Credit Crisis Act III – Are Credit Cards Next?

The worldwide credit crisis has brought us rising unemployment rates, frozen credit markets, and an increasingly tight economy. With consumers increasingly strapped, could credit cards be the next domino piece to fall?

Credit card debt reached a record high in 2008, almost topping a trillion at $951 billion, according to the Federal Reserve. An estimated one third of that debt is held by people with low credit rating, who are historically more risky borrowers.

More and more consumers who are unemployed or whose jobs have been cut back are having to rely on credit cards to pay for everyday essentials like food or utilities. Using credit cards to cover daily expenses easily becomes a vicious cycle. As credit card debt increases, so do monthly payments, eventually to levels cardholders can no longer afford. Worse, one small misstep like a late payment, or even just a high credit card balance, may cause the card issuer to raise the interest rate on the card. This in turn causes the minimum payment to go up, making it even harder for cardholders on a financial tightrope to meet their monthly obligations.

Not surprisingly, credit card defaults have reached historic levels, projected to reach as high as 10-11 percent this year. Credit card charge-offs, which are loans that banks have given up on collecting, reached a record 7.5 percent in December of 2008, according to Fitch Ratings.

Like the subprime mortgage crisis, rising credit card defaults affect us all. For credit card companies, already reeling from the blows of the subprime mortgage crisis and credit default swap debacle, it will add yet another strain on sagging bottom lines. Increasing credit card defaults hold the potential to set off another vicious cycle, plunging banks into even deeper turmoil. Credit card debt, like mortgages, is securitized, that is, it is bundled together to create “credit-card receivables.” These securities are then sold to investors. If credit card defaults continue to increase, it will become harder for credit card companies to sell their credit card debt to investors. This will cause credit card issuers to tighten terms even more, causing more defaults, and on and on.

How can you protect yourself? There never was a better time to do everything you can to get rid of your credit card debt. Interest rates have already reached astronomical levels and banks are likely to tighten the reins even further. Short of that—avoid anything that might trigger higher interest rates. Even one late payment could trigger interest rates as high as 29.99 percent. Maxing out your credit cards similarly could cause your limits to be lowered and interest rates raised.

The Fed has approved new rules that will limit the extent to which card issuers can arbitrarily increase interest rates, but these won’t go into effect until July 2010. Until then, to protect yourself from having your interest rates hiked or limits slashed, learn what credit card companies look for to isolate high-risk users, and make sure you don’t match that pattern.

Published: May 22, 2009