In the face of weakening economic conditions, many people have found the interest rates on their credit cards heading significantly higher.  As a result of “risk based” pricing by the nations largest banks, many of these individuals saw higher interest rates even though they were not delinquent on their payments.  According to CreditCard.com, the average outstanding credit card debt for households was $10,679 at the end of 2008.  This puts the average yearly interest cost on credit card balances at over $2,000 if we assume the average credit card rate is 14.2% (according to IndexCreditCards.com).

Right now, banks are cutting credit lines and raising fees — and have been reluctant to pass along the savings resulting from Federal Reserve interest-rate cuts meant to boost the sagging economy. President Obama has met with credit card executives and has called for an end to abusive credit card lending practices. Last year, the Federal Reserve passed changes to credit card practices that will take effect in 2010.  The House has just passed a bill deemed to be the Credit Card “Bill of Rights” targeting credit card fees and rates.  The Senate is expected to pass its own version shortly.  Restrictive legislation is being passed at the same time that banks have absorbed about $55 billion in credit card defaults last year, up from $43 billion in 2007.  These defaults could are likely to reach $65 billion this year.

The crux of the problem facing the banks is that credit card lending is unsecured, meaning that if an individual decides to default on his/her credit card debt that the bank has no asset to seize as compensation.  This is leading to massive charge-offs (debt that has been deemed uncollectible) at the banks.  Losses on consumer credit are probably the number one drag on bank earnings right now and these charge-offs jumped to an annualized rate of 8.8 percent in February, the highest in 20 years of data.  The credit card losses at the banks are directly correlated with the unemployment rate in the country, and according to Moody’s, credit card charge-offs are likely to peak at 10.5 percent in mid-2010.

One of the issues that very few people are talking about because it hasn’t shown up in the data yet is that the average outstanding credit card debt for households is growing, and due to the recession, is doing so at an even more rapid pace.  It’s pretty clear that in household where someone has lost a job, cash would only be used sparingly and only to pay for items that couldn’t go on a credit card such as mortgage payments, car payments, and education expenses.  The reason behind this is that since the time frame in which the person will regain employment is very uncertain, its in the best interest of the individual to deplete their savings as slowly as possible so they can continue to live in their home and drive their car until they find new employment.  The credit card would be used to put food on the table and to pay for all other living expenses.

Even personal finance guru Suze Orman, who has built a career advising Americans to get out of debt and how to do it, is now advocating that consumers go into credit-card debt in order to make sure that they have eight months worth of cash on hand in case of an emergency.

“If you have an unpaid credit card balance not much saved up in emergency savings, I need you to listen up. My advice has changed. I want you to only pay the minimum due on your credit card balance, and instead, make it your top priority to build as much of an emergency cash fund as you can”  –Suze Orman

Because of rising charge-offs and growing credit card balances, banks have no choice but to raise credit card rates to reflect the increased riskiness of their borrowers.  Even if a person has been making payments on time in the past, there is no guarantee that they will continue to do so in the future, as they could soon find themselves drowning in their own consumer debt.

Legislation to restrict credit card rate increases must be carefully crafted in order to reflect the reality of the current situation that we are in.   Banks only give consumers credit cards because they expect to make money.  In fact, credit card lending has historically accounted for between 15 percent and 25 percent of pre-tax income at JPMorgan, Bank of America and Citigroup, according to Moody’s.  If a bank feels that it can’t raise its interest rate to a point where it properly reflects the creditworthiness of the borrower, it won’t lend to them at all.  A cap on credit card rates would lead to a contraction in consumer credit, taking credit cards out of the hands of the people who need them most.

Everyone generally agrees that we need to end abusive credit card lending practices, such as the need to read the really fine print in order to avoid getting slammed with unnecessary fees, and I commend the Obama administration for showing leadership on this issue.  What we don’t need is legislation driven by consumer outrage over higher credit card rates, that has the potential to drive banks to restrict credit card lending altogether.  That is our nation’s current dilemma.

Uncategorized banks, credit cards