Charles Phelan

Today (April 12, 2006) is the 25-year anniversary of Citibank’s move to South Dakota. Why should you care? Well, if you’re paying excessively high interest rates on your credit cards, you can thank South Dakota and its sweetheart deal with Citibank.

Believe it or not, 25 years ago Citibank was bleeding red ink all over the place. The problem, you see, was that they could only charge 12% interest in New York where they were headquartered. New York’s usury law prohibited interest rates in excess of 12%. This was at a time when the prime rate stood at a mind-boggling 20%. That was during the era of “stagflation” — high inflation coupled with stagnant economic growth. And Citibank, among other financial institutions, was getting crushed. Imagine being able to borrow money on your credit card at 12%, then turn around and deposit it in a money market account tied to the prime rate, thereby pocketing an automatic profit! Those days are long gone, but at the time things looked pretty grim for the major credit card banks.

In 1978, the Supreme Court ruled that a bank could “export” interest rates to states other than its own, without respect to the interest rate regulations for the destination state. Bill Jankow, then Governor of South Dakota, met with Citibank’s VP to discuss Citibank moving its credit card operation to Sioux Falls. In 1980, Jankow succeeded in getting legislation passed in South Dakota that eliminated that state’s existing usury law, thus effectively allowing unlimited interest rates. He also got another bill passed that allowed out-of-state banks to create subsidiaries in South Dakota. This allowed Citibank to charge any interest rate it felt the market would bear, without respect to New York usury laws or those of any other state.

The result of this sweetheart deal between South Dakota and Citibank is that states no longer have any control over interest rates charged by out-of-state banks. This has caused a lot of financial pain for consumers caught on the treadmill of endless minimum payments (that never seem to reduce the principal debt balance). Of course, excessively high interest rates are not paid by cardholders with perfect payment histories. As of today, the nationwide average for standard credit cards with variable rates stands at 13.99%. (Source: Bankrate.com) This may still be too high, but it’s not in the category of “outrageous.”

However, everything changes if you fall behind. Miss one or two payments due to financial difficulty, and rates can jump to 28%, 32%, or higher — even if you later catch up and get current again with your payments. And that’s because there is no effective ceiling on what credit card banks can charge. Once a customer starts to slip, the banks no longer have to worry about the customer switching to a competitor, so they can literally charge whatever they want to.

Just to put it in perspective, here’s the common definition of usury: “the lending of money at unconscionable or exorbitant rates of interest.”

Now, let’s take a look at a $10,000 credit card balance at 32% interest. If you pay $266.67 per month — a typical minimum payment level, it will take 40 years to pay off the debt, at a cost of more than $118,000 in interest! If that doesn’t meet the definition of usury, what does? Is it any wonder people have filed bankrupcy at record pace in recent years? Or that scams have flourished that falsely promise a way out of this trap?

Something is clearly wrong here, especially when one bank can raise your interest rate when you fall behind on payments with a completely different company. (That’s the infamous “universal default” clause we’ve heard so much about lately.) So where will it stop? The genie is out of the bottle, and we’re stuck with this situation on a permanent basis. Thank you, Supreme Court, South Dakota, and Citibank!

In recent posts I’ve discussed the debt elimination scam in the context of unsecured debt. That’s where the con artists claim you can magically erase unsecured debt (credit cards, etc.) based on the absurd “no money lent” argument. Would you believe the same scam is being perpetrated for secured debt? We’re talking home mortgages here, and yes, believe it or not, there are dozens of websites promoting this dangerous fraud.

But the good news is that the scammers behind one such bogus company are sitting in jail awaiting trial. Kurt Johnson and Dale Scott Heineman of the “Dorean Group” managed to convince 574 homeowners to participate in this scam. For attempting to defraud lenders of nearly $100 million in mortgages, these two criminals are charged with 68 counts of conspiracy, bank fraud, mail fraud, and contempt of court. Conviction will bring prison sentences of up to 30 years. Naturally, these scammers are following a typical post-arrest pattern: They blame their downfall on the conspiracy of the banking cabal that secretly controls the world’s currencies. In other words, these guys are card-carrying members of the lunatic fringe.

It’s nice to see the authorities take down these clowns, but it’s probably too late for many of their victims. Many of those people will lose their homes to foreclosure as a result of this fraud. You have to ask yourself: How could people fall for this? How could you expect to stop paying your mortgage and still keep your house? Worse, the scammers were promising not only to wipe out current mortgages, but to then go back to the well for equity funding of $50,000, which they would then split with their “customers.” I can only shake my head in disbelief that anyone would be gullible enough to fall for this. Sad, but true.

Americans have a lot to learn from the Chinese when it comes to managing credit cards. Recent articles about use of credit cards in China are actually quite amusing. It’s pretty funny to hear bank executives whining about the Chinese paying off their balances every month. Sure, people are using the credit cards for everyday purchases in increasing numbers, but they aren’t rolling over the balances from one month to the next. Translation: The credit card banks aren’t making any money in China.

