Bad credit-card debt could be next shot to economy, researcher says
CHICAGO (MarketWatch) -- Credit-card debt is on the brink of imploding and will be the next storm to hit the fragile finance industry, an investment research firm predicted this week.
nnovest projects that amount would be high enough to damage some of the biggest card issuers.
Credit-card charge-offs are "defying gravity" when compared with the problems in the mortgage market, according to Gregory Larkin, senior banking analyst for Innovest. But that will change as they catch up with mortgage charge-offs, which have spiked eightfold since the third quarter of 2007.
"If history is any indicator, there should be an equivalent surge of credit-card charge-offs very soon," he said, though he concedes that an eightfold increase would be very aggressive.
Comparatively, charge-offs reached $4.2 billion in the first quarter of this year and $3.2 billion in the same period a year before, according to the Federal Reserve, which only reports non-securitized debt. Innovest's projections include all credit-card debt, which the firm believes is double what the Federal Reserve reports. For all of 2007, charge-offs tallied $26.6 billion, according to Innovest's calculations, and the firm estimates they will reach $41.5 billion at the end of this year.
The jump in credit-card charge-offs is linked in part to the credit crisis now in play. As banks have tightened lending standards, they have mostly done away with the once-popular roll-over options -- usually at 0% introductory rates -- that allowed borrowers with delinquent accounts to get new cards elsewhere. Larkin believes all that bad credit is going to surface quickly and could have a similar impact as the mortgage crisis has had on banking.
A matter of scale
But credit-industry analysts shake those prognostications off, noting that the number of dollars involved in credit cards loans versus mortgages is substantially lower.
"Defaults on $2,000 or $5,000 in credit-card debt are entirely different than someone defaulting on a $500,000 mortgage," said Greg McBride, senior financial analyst for Bankrate.com.
"I'm skeptical that the magnitude of credit quality is going to be as severe as some say," he added.
The average credit-card debt is $2,200, according to the Federal Reserve. On a revolving basis, there was roughly $970 billion owed on credit cards at the end of July. However, because many people use credit cards for the rewards programs and pay off their debt each month, it's unclear how much of that total is actually outstanding.
What's more, as delinquencies rise -- and they will because of the weakness of the economy -- credit-card issuers will take steps to stem the tide. That will include cutting credit off from problem borrowers and tightening restrictions on new cards.
"Banks already are starting to minimize their risk and drop their credit limits that they extend to people and especially those at a higher risk," said Bill Hardekopf, a partner at LowCards.com. Read more.
American Express, for example, upped its loan-loss reserves to $2.6 billion in the second quarter compared with $1.4 billion in the year-ago period.
In the second quarter, Capital One's provisions for loan losses nearly doubled to $1.1 billion compared with $535 million in the second quarter last year.
"There's no doubt there's going to be pain in the credit-card markets," said Justin McHenry, research director with IndexCreditCards.com. "But I don't see anything to the magnitude of what we've seen in the mortgage market.
"This is a different financial animal in terms of how much is being loaned out," he added. "And credit-card companies can take that credit and cut it in half. That's a tool that they have."
Larkin admits that Innovest's projections run against the financial tide: "I think they're wrong," he said.
Companies could take a hit
Laura Nishikawa, Innovest's consumer finance analyst, said the credit-card crisis will hit earnings, in particular at companies that glean high percentages of net revenue from their U.S. credit-card revenues.
"Companies that have pursued aggressive portfolio growth and higher yields at the cost of prudent risk management will struggle to manage rising loan losses, which will definitely cut into earnings or even worse," she said.
Nishikawa is also worried about companies that target lower-income consumers and use delinquencies and late payments as a means of making money.
"Delinquent borrowers become cash-flow generators," she said. "At the extreme end, the goal becomes, 'How do we get borrowers into delinquent status as soon as possible, in order to maximize returns?'"
J.P. Morgan and Amex are what Nishikawa considers best of class, while Capital One has an unsustainable business model that's based on penalty pricing -- high fees for missed payments, shooting interest rates for surpassing limits -- and that she thinks has a high exposure to subprime credit-card holders and low payment rates.
"When the economy turns bad, this strategy clearly cannot be sustained," she said.
"While a hit to topple credit cards may not topple the bank completely, it will cut into core earnings," she added. 
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