Another Day, Another Credit Disaster-in-the-Making

At the height of the housing boom, there probably wasn't a day that went by when most Americans weren't inundated with television and radio ads, direct mail solicitations, and various digital promotions for all sorts of mortgage-related products.

Not surprisingly, that activity has slowed to a trickle since the bubble burst and the subprime mortgage finance sector imploded. I guess unprecedented credit market upheaval, surginging delinquencies and foreclosures, and humongous losses at the firms pushing that kind of stuff can have that effect.

However, well before the whole mortgage financing boondoggle exploded onto the scene and through to this very day, another financial product has also been aggressively marketed to millions of Americans via the airwaves, the mailbox, and the internet: credit cards.

Based on how long that particular lemming rush has lasted, some might think the inevitable fallout -- especially in regard to banks, the primary issuers -- could be even bigger. Well, it looks like we are about to find out. In "The $915B Bomb in Consumers' Wallets," Fortune details early signs of trouble in plastic-land.

Americans have record credit-card debt and banks are starting to sweat an uptick in default rates, reports Fortune's Peter Gumbel. Why some fear this could be the next subprime.

This past summer's subprime meltdown involved about $900 billion in now-suspect securitized debt, reckless lending, and consumers who buckled under the weight of loans they couldn't afford. Now another link in the consumer debt chain - credit cards - is starting to show signs of strain. And the fear that the $915 billion in U.S. credit card debt (an uncannily similar figure) may blow up has major financial institutions like Citigroup, American Express, and Bank of America strapping on their Kevlar vests.

Last month, as banks reported their worst quarterly results since 2001, concerns about rising credit card delinquencies began to make their way onto earnings announcements alongside mentions of subprime woes.

First Citigroup, reporting a 57% decline in earnings, cited higher consumer credit costs and said it would put aside $2.24 billion in loan-loss reserves to cover future defaults.

In describing the situation to analysts, CFO Gary Crittenden said Citi's credit card holders were beginning to increase the balance on their cards or take cash advances on those cards for the first time - behavior that, in his experience (which includes seven years as CFO of American Express), can translate into future trouble. Citi said the change in loan losses was "inherent in the portfolio but not yet visible in delinquencies."

Then American Express said that it too was seeing "signs of stress" and would boost its loss reserves in its core U.S. card unit by 44%. Capital One, Bank of America, and Washington Mutual all said they are bracing for a 20% or higher increase in credit card losses over the near and medium term.

So are U.S. credit cards going to be the catalyst for the next seizing up of the global credit markets? It depends on whom you ask.

"We are in a heightened state of alert to monitor a potential domino effect," says Michael Mayo, Deutsche Bank's U.S. banking analyst.

Dennis Moroney, an analyst at TowerGroup, expects credit card delinquencies will rise as consumers, who have until now used home-equity lines of credit to pay off their cards, start ratcheting up higher card debt. When housing prices were rising, it was easy for consumers to tap the escalating values of their homes to keep borrowing. With the home-equity spigot turned off, over-leveraged consumers may have trouble keeping up with payments.

The doomsday scenario would play out something like this: Just like CDOs and other asset-backed securities, credit card debt is sliced, diced, and sold off again as packages of securities. Rising delinquencies would hurt not only the banks involved but the securities backed by the credit card receivables. Those securities would decline in value as consumers defaulted, leading to bank losses as well as portfolio losses in the hedge funds, institutions, and pensions that own the securities. If the damage is widespread enough, it could wreak havoc on the economy much as the subprime crisis has done.

To be sure, there are key differences between the subprime market and the problems brewing with credit cards. The first is that while rising mortgage delinquencies were apparent for months before the subprime market blew up, credit card delinquencies are actually coming off unusually low levels.

"This is absolutely not the next one to blow," says Meredith Whitney, banking analyst at CIBC. Christopher Marshall, CFO of Fifth Third Bancorp in Cincinnati, points out that the U.S. has a long history of credit card securitization, "so it's fairly well understood." The securitization of the subprime sector, by comparison, "got blurry, and people didn't focus on what it meant."

Credit agencies that monitor credit cards in the asset-backed securities market share that confidence. "The performance in the core consumer [asset-backed securities] sectors is expected to deteriorate modestly, but not enough to cause substantial downgrades," says Kevin Duignan, managing director at Fitch.

But credit card debt is different from subprime debt in another way: Unlike mortgages, credit card debt is unsecured, so a default means a total loss. And while missed payments are at a historical low, they show signs of an uptick: The quarterly delinquency rate for Capital One, Washington Mutual, Citigroup, J.P. Morgan Chase, and Bank of America rose an average of 13% in the third quarter, compared with a 2% drop in the previous quarter.

What's more, consumers and the people who market financial services to them may not have learned their lesson. Klaus-Peter Müller, CEO of Germany's Commerzbank, told Fortune he was stunned on a recent trip to the U.S. to see TV ads still aggressively touting no-questions-asked credit. In Germany he's calling for tighter standards.

"I'm speaking out on the ethical questions about consumer lending," he says.

If there is an international precedent the U.S. should be watching, it's actually that of the U.K. British consumers are just as overstretched as Americans, but since the real estate market there rose faster and fell earlier, they're about 18 months ahead in the credit cycle. Since the last quarter of 2005, credit card delinquencies and charge-off rates in Britain have risen as much as 50%, forcing banks to take huge write-offs.

It's a sign of the times that, according to one survey last month, 6% of British homeowners have been using their credit cards to pay their mortgages. That's suicidal, of course, given that credit card interest rates are more than double even the heftiest mortgage. Keep your fingers crossed that it's not a trend that crosses the Atlantic.

Comments

[rhysea]

I keep wondering why no one focuses on the problem at the very bottom of this heap: the fico scores. They measure nothing except the willingness to pay on time. As far as I can tell, there is no income component or asset component to the score.

Fico, with the credit card companies, has made an extraordinary push to get the american public to live in fear of being a day late, better to feed the securitization machine.

But CREDIT is about the ABILITY and WILLINGNESS to pay. I don't think FICO measures ability.

If I'm correct, then the credit card companies have no way to determine the potential extent of their losses. Just as the mortgage companies are 'surprised' to see the 'subprime' problems move into 'prime' because they are measuring with those scores, the credit card companies are looking at the same ghost.

[barry broome]

I think the answer to this mess is discipline. One problem is the banking regulations in this country. You can loan out a bunch of money that you don't even have. I believe in the restriction of credit. It's the government's job to do this - but they've outsourced it to the federal reserve. Why? So they could borrow money unrestricted. Discipline at the federal level - and the individual level. Restriction of credit is what we need.