Universal default
Encyclopedia
Universal default is the term for a practice in the financial services
industry in the United States for a particular lender to change the terms of a loan
from the normal terms to the default terms (i.e. the terms and rates given to those who have missed payments on a loan) when that lender is informed that their customer has defaulted
with another lender, even though the customer has not defaulted with the first lender.
This is a phenomenon that dates from the mid-1990s. Credit card companies included universal default language in their cardholder agreements at that time, due to increasing deregulation of the industry. Today, approximately half of the banks that issue credit cards have universal default language. However, since the inception of these provisions, most credit card companies have not enforced them regularly or systematically.
Every year since at least 2003, Congress has considered several bills to curb abusive credit card practices, including universal default provisions. In the meantime, the Office of the Comptroller of the Currency
issued a stern advisory letter to the credit card industry regarding several of the most egregious practices. Most credit card companies have not responded to the letter.
In 2007, Citibank became the first bank to voluntarily eliminate its universal default provision.
In 2009, most forms of the practice were outlawed in the United States.
, the interest rate
of the loan
should reflect the risk of the borrower to avoid subsidizing those who default
at the expense of those who always pay on time (or alternatively, to allow loans to be given to a broader range of customers, with a broad range of credit history
).
Usually, if an interest rate is to be risk-based, the risk premium
(or amount charged extra for the risk) is set at the time of an account opening. However, this does not take into consideration that the risk of a borrower defaulting may change later (or in fact the risk might be less).
Thus, while lenders have increased credit limit
s and lowered rates to borrowers in good standing, reflecting the decreased perception of risk, recently lenders have begun to raise rates to those it later has found have defaulted with other lenders.
This practice generally only happens on credit card
s, which are one of the only forms of consumer credit to have an adjustable interest rate not simply based on an interest rate index but on the perceived risk of the customer (both positive and negative).
Instead of a specific increase in the risk premium charge, credit cards often change their interest rate to what is known as the default rate. This rate is usually the highest rate charged by the card, an average of 27.8%. In addition this is charged in a first in, last out FILO
basis.
Normally the default rate is charged when a customer fails to make a payment on a particular lender's credit card, but with universal default, the lender will charge the rate if the customer defaults elsewhere.
However, if we eliminate this rule when I try to get a new card, or mortgage or other debt, my creditor will know that there is some likelihood that I will default (that I will prove to be riskier in the future than I appear in the present). With this in mind, and knowing the average likelihood that a debtor with specific traits will prove riskier in the future than they appear at the time of application the credit company will spread the increase that would have gone to the defaulter over a class of borrowers. Instead of ending up with a rate of 24%, everyone ends up with a rate of 20.4%. This seems like a small sacrifice, but nonetheless it is an increase in price (a universal increase in price). As such, marginal debtors can be expected to leave the market.
What will be the effect? Less spending will occur on credit, and credit cards will appear more attractive to debtors who have reason to expect that they will default on a card in the future. This creates two changes; one is reduced spending and the other is adverse selection
. Because credit cards become more attractive for high risk borrowers and less attractive for low risk borrowers we can expect the mix of debtors to become riskier as a whole. Over the long run if this would bring the cost of credit up.
With more expensive credit the equilibrium price of loanable funds
would increase while the equilibrium quantity would decrease. Fewer entrepreneurial projects would be undertaken and growth would be restricted for the economy as a whole.
. These supporters argue that the continuing practice of charging higher prices reflective of risk will allow lenders to charge lower prices reflective of non-risk, or, to extend credit to those previously thought to be too risky in the past, giving benefits to those potential borrowers. These supporters argue that the increased rates reflect the risk and are not price gouging
, as proven by the steady or diminishing profit margins of the credit card business.
Still others, while admitting that the increased default rate more than compensates for the risk, argue that competitive pressure makes that so (i.e. because lenders who do not charge the default rate can possibly offer lower normal rates, while lenders who don't would seemingly have to try and advertise that the lack of a default rate is a competitive advantage (opening them up to adverse selection), or adopt the practice themselves.
prohibited the practice of retroactively raising any annual percentage rate
, fees, or finance charges for reasons unrelated to the cardholder's behavior with their account. One of the intentions of this law was to shield customers from arbitrary rate increases if they have been on time with their account.
However, this law did not prohibit all forms of universal default. Credit card companies have begun the practice of canceling altogether the accounts of customers who are delinquent or in default with other credit agencies even if the customer is still in good standing with the credit card company.
Financial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are credit unions, banks, credit card companies, insurance companies, consumer finance companies,...
industry in the United States for a particular lender to change the terms of a loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
from the normal terms to the default terms (i.e. the terms and rates given to those who have missed payments on a loan) when that lender is informed that their customer has defaulted
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
with another lender, even though the customer has not defaulted with the first lender.
This is a phenomenon that dates from the mid-1990s. Credit card companies included universal default language in their cardholder agreements at that time, due to increasing deregulation of the industry. Today, approximately half of the banks that issue credit cards have universal default language. However, since the inception of these provisions, most credit card companies have not enforced them regularly or systematically.
Every year since at least 2003, Congress has considered several bills to curb abusive credit card practices, including universal default provisions. In the meantime, the Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...
issued a stern advisory letter to the credit card industry regarding several of the most egregious practices. Most credit card companies have not responded to the letter.
In 2007, Citibank became the first bank to voluntarily eliminate its universal default provision.
In 2009, most forms of the practice were outlawed in the United States.
Background
Under the theory and practice of risk-based pricingRisk-based pricing
Risk-based pricing is a methodology adopted by many lenders in the mortgage and financial services industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees...
