Universal default
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Universal default is the term for a practice in the financial services industry 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 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.
Background
Under the theory and practice of risk-based pricing, 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 limits 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 cards, 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.
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 defaults with another lender has been compared to having a cartel, or price fixing 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 fraud 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 selection. 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[citation needed].
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 thttp://en.wikipedia.org/skins-1.5/common/images/button_math.pnghe practice themselves.
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. Because credit cards become relatively more attractive for high risk borrowers and relatively 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.
While Universal Default rules look bad for individuals in the short run, in the long run it is good for responsible borrowers, and good for the economy. By replacing Universal Default with a universal presumption of risk we effectively socialize credit and restrict growth.
