Banks' Future Woes in One Word: Plastic

by David Ellis

Major banks have been hit hard by bad mortgages. Now, fears are growing that troubled financial institutions are going to have another consumer headache to deal with: credit card defaults.

There have been no shortage of warnings about the business as the economy continues to sputter.

Just last month, Bank of America CEO Ken Lewis warned lawmakers at a high-profile Congressional hearing on the government's $700 billion rescue plan that he had no doubts 2009 would be an "awful year" for the credit card industry.

Unfortunately for Lewis and his peers, the nation's leading banks dominate the credit card landscape.

Of the nearly $76 billion in credit card loans in 2008, nearly $46 billion came from Bank of America, JPMorgan Chase and Citigroup alone, according to credit rating agency Moody's.

Fearing a wave of credit card-related losses, banks have been aggressively setting aside funds to help cushion the blow. One problem, note analysts, is that banks aren't quite sure just how severe the losses will be.

Industry charge-offs, or loans a bank considers to be uncollectable, climbed to a historic high of 7.73% in December. Most analysts expect that figure to head higher as more and more people find themselves out of work.

Unemployment rates, widely viewed as the most reliable indicator of future credit card losses, climbed to 8.1% in February - its highest level in 25 years.

A widely used rule of thumb is that charge-offs typically climb to 1 percentage point above the unemployment rate. And many expect the unemployment rate to keep rising throughout the year.

With that in mind, Mike Taiano, an analyst with Sandler O'Neill, said he thinks the charge-off rate could wind up peaking at a level north of 10%.

Of course, this is not the first time that credit card issuers have had to contend with relatively high unemployment. During the recession in the early 1980s, the jobless level peaked at 10.8% in late 1982. But some experts point out that this is a much different time for the industry.

Not only did a much smaller slice of the American public own a credit or charge card, the amount of credit issued by the industry was just a fraction of what it is today. As of January 2009, the amount of outstanding credit in the industry totaled just under $1 trillion, compared to just $70.5 billion in 1982.

Coping With Losses

Banks have a whole other host of problems to worry about now that they didn't have to contend with in the 1980s.

Democratic lawmakers have proposed legislation that would allow so-called "mortgage cram downs," which would let judges reduce mortgage debt for individuals who have filed for bankruptcy.

Many in the banking industry fear that passage of this bill could prompt many homeowners to file for bankruptcy and default on many of their other debts, including credit cards.

But some analysts point out that the magnitude of any future credit card problems will be mitigated by the fact that most banks' credit card businesses are a fraction of the size of their ailing mortgage portfolios.

"You are not going to have a complete redo of the subprime mortgage mess because it is simply not the same scale," said David Robertson, publisher of the industry trade publication Nilson Report.

What is also encouraging, notes Robertson, is that banks' credit card operations have become much more adept at adjusting to tough economic times after years of practice, including the downturn that followed the dot-com bubble earlier this decade.

Facing additional losses, credit card issuers are doing what they can to insulate themselves from further losses, including lowering credit limits for some cardholders, closing accounts or getting out of the business altogether.

American Express made headlines recently after it offered to pay some of its cardholders $300 if they paid off their balances and closed their accounts by the end of April.

And there has been speculation that Citigroup is looking to enter into a joint venture for its private label credit card division -- which serves retailers -- as a way of eventually getting out of the business altogether.

What many leading card-issuing banks won't do, said Stuart Gunn, a director at the Chicago-based management consulting firm Bridge Strategy Group, is attempt to sell off their core credit card operations.

Not only would banks have a hard time attracting any bidders in the current economic environment, but they would also lose a key component of their retail business. Banks need credit card operations to both lure in new customers and keep existing ones, not to mention make a buck.

"If you want to be the retail bank of choice, it means you have to have CDs, debit cards, home equity loans and credit cards," said Gunn. "Do you really want to exit one of the major lines of business?"

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