Credit cards: The next shoe to drop

The U.S. edition of Business Week has a frightening article in this week's issue about how credit card debt defaults are the next big risk for banks. This is something that I wrote about in my other blog almost a month ago. According to Business Week, the total amount of credit card debt outstanding in the U.S. is $950 billion dollars--less than 10% of the money invested in home mortgages, but a huge number nonetheless. According to researchers, at least 20% of that amount is at risk of default. What's worse, $365 billion of the total debt is held in securitized instruments, similar to the Collateralized Debt Obligations (CDOs) that are wreaking havoc on the financial system. That means that as the rate of default increases, the value of the credit card debt-backed securities will plummet, and much of that $365 billion could be at risk. And, if there are Credit Default Swaps held against that $365 billion, seven trillion dollars or more could actually be at risk. There is nothing whatsoever in the financial bailout plan passed in the U.S. Congress to address this problem.

Defaults are going to increase because consumers have been shifting their purchases from second mortgages and lines of credit to credit cards. With home values dropping, mortgages and home equity loans almost impossible to find, and real personal income declining, credit cards are the only option left. Missing a single payment on a single credit card could cause the interest rate on all the cards and balances held by a consumer to jump to 20 to 30%, or even more, increasing payments and the probability of default. And, a law passed last year requiring banks to increase their minimum monthly payments that was intended to help consumers pay off their debts more quickly has instead increased default rates.

As with mortgages, the banks have no one but themselves to blame for this problem. First, they got Congress to abolish usury laws, which removed caps on the amount of interest that they could charge. Next, they gave credit cards to just about everyone, regardless of their credit. The first generation of credit card issuers who targeted risky borrowers, MBNA and Providian, were acquired by Bank of America and Washington Mutual, respectively. Those banks adopted the aggressive tactics of the banks they acquired, and were followed by J.P. Morgan Chase, Capital One and others. Now, Chase owns Washington Mutual. Note that Chase and Bank of America are considered two of the "too big to fail" superbanks.

There are efforts in Congress to limit interest rates and decrease or eliminate some fees, so what are the banks doing? They're increasing interest rates ahead of the new laws, which will increase the number of defaults. Investors are demanding default insurance from the banks, and many are refusing to buy the banks' securitized instruments altogether, which means that more banks will have to keep their defaulted credit card debt on their own books.

This is one reason why I say that there's no such thing as a "safe" bank. Even the ones that have profited from the mortgage implosion may still be at risk from credit card defaults.