It's an unusual bank that has the guts to sue a regulator. But First Premier of South Dakota is a unique bank. And unlike TCF and Republic in Kentucky, which filed and dropped such suits, First Premier won.
A federal judge granted a preliminary injunction against a new Federal Reserve regulation last fall. Now the Consumer Financial Protection Bureau has caved, proposing to modify the regulation it inherited from the Fed.
I salute First Premier. A financial environment with incessant litigation to invalidate regulations would create excessive uncertainty, delay and expense. But regulators have too much to do, too quickly. If we don't catch them on their most egregious errors, then we're patsies who deserve whatever they dish out.
All this results from the prohibition of the Card Act of 2009 against lenders' charging to a card account in the first year required total fees over 25% of the initial credit line.
First Premier argued, and the federal judge in South Dakota agreed, that the Fed acted illegally in its 2011 revised regulation when it stated that the 25% includes "processing" or other fees required to be paid before the card is activated for use.
Thanks to the preliminary injunction, First Premier offers on the Internet three different unsecured cards that, for a $300 line, require a $95 "processing fee" paid before issuance, plus a $75 annual fee (25% of the credit line) for the first year, charged to the card, and a 36% APR. Hence, using the full line for one year you pay a total of $278, more than 90% of the line.
Every victory has its price. In this instance, the privately-owned First Premier, in order to prove irrevocable harm, had to expose in court filings facts about its exceptional business model that were previously unknown. First Premier asserted it expected to open 50,000 of these accounts per month, and already had 340,000 of them. Profit averages at most $2 per month per account, which is $18 million a year, assuming a two-year account life, according to the judge's opinion. This was slated to be 50% to 60% of the bank's business, and the bank had 1,800 employees before laying 300 off in anticipation of the new rule. It says it's the ninth-largest MasterCard issuer in the United State, with over 2 million cards. But this card program is minuscule compared to the unsecured subprime businesses operated by HSBC and Capital One – which charged much lower fees.
What is the loss rate on a $300 line that costs the customer $278—but yields at most $24 per year in profit? If marketing and set-up costs $100 amortized over two years, and operations and administration are $60 in the first year, then first-year losses would be $278 minus ($50 + $60+ $24), or $144. That's more than 50% of the balance, assuming a utilization rate of 90% ($280).
But the ability-to-pay rule (progeny of the same Card Act) prohibits a card from being issued unless the lender has "considered" the customer’s "ability to pay." So, has First Premier "considered" ability-to-pay and concluded, from its past experience, that each person approved has, for instance, a less than 50% chance of being able to pay for two years? They certainly don't have a 97% or even a 90% annual chance of paying, as do prime and subprime card customers, respectively.
If a 50-50 probability of paying is good enough, then the large issuers that are making elaborate income assumptions before approving credit on prime credit cards—and rejecting those who don't have better than a 97% or 95% annual probability of paying—are leaving money on the table. But the prudential regulators made them do it. Why?
Unfortunately the CFPB, while reversing one of the Fed's errors has also repeated another. It proposes to count towards the allowed maximum of 25% fees even card-related fees that are not charged to the card account—for instance, card fees automatically debited to the customer's checking account. But, the South Dakota judge quite convincingly ruled that out. So, though claiming to be "proposing … to resolve the uncertainty caused by the litigation," the CFPB has failed to do that and instead has put forward its own illegal regulation to replace the Fed’s illegal regulation.
Could this have been done in the cynical belief that cutting this baby in half is fine since the only bank willing to sue has already had its needs met by the CFPB's halfway compliance with the law?
And is a 50% loss rate inconsistent with Ability-to-Pay? Does First Premier's pricing constitute an unfair or abusive, hence illegal practice? Are 90%+ first-year fees and charges as a percentage of credit line inevitably illegal for either or both of these reasons?
Let's hear more and better from the CFPB.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.