ould the financial meltdown threatening Wall Street spread to the credit card sector? Some say it has already with the recent shutdown by regulators of NextBank, the dot-com credit card bank, and its NextCard portfolio. The greater threat, though, is that Visa and MasterCard could someday find themselves in an Enron-like situation - in bankruptcy court, with one-time competitors vying for their brand-name assets.

It sounds far-fetched, I know. And some payment experts postulate that even if this were possible, Washington would step in before things ever got to that point. But faint warning signs are beginning to glimmer on the horizon, and Visa seems to be taking notice. The card giant has even hired a big-name lobbyist - former Senator Alan Simpson (Republican from Wyoming) - in hopes that it can sway Congressional sentiment to its favor.

Warning Signs
In June, Standard & Poor's, the rating service, cut its rating outlooks for both Visa and MasterCard to "negative" from "stable." Now, this isn't as bad as cutting their credit ratings. (S&P continues to rate MasterCard's long-term debt "A" and Visa's "A+;" S&P rates short-term debt for each company "A-1.")

What the change says, however, is that in the opinion of S&P analysts, the two companies' credit ratings are more likely to be lowered than raised over the next two to three years. And they point to pending litigation against the two - namely, the so-called "Wal-Mart suit," which calls into question interchange fees - as a precipitating factor.

Visa and MasterCard both have downplayed the significance of the S&P change. "We continue to believe that Visa USA has a very strong position in the Wal-Mart case and that when the merits of the case are heard in court, we will prevail," read a statement out of Visa's headquarters.

A spokeswoman for Visa told us there were no obvious short-term consequences of the S&P action, adding that the bank-owned company "only rarely accesses the credit markets." What's more, she noted, Moody's Investors Service, another well known rating service, in early July "reaffirmed our strong credit rating and kept our long-term outlook at 'stable.' "

Wal-Mart and a slew of retailers have a class-action lawsuit pending against Visa and MasterCard challenging the associations' "honor all cards" rules, which require any retailer that accepts Visa- or MasterCard-branded credit cards to also accept debit cards bearing those brand names.

While in theory retailers would like to accept these Visa and MasterCard "offline" (or signature-based) debit cards - let's face it, retailers, in theory, want to be able accept all forms of value exchange - they resent that the interchange fees assessed for the Visa- and MasterCard-branded debit cards are equal to those for credit cards (1% or more of the transaction total).

Retailers insist that the risks are different between credit cards and offline debit cards and that interchange fees are tied to risk. The retailers' reasoning: Debit card transactions post against checking accounts (where funds are on deposit), whereas credit card transactions represent an extension of unsecured credit by the card-issuing bank.

What's more, online (PIN-based) debit card transactions (which also post against checking accounts and clear through ATM networks) are priced substantially lower than offline debit cards, at a flat rate of about 65 cents per transaction.

The bottom line, retailers assert, is that the honor-all-cards rules result in massive overcharging and violate federal antitrust laws by "tying" acceptance of one product (credit cards) to another (offline debit cards). And the retailers want to be refunded what they claim are overcharges dating to the introduction of Visa and MasterCard offline debit cards nearly a decade ago.

Visa and MasterCard challenged the class-action status of the retailers' suit, taking the matter all the way to the U.S. Supreme Court. But in June the Supreme Court refused to consider the case, which means that every Visa- and MasterCard-accepting merchant in the country (about 4 million) potentially qualifies for a piece of the settlement if the retailers prevail.

The potential cost to the card companies of this outcome is huge. Depending upon whose assertions you believe, the overcharges range from about $13 billion to $39 billion, and under federal antitrust law those amounts are subject to tripling in final judgment, which means the card companies could be liable for amounts totaling $100 billion or more. It's Not Just U.S. Retailers The retailers have a lot going for them. A case brought against Visa and MasterCard by the U.S. Justice Department ended in a ruling last year that the two card companies acted illegally by not allowing member (owner) banks to issue competing cards, such as Discover and American Express. (That decision is pending appeal.)

The retailers also have a formidable ally heading up their legal team: Lloyd Constantine, a New York-based attorney who made a name for himself when, as chief of New York state's antitrust team, he led a task force of state attorneys general that challenged MasterCard and Visa plans to create a joint-venture national online debit card program dubbed Entre. The card organizations settled that suit by pulling the plug on Entre.

Constantine has gone on record as saying the Wal-Mart case is the biggest of his career, dubbing it "the Super Bowl for us" in a 2001 interview with the American Banker newspaper.

Wal-Mart's allies aren't limited to the United States. Government officials in Australia and Europe also have raised questions about MasterCard and Visa interchange fees.

The Reserve Bank of Australia, which unlike its U.S. counterpart (the Federal Reserve) actually wields regulatory power over MasterCard and Visa, last year proposed sweeping reforms to the credit card schemes operating in that country. Among its proposals: "an objective, transparent and cost-based methodology" for setting interchange fees, and the elimination of card company rules that prevent retailers from recouping costs by surcharging payments made by credit card.