, the interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
of the loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
should reflect the risk of the borrower to avoid subsidizing those who default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
at the expense of those who always pay on time (or alternatively, to allow loans to be given to a broader range of customers, with a broad range of credit history
Credit history
Credit history or credit report is, in many countries, a record of an individual's or company's past borrowing and repaying, including information about late payments and bankruptcy...
).
Usually, if an interest rate is to be risk-based, the risk premium
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
(or amount charged extra for the risk) is set at the time of an account opening. However, this does not take into consideration that the risk of a borrower defaulting may change later (or in fact the risk might be less).
Thus, while lenders have increased credit limit
Credit limit
A credit limit is the maximum amount of credit that a financial institution or other lender will extend to a debtor for a particular line of credit...
s and lowered rates to borrowers in good standing, reflecting the decreased perception of risk, recently lenders have begun to raise rates to those it later has found have defaulted with other lenders.
This practice generally only happens on credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
s, which are one of the only forms of consumer credit to have an adjustable interest rate not simply based on an interest rate index but on the perceived risk of the customer (both positive and negative).
Instead of a specific increase in the risk premium charge, credit cards often change their interest rate to what is known as the default rate. This rate is usually the highest rate charged by the card, an average of 27.8%. In addition this is charged in a first in, last out FILO
FIFO and LIFO accounting
FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks....
basis.
Normally the default rate is charged when a customer fails to make a payment on a particular lender's credit card, but with universal default, the lender will charge the rate if the customer defaults elsewhere.
Example
When an individual defaults on one of their debts that communicates to lenders that that person is riskier than they previously thought. If I default on card B and card A raises my rate from 8% to 24%, that is to reflect their perception that I am a risk and may default on that debt as well. Of course, this makes it more difficult for me to pay off card A and this is unfortunate for me.However, if we eliminate this rule when I try to get a new card, or mortgage or other debt, my creditor will know that there is some likelihood that I will default (that I will prove to be riskier in the future than I appear in the present). With this in mind, and knowing the average likelihood that a debtor with specific traits will prove riskier in the future than they appear at the time of application the credit company will spread the increase that would have gone to the defaulter over a class of borrowers. Instead of ending up with a rate of 24%, everyone ends up with a rate of 20.4%. This seems like a small sacrifice, but nonetheless it is an increase in price (a universal increase in price). As such, marginal debtors can be expected to leave the market.
What will be the effect? Less spending will occur on credit, and credit cards will appear more attractive to debtors who have reason to expect that they will default on a card in the future. This creates two changes; one is reduced spending and the other is adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
. Because credit cards become more attractive for high risk borrowers and less attractive for low risk borrowers we can expect the mix of debtors to become riskier as a whole. Over the long run if this would bring the cost of credit up.
With more expensive credit the equilibrium price of loanable funds
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...
would increase while the equilibrium quantity would decrease. Fewer entrepreneurial projects would be undertaken and growth would be restricted for the economy as a whole.
Criticisms
The concept of universal default is criticized for many reasons.- Those who disagree with the entire concept of risk-based pricing disagree necessarily with an application of that concept.
- The concept of one lender charging a higher price when their customer defaultDefault (finance)In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
s with another lender has been compared to having a cartelCartelA cartel is a formal agreement among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production. Cartels usually occur in an oligopolistic industry, where there is a small number of sellers and usually involve homogeneous products...
, or price fixingPrice fixingPrice fixing is an agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand...
structure. - It is thought that when a customer in dire financial straits defaults with one lender, the concept of universal default, and the subsequent interest rate increases, can create a vicious cycle which can cause the customer to default everywhere.
- There is the possibility that the credit product which was shown as being in default in the first place was in default due to fraudFraudIn criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...
or institutional error. If this is the case, while the customer has full legal rights to have the error corrected on his credit report, any lender who instituted the universal default rate is under no obligation to return to the normal rate. - The increased rate is seen by some critics to be too high even reflecting the risk.
- Nature of the rate structure means that the customer usually must fully pay off their credit card before receiving the normal rate again.
Support
Supporters of the concept argue that lenders should use all available information at all times in order to avoid adverse selectionAdverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
. These supporters argue that the continuing practice of charging higher prices reflective of risk will allow lenders to charge lower prices reflective of non-risk, or, to extend credit to those previously thought to be too risky in the past, giving benefits to those potential borrowers. These supporters argue that the increased rates reflect the risk and are not price gouging
Price gouging
Price gouging is a pejorative term referring to a situation in which a seller prices goods or commodities much higher than is considered reasonable or fair. In precise, legal usage, it is the name of a crime that applies in some of the United States during civil emergencies...
, as proven by the steady or diminishing profit margins of the credit card business.
Still others, while admitting that the increased default rate more than compensates for the risk, argue that competitive pressure makes that so (i.e. because lenders who do not charge the default rate can possibly offer lower normal rates, while lenders who don't would seemingly have to try and advertise that the lack of a default rate is a competitive advantage (opening them up to adverse selection), or adopt the practice themselves.
Ban on forms of Universal Default
The Credit Card Accountability, Responsibility, and Disclosure Act of 2009Credit CARD Act of 2009
The Credit Card Accountability Responsibility and Disclosure Act of 2009 or Credit CARD Act of 2009 is a federal statute passed by the United States Congress and signed by President Barack Obama on May 22, 2009...
prohibited the practice of retroactively raising any annual percentage rate
Annual percentage rate
The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate...
, fees, or finance charges for reasons unrelated to the cardholder's behavior with their account. One of the intentions of this law was to shield customers from arbitrary rate increases if they have been on time with their account.
However, this law did not prohibit all forms of universal default. Credit card companies have begun the practice of canceling altogether the accounts of customers who are delinquent or in default with other credit agencies even if the customer is still in good standing with the credit card company.