Although only a small fraction of the Chinese population have obtained credit cards compared with the U.S., the difference in statistics among those using cards is staggering: Only 2 percent of Chinese credit card holders carry a balance forward on a frequent basis, compared to a whopping 56% in the U.S.

We just can’t have this! How dare the Chinese save 16% of their nation’s gross domestic product. They have a long way to go to catch up with our negative 3.5% savings rate here in the States. Those folks are just not consuming enough, spending enough, and racking up enough debt to suit the banks trying to make an honest buck over there.

Of course, the banks are determined to get the Chinese addicted to credit card debt. So they are using enticing low interest offers, 0% promotions (sound familiar?), and deferred payments for high-income earners. It’s probably only a matter of time before we hear tales of mounting credit card debt in China. But for now, it’s rather fun to watch the banks trying to figure out ways to get the frugal Chinese population to behave like American consumers.

OK, here’s the big news today, shouted from several breathless headlines: Bankruptcy Filings at Lowest Level in 20 Years for First Quarter of 2006!

Wow. You might think that statistic means the new bankruptcy law is actually working. The hoopla is over a report published by Lundquist Consulting showing that around 103,000 personal BKs were filed in January-March of this year, versus almost 382,000 for the same period in 2005.

There are two key points I want to make here:

First, total BK filings for 2005 were up more than 400,000 compared to 2004. And much of that increase came in the 3rd and 4th quarters of 2005, right before the new law went into effect. The simple fact is that hundreds of thousands of consumers filed for bankruptcy before the deadline, when they would otherwise have dragged their feet hoping to avoid it. I think we can safely assume than many, if not most, of those extra 400,000+ bankruptcies would have happened in 2006 if the new law had not been a factor. So the first quarter stats are basically meaningless. We’ll need a full year for the impact to be absorbed before we really understand the impact of the new law on the overall number of bankruptcy cases.

The same is true for the ratio of Chapter 7 to Chapter 13 filings. Right after the law went into effect, Chapter 13 cases jumped up to 60%, compared with an average of 29% in prior years. Now it’s down to the 40% territory, and will probably drop even further as the year proceeds. Again, that’s simply because anyone and everyone who could file Chapter 7 did it before the deadline.

The second point, which I have yet to see discussed in the financial media, is the “stealth bankruptcy” factor. What I call stealth bankruptcy is BK without the paperwork. People up against the new BK law will simply move without forwarding their address, dodge their creditors, and default on their obligations without the protection of the courts. I am certainly NOT advocating this approach, but given the tough new requirements it’s simply reality that many people will go this route. So even if the overall numbers for BK filings remain lower in 2006 versus 2004 or earlier (2005 will be a statistical anomaly), that will not mean fewer consumers in trouble.

While I am a big fan of debt settlement as an alternative to bankruptcy, I strongly believe that the do-it-yourself approach works better for consumers than using a professional debt settlement company. I hasten to add that I have nothing against third-party debt settlement companies. Many of them do a good job for their clients, and in fact I personally know a number of the owners and executives in this industry. Most of the criticisms of the industry are misplaced, and are usually put forth by people associated with credit counseling. In other words, the criticisms are usually from a source that is biased at best, and actively hostile at worst.

The critics usually display ignorance when it comes to any understanding of what the debt settlement industry is actually all about. Debt settlement is an alternative to bankruptcy, period. Once this is understood, most of the criticisms miss the mark by a wide margin. For example, it is widely stated that settlement companies “ruin people’s credit.” Excuse me? The client was already there, starting to miss payments, and headed off a financial cliff. I have personally talked with consumers who had more than $100,000 in debt and still had a good credit score. But they had only been able to keep up the $2,500 in monthly payments by using one card to make payments on the others, doing the credit card shuffle until the house of cards came crashing down. What the critics don’t realize is that most people who turn to debt settlement simply cannot keep going down their present path. The money simply isn’t there. They just don’t have the monthly cash flow to make it happen. Criticizing a settlement company for ruining someone’s credit when they are already in this situation is like complaining that a doctor doing open-heart surgery to save a patient’s life will leave a nasty scar behind. It’s simply part of the cure.

If I am in favor of debt settlement and have nothing against the companies providing this service, why do I recommend the DIY approach? There are several reasons, but the one I will concentrate on in this post is FEES. I’m not opposed to companies earning money for their services. I think the whole “non-profit” thing is largely a trick on consumers anyway, and I believe that for-profit companies are in a better position to pay a decent salary to their staff. No, my beef is not with the existence of fees in general. Rather, what I object to is the TIMING of the fees, as well as the sheer SIZE of the fees. Let’s say you owe $50,000 in debt. Most settlement companies will charge around 15% of the enrolled debt, so in this example, that’s $7,500 in fees. Frankly, that’s simply too big a number. But the timing of how those fees get collected makes the problem even worse. That’s because most companies FRONT-LOAD the fees. So that $7,500 would be deducted from the monthly program payment over a 10-18 month period. Let’s say the company collects the $7,500 over 12 months. This results is fee payments of $625 per month. Where’s the money to settle the debts with? A typical client who’s $50k in debt would pay into the program at around $750 to $1,000 per month in order to build up funds for settlements. That leaves only $125 to $375 per month building up toward settlements. At the end of that first year, the $7,500 in fees are fully paid, but the client has only saved $1,500 to $4,500 against $50k of debt. (Actually, it’s worse than that, because the debts will probably inflate to at least $60,000 during that period, due to all the interest, lates fees, and penalties.)