The proposal elicited responses from about two dozen organizations, including magnum opuses from both Visa and MasterCard that railed against the plan. A spokesman for the Reserve Bank of Australia told us the plan and comments are under study; a final ruling doesn't seem likely before the end of this year.

(In July, the Reserve Bank of Australia also announced it was considering options for mandating changes in the interchange fees for online POS debit transactions. Recent press reports out of Australia suggest interchange fees for both debit and credit could be slashed by as much as 30% as a result of these pending actions.)

Antitrust authorities with the European Union also have been investigating interchange fees. According to a July 19 report on the Dow Jones Newswire, the E.U.'s trustbusters soon will announce a victory of sorts for Visa and MasterCard: Interchange fees, in concept, are acceptable, but the rates are too high.

The E.U. reportedly wants the card companies to slash interchange fees by about 20%. That decision won't sit well with the 5 million-plus European merchants who have complained about interchange; EuroCommerce, a group representing those merchants, has said it likely will appeal any decision by the E.U.'s Competition Commission that OK's interchange fees, even if the banks are ordered to cut the fees.

European bankers aren't just concerned about homeland merchants, either. In the recent merger of Europay (a European-based debit card network) and MasterCard, the banks that had bankrolled Europay reportedly demanded they be excused from any liability arising out of the pending U.S. retailers' lawsuit.

Sizing Up the Risks
Interchange, which comprises the bulk of the discount fees merchants pay for card payments, originally was designed to defer card issuer costs and risks. (Card issuers, remember, are granting credit to cardholders based on analyses performed by card acquirers, merchants and the issuers themselves.)

But with the advent of electronic terminals and sophisticated fraud databases, the underlying risk calculations have been rendered significantly less relevant. So today we have what Visa and MasterCard have dubbed "incentive pricing," featuring a plethora of fees based on an assortment of factors, including retail sector, transaction size, risk and type of card used.

These last two factors have retailers crying foul. As noted earlier, debit cards post against checking accounts, where cardholders presumably have available funds on deposit; credit cards represent extensions of unsecured credit. From the merchant perspective, interchange fees for debit cards should be lower because the risk of loss to issuers is lower.

The Wal-Mart suit has been in the courts for nearly six years, and with each passing year Visa- and MasterCard-branded offline debit card transactions (and by extension, the disputed "overcharges") have grown substantially. Last year, transactions using these MasterCard and Visa cards totaled in excess of $260 billion combined. This year, it's reasonable to expect the total will surpass $300 billion.

It's anybody's guess how huge the total will be when a final court decision is rendered, but the "overcharges" and potential damage awards, should Visa and MasterCard lose this case, will be substantially greater than the current estimates of $100 billion.

The Wal-Mart case is pending in U.S. District Court in New York and, regardless of the outcome, most certainly will be appealed. And with each passing year, the potential damage awards will grow as offline debit card usage grows.

The big question, of course, is how Visa and MasterCard will pay up if the retailers win. Historically, the associations' operating budgets have been tied to assessments on member banks, based upon the volume of card business transacted through those banks.

In recent years, however, many banks have balked at paying what often amount to huge assessments that are often spent to boost card businesses at competing banks. (Some industry experts, for example, have suggested the decision by Citibank to leave Visa and become a sole MasterCard issuer was premised at least in part on this concern.)

According to Moody's, Visa's capital-markets activities are limited primarily to medium-term notes and commercial paper (about $300 million outstanding) that are used to help maintain a liquid position in multicurrency transactions. Visa also has access to about $1 billion in bank credit, Moody's estimates.

MasterCard has about $80 million in subordinated debt dating to 1998, according to a spokeswoman. She adds that with the recent change in MasterCard's corporate structure, the company has more than $700 million in shareholder equity and no longer has any need for the debt. "It could be repaid at any time," she said.

The potential exposure in the Wal-Mart case alone is huge and growing each day. Do the banks that own MasterCard and Visa have deep enough pockets to foot that potential bill? Might they (can they) walk away from this liability, forcing one or both organizations into bankruptcy?

Anything is possible in the payment business. The fact that MasterCard and Visa could lose this case hasn't been lost on either organization. That Visa has hired former Senator Simpson to plead its case offers clear evidence of this.

It's not uncommon for Congress to step in and force compromises in legal cases where the stakes are huge. Or, as one of my Washington lawyer friends explained, "Congress can just change the law."

But what if that doesn't happen, and there's no out-of-court settlement, and the retailers prevail in the courts? Could we witness Visa and/or MasterCard in the throes of bankruptcy proceedings, and a company like Morgan Stanley Dean Witter (which runs Discover Card) bidding on the assets of these payments networks? Hmmm.

Patti Murphy is Contributing Editor of The Green Sheet and President of Takoma Group. She can be reached at pmurphy@takomagroup.com.