House of Cards

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Even as the subprime mortgage fallout continues its ripple effect across the economy, fiscal storm-watchers have an eye on the next gathering cloud: nearly $1 trillion of consumer credit card debt. Defaults are up; in November, the percentage of charge-offs — money card issuers give up on ever collecting — rose to 5.62 percent. According to some economists, that percentage could double before this current downturn is over. The bearish RGE Monitor predicts the default rate could rise as high as 13 percent, eclipsing the previous high-water mark of a 7.85 percent in the first quarter of 2002.

This is bad news for the banks and third-party investors that hold this debt, as well as for consumers hit with the double-whammy of rising unemployment and restricted credit. Americans are relying on their credit cards to an ever-increasing degree. In 2008, the average credit card balance was $11,212, according to CardTrak.com. Compare this to 15 years ago, when the average credit card debt was a comparatively paltry $4,306. Factors like California’s plan to delay income tax refunds and long-jobless workers running out their unemployment benefits don’t help the situation, either. With no silver-bullet solution in sight, economists and analysts are nervous.

Illustration by: Matt Mahurin

In the near term, things are likely to get worse before conditions improve. Ravi Batra, economics professor at Southern Methodist University, said defaults are likely to rise sharply towards the end of this quarter, reflecting fourth quarter 2008 job losses. If the unemployment rate grows — a near-certainty, according to many economists — the number of consumers ditching their monthly payments will rise, too.

Credit card companies have already started to batten down the hatches by cutting cardholders credit limits and raising interest rates. “What institutions are doing now is circling the wagons,” said Dennis Moroney, research director, bank cards, at finance-industry research firm TowerGroup.

Additional retrenchment looks inevitable. Although about half of all credit card debt has been repackaged and sold as securities, it’s a much smaller pool of capital than the mortgage securities market, so a rise in default rates probably won’t cause the kind of systemic domino effect that the mortgage collapse triggered. It will, however, make third-party investors much more reluctant to purchase such debt — and risk getting burned — in the future. With mounting default losses on their own books, banks will have to raise more capital to meet their reserve obligations. Like a retailer trying to unload Christmas paraphernalia on December 26, they’ll have to slash prices if they want to attract buyers. As a result, consumers — especially those with blemished credit — are going to have difficulty securing loans or lines of credit.

In addition, the banking industry contends that new regulations passed by the Federal Reserve last month will give them no choice but to sharply curtail lending — putting at risk the consumer purchasing power that drives 70 percent of spending in the U.S.

Consumer advocates hail the Fed’s new rules, which prohibit tactics like interest rate hikes on existing balances. “We think they’re a big step in the right direction,” said Kathleen Day, spokesperson for the non-profit Center For Responsible Lending.

Banks and institutional investors take a different view. Meredith Whitney, an analyst at Oppenheimer & Co., predicted that $2 trillion in consumer credit will disappear due to the financial sector’s existing troubles plus the Fed’s new mandates. In a recent report, Whitney essentially says lenders will opt to sit on their cash rather than dole it out to borrowers who might not pay it back.

This wasn’t supposed to happen. The thinking behind the bank bailout (formally the Troubled Asset Relief Program) was that the government would funnel money to the banks by purchasing shaky mortgage-related assets, which in turn would write loans for their customers. It didn’t turn out like that. The Treasury Department scrapped this initial plan in favor of outright loans to banks, but they never required banks to use that money to write loans. That part of the plan was couched more as a request, which banks promptly and pretty much wholly ignored. Banks have used bailout funds to shore up their balance sheets, buy other banks and pay down debt, but the anticipated flood of consumer loans is still barely a trickle.

Of course, giving money to borrowers who had no business getting loans in the first place is a large part of what started this meltdown, but turning off the spigot during a drought will only exacerbate the problem, the report concludes.

Many economists are looking to the new Obama administration to pass a massive stimulus package aimed at reversing rising unemployment numbers and getting both citizens and banks back in the mood to borrow and lend. George Feiger, chairman and chief executive of Contango Capital Advisors, suggest the federal government might eventually buy credit card debt directly, as it did with commercial paper last fall. The government will do whatever it takes to prop up commercial banks, he predicts.

“We’re facing a wave of bad news in the next three months,” said Ravi Batra. “People right now are putting all their hope onto Obama’s stimulus plan.”

Martha C. White is a freelance journalist in New York. She regularly writes about finance and the economy.