The big problem here is that some of the best deals happen right before charge-off, which is usually in the 6th or 7th month of the program (assuming the client was current or near-current at the start of the program). So this means that some of the best deals cannot be taken, because too much money has gone to fees and not enough toward savings for settlements. In the old days, the fees were on the back end, charged only AFTER successful settlement. We used to negotiate the first settlement, charge a percentage of the savings, and then start building toward the next settlement. This was much better for the consumer, but it’s tough to find a company out there that still charges this way. There are a few still operating with this contingency system, but even those companies charge 4-5% up front, plus monthly fees. So the original advantage of this type of program has been eroded by the steadily increasing fee structure of the industry.

Since the front-loaded fee structure, or variations on it, have become the norm, it makes good sense for a consumer to bypass those fees entirely by taking matters into their own hands. If it were not possible for consumers to negotiate on their own, that would be one thing, and those front-loaded fees would be justified. But the opposite is the case. Creditors routinely settle directly with consumers, and in fact PREFER to deal directly with the consumer without any third-party intervention. Most of the clients whom I’ve coached on how to do their own settlements are shocked at how easy it really is. In fact, in a lot of cases, it happens automatically as the account gets close to chargeoff. So the message here is simple: Save the fees by doing it yourself. You’ll get out of debt faster as a result, because 100% of your money is going toward debt reduction and none of it toward fees.

Picking up where I left off yesterday on the debt elimination scam, I’d like to shift gears a little and lay down a challenge. I sometimes receive calls or emails from people promoting this system. Because I am easy to reach and I’m a well-known debt expert, they seem compelled to convince me of the worth and merit of their system. Often, the people contacting me are ignorant of the nature of the scam. That’s because this program is frequently sold through MLM or network marketing systems, and a lot of the people involved simply don’t know any better. I respond by making a simple request, and any “true believers” in this system who happen to read this article can take this as a challenge. All I ask is for a single verifiable court case where a judge agreed with the “no money lent” argument and ruled in favor of the debtor. It’s really that simple. After asking this question for several years, I’m still waiting. No such case exists, despite false claims to the contrary. The response is usually that the company must protect the clients’ privacy, but they have “hundreds of success stories” and have dismissed “millions of dollars” of debt.

Nonsense! The only way this system could possibly work is if a judge ruled on it in court. And since court cases are public record by definition, privacy cannot be an issue here. The “client” gave up any right to privacy when he or she tried to convince a judge that the 50 grand they owed on their credit cards was really just “funny money.” And yet the con artists cannot provide a single solitary case in support of their outrageous claims. (Note to scammers: Don’t waste my time emailing me with your threats or your legal mumbo-jumbo. I’ve heard it all before. Just send me the civil docket number for a single case where your “client” won in court using this system, and identify the court venue so I can look up the case myself online. Simple enough, right? I won’t hold my breath though.) In fact, the “no money lent” argument has been shot down in court on multiple occasions. When confronted with this embarrassing fact, the scammers simply reply that the courts are part of a “conspiracy” to keep this information from the public!

The absence of any verifiable documentation is the red flag that tells you this scheme simply doesn’t work. But let me take this a step farther. Let’s set aside for a moment the whole question of the legal basis for the “no money lent” argument. Let’s take a huge silly leap for a moment and say that the system is valid from a legal perspective. Well, it’s STILL not going to work for the average consumer! Why? Two reasons. First, it requires a fight in court, and the average consumer wants to go to court over debt-related matters about as much as they want to have multiple root-canals without anesthetic.

Second, nothing gets resolved this way. I’ve worked with thousands of people struggling with serious debt problems. I talk to people in this situation every day. I can’t think of a single instance where the person’s priority was anything other than to GET THE MATTER RESOLVED PERMANENTLY. The techniques used by the debt elimination scammers do not achieve any resolution at all. Even if the debtor successfully gets a creditor to back off from its collection effort, all that will happen is the creditor will sell the account to a debt purchasing company, who will then try to collect all over again. So the whole process will have to be repeated, over and over again as the debt gets sold multiple times down the line. There is no resolution here. Just a bag of useless tricks. Boil it all down and here is what the debt elimination scammers are telling you: Walk away from your debts, don’t pay, and duck and cover. That’s it. It’s a lot of hot air and bogus nonsense, and it only exists because debt-weary consumers are desperate for solutions.

If you have become the victim of a debt elimination scam, I urge you to take action. Demand a refund in writing. Complain to the Better Business Bureau where the company is located (assuming you can even find them), complain to your state Attorney General and the Federal Trade Commission. And then get on the phone with your creditors and explain that you were misled and that you would like to work things out in good faith. It may be necessary for you to formally retract any documentation that the scammers sent to your creditors. Consumers may also feel free to email me for further advice or information on this subject.