The Coming Credit-Card Crunch

THE SUBPRIME-MORTGAGE crisis has cost millions of homeowners their homes. Now it threatens to put the squeeze on even more consumers by spilling into the credit-card market.

The bad news is pretty straightforward: With home equity dried up, consumers are piling up credit-card debt at a rapidly increasing pace. As of the third quarter of 2007 (the latest for which data is available), credit-card balances increased by 7% on an annualized basis, according to statistics compiled by market research firm TowerGroup. Compared to the average annual increases of 2% over the previous six years, it's clear that we are fast becoming a country precariously living on borrowed money.

"Consumers are being squeezed out of the credit markets," explains Dennis Moroney, senior research analyst at TowerGroup. "They've used up their home equity to finance their lifestyle, but now with that not available, you're seeing a rise in credit balances and a rise in delinquencies."

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Indeed, in the third quarter of 2007, delinquency rates — the ratio of the dollar amount of loans 30 days or more past due to the amount of total loans outstanding — at the country's 100 largest banks crept up to 4.47%, from 4.24% for the same period in 2006, according to Federal Reserve statistics. During the real-estate boom years (2004 to early 2006), when homeowners easily refinanced mortgages or took home equity loans to pay off mounting credit-card debt, delinquency rates rarely surpassed 4%. Charge-offs, or debt that has been removed from the banks' books and declared a loss, are also on the rise, at 4% at the end of the third quarter, compared with 3.84% a year earlier.

Should delinquencies continue to mount, it could impact a wide swathe of credit-card holders — even those who don't have trouble paying their mortgages or managing their finances. Credit-card debt, like mortgages, is sold to investors in the form of asset-backed securities. The more consumers default on credit cards, the more these investors have to lose and, much like the situation with mortgage-backed securities, they may start shying away from these investments. As a result, banks will be less willing to extend credit to consumers.

There is some good news. "Assuming the economy doesn't go into recession — and that's a critical assumption — we don't expect things [in the credit-card markets] to get as bad [as the mortgage market]," says Scott Hoyt, director of consumer economics at Moody's Economy.com. Historically, delinquency rates are lower than they were during the recession of 2002 to early 2003, when they bordered on 5%. And they're certainly lower than delinquency rates in subprime mortgages.

At least for now they are. Charge-offs and delinquencies are expected to keep rising. TowerGroup's Moroney predicts they'll start peaking this summer, when the debts incurred during the holidays are charged off the banks' books. The latest job numbers released Friday, which put December unemployment at 5%, don't bode well either, as credit-card delinquencies are tightly linked to folks having jobs. While a single jobs report isn't enough to make Hoyt change his outlook for credit cards — Economy.com's forecast is delinquencies could reach 2002-03 levels by the end of the year — he concedes that the report does present "even more downside risk" to the credit-card industry.

Working to the banks' advantage — and consumers' detriment — is the fact that banks can control credit risk and easily make up at least part of their losses. "Issuers have been through downturns before," says David Robertson, publisher of the Nilson Report, a credit-card industry newsletter. "They look ahead and use analytics to determine the people more likely to become delinquent and therefore result in a charge-off." Those people might see their interest rates go up, or their credit availability decrease. In addition, those who've been late on payments are already paying higher interest rates that make up for potential losses. "You might ultimately charge off $1,000, but you might have made more than $1,000 from that person in high rates and fees," Robertson says.

In short, creditors will fight the threat of a crunch by squeezing consumers. Here's what you should watch out for this year.

1. Tighter lending standards

If charge-offs and delinquencies continue to rise, credit-card companies will likely respond by making it harder for consumers to access credit.

"To sign someone up for a new account, banks are going to look for higher credit scores," says Robert McKinley, president of CardTrack.com, a consumer credit card information web site. "Just like in the subprime-mortgage market, the days of easy lending are gone." This means consumers will have to work harder to improve their credit scores, paying their bills on time, trying to keep their balances low and monitoring their credit reports for errors.

2. Reduced credit lines

Like Big Brother, credit-card companies are constantly monitoring everyone. They track customers' card activity, credit scores and other debts, using complex algorithms to predict their risk of becoming delinquent.

When a consumer is flagged as an increased risk, lenders take steps to protect themselves. In the past, the most widely-used tactic was hiking such consumers' interest rates, says CardTrak.com's McKinley. Through a practice called "universal default," a credit-card company could increase your rate even if you always paid your bills on time, but were late on a payment with another bank's account. Now that Congress is taking a closer look at universal default, credit-card companies are turning to other tried and true strategies like reducing the amount of credit they extend.

This year, more consumers can expect to be hit with unexpected decreases on their already existing credit lines, predicts McKinley. The ramifications of such a move could quickly snowball: Lower limits could bring your balance dangerously close to the credit limit, lower your credit score and result in similar action from your other lenders. One way to protect yourself is to make sure you have more credit available elsewhere.

3. Enhanced collections efforts

All of these delinquencies come as welcome news to the folks in the collections industry. After all, more charge-offs mean more business. Collectors take control of these past-due accounts — called receivables — from credit-card companies and keep a portion of each dollar they collect. How soon an account is sold to a third-party collections agency varies by bank, but if delinquencies rise sharply, banks are likely to start passing them along much sooner. "Banks will aggressively peddle this stuff," Moroney says. By selling their receivables to collectors, banks cut the costs of servicing a debt that they may not be able to collect anyway.

Needless to say, all of this is bad news for consumers. Anyone who's ever dealt with a collections agency can tell you their methods can be rough. Worse, there's not much a consumer can do to prevent a delinquent account from going into collections. To protect yourself, be sure to contact your creditor at the earliest sign of trouble. If your interest rate is unmanageably high, ask the lender to lower it. If you're already behind on payments, seek the help of a reputable credit-counseling agency. Even if you're not planning to file bankruptcy, your best bet is to go with one that has been approved to provide prebankruptcy credit counseling by the Department of Justice's Trustee Program, as all such agencies have to pass the program's review process.