Newspapers are reporting on the credit card problems faced by consumers with increased frequency. This issue was noted several months back by respected financial blogs, such as Mish’s Global Economic Trend. In his December 25, 2007 blog entitled Credit Card Defaults move to Forefront of Deflation Debate, Michael “Mish” Shedlock concluded that:
“It took a while, but now credit cards can be added to the growing list of problems. Rather than a single domino triggering a collapse, perhaps there is simply a sudden out of the blue implosion caused by too much debt with no possible way to service it.”
His conclusion, being echoed by the major media, correctly assesses the increasingly difficult financial landscape that consumers are facing. However, they are looking at this mounting problem from a consumer’s perspective. In looking at this issue from a business risk perspective, the picture is not any prettier.
National Bureau of Economic Research[i] notes two recessions, each taking eight months from peak to trough, since 1990:
(1) July 1990 to March 1991
(2) March 2001 to November 2001.
Using the Federal Reserve Statistical Release statistics for credit card charge-off rates and total revolving charged amounts for the two recessions, one gain a sense of the size of the losses incurred by the financial institutions:
Credit Card Default % (http://www.federalreserve.gov/releases/chargeoff/delallsa.htm)
A Quick Assessment Of The Current Credit Card Issue:
Based on the most recent financial reports of the four major credit card issuing companies – American Express[ii], Discover Card[iii], Master Card[iv], and Visa[v] – and the latest the Federal Reserve Statistical Release statistics for credit card charge-off rates, even if the current charge-off rate remains constant at around 4.15%, the estimated losses by financial institutions using these four card brands may experience approximately $91.7 billion:
Notes:1. % of total receivable of $40.1 billion
2. FRB seasonally adjusted delinquency % (http://www.federalreserve.gov/releases/chargeoff/chgallsa.htm)
3. FRB seasonally adjusted charge-off % (http://www.federalreserve.gov/releases/chargeoff/delallsa.htm)
How Badly Can It Get?
Former Fed Chairman Alan Greenspan noted the increased credit card uses in his speech, Understanding household debt obligations, at the Credit Union National Association 2004 Governmental Affairs Conference, Washington, D.C., on February 23, 2004[vi] [bold and italic, added for emphasis]:
Although it does not show the relationship conclusively, the Federal Reserve's Survey of Consumer Finances suggests that these newer homeowners who make smaller down payments tend to bring with them higher levels of nonmortgage debt and, in particular, credit card debt.”
Chairman Greenspan concludes by stating [bold and italic, added for emphasis]:
“Another possible reason for rising credit card debt ratios is the use of credit cards for a variety of new purposes. The rise in credit card debt in the latter half of the 1990s is mirrored by a fall in unsecured personal loans. Reflecting this general trend, the proportion of personal loans in credit union portfolios has been declining as well. The wider availability of credit cards and their ease of use have encouraged this substitution. The convenience of credit cards also has caused homeowners to shift the payment for a variety of expenditures to credit cards. In sum, credit card debt service ratios have risen to some extent because households prefer credit cards as a method of payment.”
“Credit bureau analyses of consumer payment data show that financially squeezed borrowers have begun paying their credit card and car bills before their mortgages. That's a striking reversal from the norm, one that reflects rising desperation. It suggests that some people essentially have given up trying to stay current with their mortgages and instead are focused on using credit cards to squeak by.”
This trend of using credit card for daily expenses is going to increase as more companies including utilities and even mortgage servicers accept credit card payments. The current view is grim. According to Mark Zandi, chief economist and co-founder of Moody's Economy.com Inc.: "Credit card quality will continue to erode throughout next year." [viii]
Additionally, if history is any indication, we may see further losses in our current environment:
Business Risk Analysis
Financial: Applying 6.83% default rate as our stressed maximum, calculated at 130% of 5.25% default rate as at 3Q 2001, to the current credit card use of $2,207 billion, the approximate total expected loss, industry wide, from credit card default is $150.6 billion. This will substantially impact earnings.
Reputational: As financial institutions continue to mitigate losses from credit card defaults, the use of more aggressive credit collection methods will increase, resulting in continued negative news reports on credit card lending practices and debt collection methods. This reputational harm will have repercussion on the financial, by manifesting itself in lower stock prices, and to internal stakeholders, by lowered employee morale.
External Stakeholder: Along with internal stakeholder risk, there will be increased risk of external stakeholders’ dissatisfaction, as expressed in either lower stock prices or higher P/E ration, or both.
Compliance: Pressured by their constituents, more politicians will try to enact or further enforce legislations, aimed at protecting the consumers, or hold hearings with financial institutions’ CEOs. This will increase the legal and compliance cost to the financial institutions, resulting from preparing and responding to legislative and media inquires.
It will be tough for financial companies for the next few quarters as they try to manage their credit card delinquency and charge-off rates. However, this too shall pass. Hopefully, financial companies are currently enhancing their brand strategy, readying themselves for the better times ahead.
DISCLOSURE: The author holds no long or short positions in Amex, Discover, or MasterCard at this time.