The Next Meltdown: Credit-Card Debt

Rising rates are accelerating credit-card defaults and soured debt could further undermine the financial system

by Jessica Silver-Greenberg

That's bad news for players like JPMorgan Chase (JPM) and Bank of America (BAC) that have largely sidestepped—and even benefited from—the mortgage mess but have major credit-card operations. They're hardly alone. The consumer debt bomb is already beginning to spray shrapnel throughout the financial markets, further weakening the U.S. economy. "The next meltdown will be in credit cards," says Gregory Larkin, senior analyst at research firm Innovest Strategic Value Advisors. Adds William Black, senior vice-president of Moody's Investors Service's structured finance team: "We still haven't hit the post-recessionary peaks [in credit-card losses], so things will get worse before they get better." What's more, the U.S. Treasury Dept.'s $700 billion mortgage bailout won't be a lifeline for credit-card issuers.

The big firms say they're prepared for the storm. Early last year JPMorgan started reaching out to troubled borrowers, setting up payment programs and making other adjustments to accounts. "We have seen higher credit-card losses," acknowledges JPMorgan spokeswoman Tanya M. Madison. "We are concerned about [it] but believe we are taking the right steps to help our customers and manage our risk."

But some banks and credit-card companies may be exacerbating their problems. To boost profits and get ahead of coming regulation, they're hiking interest rates. But that's making it harder for consumers to keep up. That'll only make tomorrow's pain worse. Innovest estimates that credit-card issuers will take a $41 billion hit from rotten debt this year and a $96 billion blow in 2009.

Those losses, in turn, will wend their way through the $365 billion market for securities backed by credit-card debt. As with mortgages, banks bundle groups of so-called credit-card receivables, essentially consumers' outstanding balances, and sell them to big investors such as hedge funds and pension funds. Big issuers offload roughly 70% of their credit-card debt.

But it's getting harder for banks to find buyers for that debt. Interest rates have been rising on credit-card securities, a sign that investor appetite is waning. To help entice buyers, credit-card companies are having to put up more money as collateral, a guarantee in case something goes wrong with the securities. Mortgage lenders, in sharp contrast, typically aren't asked to do this—at least not yet. With consumers so shaky, now isn't a good time to put more skin in the game. "Costs will go up for issuers," warns Dennis Moroney of the consultancy Tower Group.

Sure, the credit-card market is just a fraction of the $11.9 trillion mortgage market. But sometimes the losses can be more painful. That's because most credit-card debt is unsecured, meaning consumers don't have to make down payments when opening up their accounts. If they stop making monthly payments and the account goes bad, there are no underlying assets for credit-card companies to recoup. With mortgages, in contrast, some banks are protected both by down payments and by the ability to recover at least some of the money by selling the property.

THE BIG BOYS' BURDEN

Making matters worse, the subprime threat is also greater in credit-card land. Risky borrowers with low credit scores account for roughly 30% of outstanding credit-card debt, compared with 11% of mortgage debt. More than 45% of Washington Mutual's credit-card portfolio is subprime, according to Innovest. That could become a headache for JPMorgan Chase, which agreed on Sept. 25 to buy the troubled thrift's credit-card business and other assets for $1.9 billion. Says a JPMorgan spokeswoman: "

We are aware of the credit quality of [WaMu's] portfolios and will manage risk appropriately."

Credit-card losses are already taking a bite out of lenders' balance sheets. Bank of America, the nation's second-largest issuer behind JPMorgan, revealed on Oct. 6 that roughly $3 billion of its $184 billion credit-card portfolio has soured, a 50% increase from a year ago. At the same time the bank, which is also dealing with the broader financial tumult, said it would have to cut its dividend by 50% and raise $10 billion in fresh capital. The stock stumbled more than 25% the next day when investors largely scoffed at the new shares BofA was offering. "The good news for us is that we have the strength to get through this, but the bad news is that the earnings recovery does take a while," says BofA spokesman Bob Stickler. "We are prudently adjusting our underwriting standards to adapt to changing economic conditions."

Likewise, American Express (AXP), which caters to wealthier borrowers, upped its provisions for credit-card losses from $810 million to $1.5 billion in the latest quarter, a sign that even upscale consumers are having trouble. "We have enhanced our credit models and continue to prudently manage our risk by scaling back some card acquisition efforts and reducing credit lines where appropriate," says an AmEx spokeswoman.

The industry's practices during the lending boom are coming back to haunt many credit-card lenders now. Cate Colombo, a former call center staffer at MBNA, the big issuer bought by Bank of America in 2005, says her job was to develop a rapport with credit-card customers and advise them to use more of their available credit. Colleagues would often gather around her chair when she was on the phone with a consumer and chant: "Sell, sell." "It was like Boiler Room," says Colombo, referring to the 2000 movie about unscrupulous stock brokers. "I knew that they would probably be in debt for the rest of their lives." Unless, of course they default. Responds BofA spokeswoman Betty Riess: "The allegations do not reflect our practices. The bank has nothing to gain by extending credit to people who do not have the ability to pay us back."

Now regulators and politicians are trying to curb some of the industry's abusive practices by limiting interest rate hikes, abolishing certain fees, and cracking down on questionable billing practices. Under rules proposed by the Federal Reserve, a borrower would have a 21-day grace period before being hit with a late fee, instead of the few days offered by some firms now. A similar plan working its way through Congress would allow banks to increase rates only on consumers' future purchases—not existing balances. And under both proposals, credit-card companies would have to allocate account holders' payments equally to balances with different interest rates. Currently, firms first apply payments to the debt with the lowest rate, which means it takes longer and makes it costlier for consumers to pay off their debt.

LAST HURRAH

The Senate isn't expected to vote on the matter until early next year. The Fed's rules, currently being reviewed by the industry, could take effect around that same time. But lenders seem to be preparing for the worst-case scenario: an outright ban on some practices.

To get ahead of rules that would hamper their ability to reprice accounts, for example, many firms are jacking up interest rates. A survey of major issuers by consumer advocacy group Consumer Action found that 37% of firms have raised rates across the board, even for borrowers with relatively pristine credit records. "In anticipation of a federal crackdown, card companies are scouring their portfolios and tightening credit," says Tower Group's Moroney.

Even consumers like Michael Polemeni, who miss only a single payment, can find themselves in the crosshairs of credit-card companies. The independent computer specialist relied heavily on his credit cards for child support payments and business expenses. Polemeni generally made more than the minimum payment each month, carrying a $2,000-or-so balance. But in July he missed a payment, and Providian, owned by Washington Mutual, jacked up his rate from 9% to 30%. "I was shocked because I am a very good customer," say Polemeni, who paid off the full balance immediately. WaMu didn't return calls for comment.

Not everyone will be able to pay down their debts like Polemeni. And that could make for a vicious cycle: As credit-card companies raise rates, more consumers fall behind on their payments, which then hurts the issuers. Says Innovest's Larkin: "We are going to see the banks massively hit."

Matt Mahurin

Matt Mahurin

Polemeni's interest rate jumped to 30% after a missed payment John Chiasson