Are credit cards the next collapse?

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By Christina Rexrode

First came trouble with mortgages, then home equity loans and commercial real estate. Now, banks are starting to worry about credit cards.

As the economy slows and unemployment rises, consumers are defaulting on credit-card payments more often. And though that trend is unlikely to create a crisis in line with the mortgage fallout, it's still a headache for banks that are already hurting.

U.S. banks charged off 5.47 percent of all credit card loans in the second quarter, according to the Federal Reserve, representing some $50 billion that they'll likely never collect. That's up from 3.85 percent the year before, and that is a movement that's on the radar of Ken Lewis, chief executive of Charlotte's Bank of America Corp.

Asked in a recent TV interview if credit-card debt would be “the next shoe to drop” for the banking industry, Lewis replied: "It, in some ways, already is," adding that such losses have risen "pretty substantially."

Laura Nishikawa, an analyst at the Innovest ratings agency, predicts that banks such as Bank of America and New York's Citigroup Inc. could be hit especially hard by credit-card defaults. That's because those banks, which offer both consumer and investment services, have been depending more heavily on money made on consumer services such as credit cards as the returns in investment banking grow increasingly unpredictable.

To be sure, credit cards don't represent a huge portion of assets for most banks. For example, they comprise about 14 percent of all consumer loans and leases at Bank of America, the country's largest credit-card issuer. The main problem, Nishikawa said, is that "everyone is so weak after what happened with mortgages that another blow to a consumer product would be hard to handle."

Consumer groups have long complained that credit-card issuers push cards onto people who don't need them or can't afford them. They say that rising credit-card defaults – just like mortgage defaults – are largely the fault of banks who lent to risky borrowers.

Innovest estimates that about 30 percent of Bank of America's credit card loans are to subprime borrowers – second only to the failed Washington Mutual Inc., which had almost half of its credit-card loans held by subprime borrowers.

Innovest also estimates that more than half of Bank of America's credit cards are high-limit cards – second only to American Express Co. (Innovest classifies high-limit cards as those with lines of more than $10,000.) Nishikawa says that combination could prove toxic for Bank of America, which may have "lent more than (borrowers) can be expected to pay back."

Bank of America's charge-offs, or loans it doesn't expect to collect on, increased to 6.14 percent of all credit-card loans, or $1.24 billion, in the third quarter. That's up from 4.61 percent the year before.

Executives of Wells Fargo & Co., which is buying Charlotte's Wachovia Corp., also noted credit-card troubles in their recent earnings call. The San Francisco bank, which is the country's eighth-largest credit-card issuer according to The Nilson Report, saw credit-card charge-offs increase to 7.2 percent, or $361 million, from 4.3 percent a year ago. Chief financial officer Howard Atkins blamed "higher bankruptcy rates, seasoning of the portfolio, and continuing economic pressure on consumers," though he said the losses were in line with the bank's expectations.

Innovest predicts that credit-card charge-offs across the industry will continue to rise, peaking around 10 percent by the first quarter of 2009. Some banks are also reporting that consumers are spending less with their credit cards, which hurts the banks because they collect fees from merchants every time a consumer uses a card.

Even so, credit card defaults probably won't wreak as much havoc as mortgage defaults already have, because they're on a much smaller scale.

"This won't be anything like the mortgage crisis," said James Early, an analyst at The Motley Fool. "Simply put, the average person owes a lot more on her house than on her credit cards."

U.S. consumers have less than $1 trillion in outstanding credit-card loans, but more than $10 trillion in outstanding mortgage loans. And the delinquency rate for mortgages is higher than that for credit-cards: 6.41 percent in the second quarter, up from 5.12 percent the year before, according to the Mortgage Bankers Association.

Indeed, no one is predicting that banks will abandon credit cards &mash; only that they'll get stingier with lending and perhaps lose money for a few quarters. Banks usually expect higher default rates on credit cards anyway, since those loans are not secured by a house, car or other type of collateral. That's one reason why banks charge such high interest rates on credit-card loans.

Guy Cecala, publisher of Inside Mortgage Finance, says that the most notable characteristic of the current cycle isn't the rising percentage of credit-card defaults, but the fact that people started defaulting on mortgages before credit cards. This time is different – the mortgage defaults are driven less by the slowing economy, Cecala said, and more by unwise lending and the declines in home prices. "The people going into default actually have jobs," he said.

As banks get squeezed on credit cards, they're sure to pass the pain along. That means they're lowering — sometimes even closing — customers' credit lines, increasing interest rates and declining more applications, which will especially hurt poor or unemployed consumers who use credit cards for basic living expenses. Early, the analyst, said it's hard to feel sorry for credit-card issuers even if they do encounter serious losses: "I don't think these guys will get much sympathy," he said.