Since the onset of the financial crisis ten months ago, the federal government has burrowed its way deep into the workings of American capitalism which has created many unintended consequences. Tucked away on banks' books, a familiar problem remains: bad loans and the other toxic assets that plagued the markets for so long. That's terrible news for the economy.
A House of Cards; Credit Cards, that is
The big fear, say analysts, is a repeat of last summer when Lehman Brothers failed and the bad assets tumbled in value as the banks burned through their newly raised capital. With banks' capital depleted, the government had to come to the rescue. That problem hasn't changed.
By the end of 2008, households were on the hook for $13.8 trillion in debt (they owed roughly 130% of disposable income)--nearly matching the $14.3 trillion output of the entire U.S. economy, not adjusted for inflation, that year. Households are now shedding debt; they're just not doing it very quickly. "Without stronger financial underpinnings, growth will likely be narrowly based and not dynamic, and deflationary undercurrents will persist," Citigroup economist Robert DiClemente recently wrote.
The financial crisis has battered not only investors' nest eggs; in many cases it has battered their trust. Prominent financial companies have been accused of cheating clients. Ponzi schemes and other scandals have robbed people of their life savings. People and small businesses have seen their money tied up for months as financial firms have breached trust by finding ways of restricting cash flow beyond their clients' control.
Banking has been, and should be again, a simple business
At its heart, banking is a simple business. Customers deposit money at the bank, in return for interest; the bank lends that money to other people, at a higher rate of interest. That is good way of making steady money (and of creating credit in the economy), as long as the bank is careful about whom it lends money to. The quality of those loans are the bank's earning assets.
Unfortunately, banks came up with clever new financial instruments, like credit derivatives, that broke banking. Instead of swapping bonds or currency or interest rates, banks decided to swap the risk of default. In effect, it could sell the risk that a borrower won't be able to pay back his debt. Since banking is based on making loans to customers, the risk of default by those customers is a critical part of the business....and...it was obvious that the banking sector was running irresponsibly large risks in the overexpansion of credit card and equity loan debt. These credit derivatives lie at the heart of the current credit crisis.
The lax oversight by the federal government allowed for industrial loan companies ("ILCs"), organized under state-issued charters, to collect federally insured deposits, offer credit cards, make loans and process financial transactions without facing much scrutiny as traditional banks do. As of last month, there were 45 ILCs with combined assets of $232.3 billion, according to the Federal Deposit Insurance Corp. (FDIC).
In 2006, ILCs were thrust into an especially bright spotlight after Wal-Mart Stores Inc. applied for a charter to process credit card transactions. Banks waged an aggressive lobbying campaign to derail the retailing behemoth's application, arguing that it was laying the groundwork for a foray into retail banking. Amid the mounting furor, the FDIC imposed a moratorium on new applications for ILC charters, to allow Congress time to debate whether to change the law. Wal-Mart withdrew its application.
The Term Asset-Backed Securities Loan Facility (TALF) lends money to investors to buy securities backed by credit card loans and other consumer debt. But undercapitalized "merchant services" firms who process credit cards don't qualify for federal help. By law, the Fed's loans have to be well-secured, so for the most part the Fed can finance only borrowers with top credit ratings. That's hurting smaller firms that can't get the high ratings. Whereas, the Fed and the Treasury Department provided nearly $400 million to Cabela's credit card operations through a program aimed at reviving the consumer loan market.
The lack of credit forces the undercapitalized merchant services firms to find other sources of external funding to sustain their operations. One interesting approach is for these credit card processors to use their risk management departments to target reputable small businesses (who depend on big ticket credit card transactions in payment of customer purchases), suspend the small business' merchant account for some obscure reason---in order to hold the large dollar transaction for a minimum of 180 days; thereby using the small business' transaction as a long term interest free loan to finance their operations.
The National Processing Company, LLC ("NPC") Story
My company, Signature, Inc., for several years used NPC, a wholely owned subsidiary of National City Bank, to process the company's credit card transactions that normally ranged up to $6,000 per transaction. This arrangement worked well as transactions were deposited into the firm's corporate checking account at National City.
However, when the financial crisis hit, National City moved to limit their liabilities by selling off their credit card processing firm NPC; transferring about 17,000 merchant accounts along with the NPC name to Houston, TX based Retriever Payment Systems Inc. Sometime after the NPC sale, National City was acquired by PNC bank of Pittsburgh, PA. The divesting of NPC has seemed to cause undue hardship on a number of National City employees and their merchant customers.
Specifically, Signature, Inc. experienced poor customer service from NPC in January 2009 when a $3,000 international credit card transaction was questioned by their risk management department. A NPC risk management representative even called the customer in the middle of night in China to verify the transaction and required Signature to resubmit the transaction--which then went through the system normally.
In May 2009, when another $3,000 transaction from the same customer was cleared through the system, NPC decided to suspend Signature, Inc's merchant account and not deposit the $3,000 into Signature's bank account. Signature received a May 20th letter from NPC's risk management department informing the company that their "bankcard processing relationship has been terminated" and that NPC would not forward the $3,000 to Signature but the money "will be placed on hold and will not not be transmitted to your local depository bank account. Instead, any funds will be retained for a minimum of one hundred eighty days (180) and may be offset by chargebacks and uncollected fees."
Bottom Line: Retriever's NPC has engineered a way to generate an interest free loan of $3,000 for a minimum of six months.
Hopefully, this retrieving of good transactions from other small business owners to fund credit card merchant services operations will be recognized by government officials as an unintended consequence of the continuing financial crisis.
Sources: The Wall Street Journal June 1,9,15,19, 2009, BusinessWeek June 22, 2009 and The New Yorker June 1, 2009