simkovic noted in his study. He said that even though sponsors of the bankruptcy bill promised that consumers would benefit from lower borrowing costs as delinquent borrowers were held more accountable, the cost of borrowing from credit card companies has actually increased anywhere from 5 percent to 17 percent.

Among the most profitable were McLeod’s creditors.

Capital One, which charges her 28 percent interest on her credit card, saw net interest income, after provisions for loan losses, rise a compounded 25 percent a year since 2002.

GE Money Bank, which levied a 27 percent rate on Ms. McLeod’s debt and is part of the GE Capital Corp., generated profits of $4.3 billion in 2007, more than double the $2.1 billion it earned in 2003.

Because many large institutions pool the loans they make and sell them to investors, they are not as vulnerable when the borrowers default. At the end of 2007, for example, one-third of Capital One’s $151 billion in managed loans had been sold as securities.

Officials at General Electric declined to comment. Capital One did not return phone calls.

In the mid-’90s, McLeod got several credit cards. When her marriage began to founder, she said, she shopped to make herself feel better.

Earning a livable wage at Verizon Yellow Pages, McLeod decided to leave her marriage and buy a home in February 2003. It cost $135,000, but required no down payment because her credit history was good.

“I was very proud of myself when I bought the house,” McLeod explained. Adding to her burden, however, was about $25,000 in credit card debt.

After she had been in the house for a year, a friend who was a mortgage broker suggested she consolidate her debts into a new home loan. The property had appreciated by about $30,000, and once again she put no money down. “It was amazing how easy it was,” she recalled. “But that’s a trap, and I didn’t know it then.”

The refinance had costs. There was an $8,000 penalty to pay off the previous mortgage early as well as roughly $1,500 in closing costs on the new loan.

To cover these fees, McLeod dipped into her retirement account. Only later did she realize there was an early-withdrawal penalty of $3,000. Short on cash, she put it on a credit card.

Soon she had racked up another $19,000 in credit card debt. Once again she refinanced.

Almost immediately, in late 2005, the store where she worked her second job, cut back her hours. Then an unexpected illness helped push McLeod over the edge. And in February, she was fired from Verizon.

Totaling up her financial obligations, McLeod said she owed $237,000 on her home mortgage. Of that, sheriff’s costs are $4,350, and “other” fees related to the foreclosure come to $3,000.

A sheriff’s auction of her home on June 12 received no bidders. The bank will soon evict her.

She does not want another credit card, she said. But even though her credit profile is ruined, she still receives solicitations. Recently an envelope arrived offering a “pre-qualified” Salute Visa Gold card issued by Urban Bank Trust. “We think you deserve more credit!” it said in bold type.

The Salute Visa offered McLeod a $300 credit line. But a closer look at the fine print showed that $150 of that would go, as annual fees, to Urban Bank.

Originally published: July 20th, 2008 01:25 AM (PDT)