Credit-Card Debt: The Next Possible Implosion

As consumers face a cornucopia of bad financial news -- plunging home values, higher food and gas prices, a shrinking job market and the like -- there is one place they may be turning to fill in the gaps: credit cards.

U.S. consumers are already burdened with a mountain of debt: $2.54 trillion at the end of February, according to the Federal Reserve. Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.

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The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.

The other available crutch -- credit cards -- may simply inflict more pain, as balances accrue, interest rates rise and fees are attached. This is especially true for those with weak FICO scores, who are already in a bad debt situation and face higher interest rates because of the risk involved in lending to them.

"To go to worse in debt from badly in debt right now could be something that is largely irreversible," says Michael Branham, a financial planner at Edina, Minn.-based Cornerstone Wealth Advisors. "It doesn't make any sense, and yet people are doing it. They continue to spiral into more and more debt."

Nonetheless, lenders are happy to oblige, with some caveats, in an effort to make up for miserable first-quarter results. The banking industry has posted massive losses from mortgages and other housing investments as the market began to collapse.

The downturn was due in large part to risky loans issued to consumers with weak credit profiles, known as "subprime" or "Alt-A" borrowers. Now that those customers -- as well as some with better financial measures -- are facing delinquencies, defaults and foreclosures, lenders of all stripes have tightened their standards.

"There are many banks that see opportunities in the consumer-lending space because they feel they have the capital and resources to take some market share," says James Chessen, chief economist at the American Bankers Association, an industry trade group. But, he adds: "I guarantee any borrower that's had late payments on their mortgages will not see a lot of offers for any other type of consumer-loan product."

Credit-card debt, which is unsecured, is riskier for banks to provide and requires more capital reserves than asset-backed loans. But the return on equity for credit-card lending far exceeds that of mortgages or other loans, because of higher interest rates and other fees. For instance, Capital One's business that handles credit cards had a 50% ROE last year, compared with 6.5% for its mortgage business and 10% for the company overall, according to Senior Banking Analyst Philip van Doorn. The bank lifted pricing and fees and modified terms of its card agreements last year.

"It's an uglier business," says van Doorn, "but there's oodles of money to be made."

Several major banks and credit-card companies are looking to drive growth by tapping into new credit-card customers at home and abroad, according to outlooks they provided in recent weeks. Whether this will ultimately help the banks -- or cash-strapped consumers -- is uncertain and depends on whether the economy can regain its footing.

American Express said Wednesday that profit from its U.S. card business fell nearly 20% last quarter as it spent more to attract new business and faced higher delinquency rates and charge-offs. However, earnings from its much smaller international segment rose 30% on higher borrowing and spending by cardholders. CEO Kenneth Chenault said the company is targeting affluent U.S. consumers and new customers abroad.

Bank of America, the largest U.S. retail bank, said earlier in the week that credit cards represented nearly two-thirds of the bank's consumer losses during the period. Delinquencies of 30 days or more rose to 5.61%, up from 5.45% in the previous quarter. They were particularly higher in states worst affected by the housing market -- like California, Florida, Nevada and Arizona -- which make up about a quarter of Bank of America's card portfolio.

Still, Bank of America remains hopeful as consumers keep spending: It had 10% higher outstanding card balances last quarter, on average, than during the same period a year ago. "Even though the economy has slowed, we continue to add new retail customers and expand our relationships with existing customers," CEO Ken Lewis said during a recent conference call.

Similarly, Citigroup posted higher U.S. credit-card write-offs during the first quarter as delinquencies advanced at a faster rate and more customers filed for bankruptcy. JPMorgan Chase said its card-services business had a 20% profit decline in the same period. That was caused by higher charge-offs, but also increased spending to draw in new customers.

Despite all the bad news -- more debt, more delayed payments, more bankruptcies -- there are some silver linings for the banks. As the U.S. market soured, Citi opened 2.3 million new card accounts abroad last quarter, particularly in Mexico and India, where the economy and middle class are growing rapidly.

Even in the U.S., not all the news is foul.

Capital One CFO Gary Perlin noted a "striking finding" that about two-thirds of its credit-card customers who were 90 days or more past due on mortgage payments were still current with credit-card payments. That figure has remained steady over the past year, he said, because consumers "have a bias to pay the loans that ... provide enduring value."

By such logic, at least 66% of consumers value credit-card purchases above their homes. Certainly that's true for some who feel a need to have the latest fashion, accessories, technology and cars, regardless of financial circumstances. But others place higher importance on credit cards because they're a means to purchase immediate needs, like food and gasoline, when cash isn't available. For those with adjustable-rate mortgages that reset at higher rates, perhaps making huge mortgage payments on a home whose value is plummeting seems like throwing cash into a black hole.

"People feel like a $500 credit-card payment is more affordable than their $2,500 mortgage payment," Branham says. "Psychologically, it makes sense."

While the problem for banks is the risk, the problem for consumers is the cyclical nature of credit-card debt. A load of debt can take decades to pay off, and only lengthens if the cardholder is still making purchases. High interest rates and fees only compound the problem.

Say a consumer has $10,000 of credit-card debt with a 20% interest rate and the minimum payment is calculated by taking 2.5% of the average daily balance. It will take more than 50 years to pay off the balance with just the minimum payments -- if no further debt is added -- and cost nearly $20,000 in interest charges, according to City National Bank's online calculator. That doesn't include additional spending, fees for late payments, potential interest-rate hikes or other charges the consumer may incur.

The outlook for card issuers may be sunny if they hold to stricter lending standards and expand the business at a sensible rate. But the outlook for U.S. consumers is less robust, especially if current economic trends continue. Further job cuts, higher costs of living and a weaker housing market will leave very few U.S. consumers isolated from the downturn.

Using credit-cards as a last resort might seem like temporary relief, but it may also be the straw that breaks the back of the consumer.

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