The Coming Credit Card Meltdown

BusinessWeek takes a useful look at the next big problem in consumer credit. One word: plastic.

The piece’s perspective is upside-down, in my view, in that it concerns itself with the effect of looming defaults on lenders. Really, at this point, it’s borrowers you have to worry about.

But the issue is important.

…The next horror for beaten-down financial firms is the $950 billion worth of outstanding credit-card debt—much of it toxic.

That's bad news for players like JPMorgan Chase (JPM) and Bank of America (BAC) that have largely sidestepped—and even benefited from—the mortgage mess but have major credit-card operations. They're hardly alone. The consumer debt bomb is already beginning to spray shrapnel throughout the financial markets, further weakening the U.S. economy. "The next meltdown will be in credit cards," says Gregory Larkin, senior analyst at research firm Innovest Strategic Value Advisors. Adds William Black, senior vice-president of Moody's Investors Service's structured finance team: "We still haven't hit the post-recessionary peaks [in credit-card losses], so things will get worse before they get better."

In fact, the “meltdown” for banks from credit cards is actually going to be on the modest side, even using BW’s figures:

Credit-card losses are already taking a bite out of lenders' balance sheets. Bank of America, the nation's second-largest issuer behind JPMorgan, revealed on Oct. 6 that roughly $3 billion of its $184 billion credit-card portfolio has soured, a 50% increase from a year ago. At the same time the bank, which is also dealing with the broader financial tumult, said it would have to cut its dividend by 50% and raise $10 billion in fresh capital.

Three billion on $184 billion is 1.6 percent, so that's not a big problem, yet.

But as BW mentions, it will get worse:

Innovest estimates that credit-card issuers will take a $41 billion hit from rotten debt this year and a $96 billion blow in 2009.

For a market of $900-plus billion, that’s a lot.

Again, I would love to have read more about families’ balance sheets, which are getting crushed and will have much more to do with how long this recession is going to last, rather than those of banks.

We’ve written at length about the shift in the credit-card business from an underwriting paradigm to a sales paradigm and the consequences for consumers.

The stats are more devastating for borrowers than for lenders:

• Bankruptcies tripled between 1989 and 2004, to 1.8 million.

• For the first time in 2004, more people went bankrupt than were divorced or were diagnosed with cancer or graduated from college.

• For every household that files for bankruptcy, another ten would have benefited economically from doing so.

And here’s another:

Research shows, for instance, that nearly 30 percent of low and middle-income people with credit-card debt reported medical expenses to be a major contributor. And in a study cited by [bankruptcy expert and Harvard Law Professor Elizabeth] Warren, 87 percent of families with children filing for bankruptcy listed one of the “big three” reasons—divorce or separation, job loss, or medical expenses—as the cause.

A public interest research group, Demos, compellingly showed how middle class borrowers have used credit cards as a “plastic safety net” to supplement stagnating wages.

But I take what I can get.

BW moves the ball forward a bit with a detail that begins to tell the story of how banks, and borrowers, got into this overly leveraged predicament.

It wasn’t an accident:

The industry's practices during the lending boom are coming back to haunt many credit-card lenders now. Cate Colombo, a former call center staffer at MBNA, the big issuer bought by Bank of America in 2005, says her job was to develop a rapport with credit-card customers and advise them to use more of their available credit. Colleagues would often gather around her chair when she was on the phone with a consumer and chant: "Sell, sell." "It was like Boiler Room," says Colombo, referring to the 2000 movie about unscrupulous stock brokers. "I knew that they would probably be in debt for the rest of their lives." Unless, of course they default. Responds BofA spokeswoman Betty Riess: "The allegations do not reflect our practices. The bank has nothing to gain by extending credit to people who do not have the ability to pay us back."

That’s quite an anecdote. The use of “boiler room” tactics to sell consumer debt is, in my view, one of the most under-reported stories of the mortgage crisis.

Credit to BW for shining a bit of light on such tactics in the credit-card business.

More, please.