Cash-strapped Americans are ringing up more and more purchases on their credit and debit cards, and there could be a steep price to pay ahead.
Though the trend is a boon for the companies that issue the cards, analysts worry that there could be long-term problems not only for consumers but also for the anemic economy and the already-troubled banks that will be underwriting all that risky debt.
"Right now what we're seeing is the US consumer losing their disposable income as they have to spend more and more on necessities because of higher prices for gas and food," says Ron Ianieri, a market strategist and co-founder of the Options University investor education center. "Normally when you have a certain budget and you can't keep up with the budget one of the easy steps is to extend that budget using credit."
One of the main problems with that is US consumers—and their counterparts in Europe as well—already are delinquent on their credit card payments in numbers not seen in six years. The Federal Reserve last week said credit card delinquencies hit 4.86 percent in the first quarter in 2008, while revolving debt—or the type used in credit purchases—hit $957.2 billion in March, a 7.9 percent increase.
As all that risky, high-interest debt keeps accumulating, consumers will find themselves deeper in a hole that threatens to keep the economy in its sluggish state. Economists worry that the problems are being exacerbated by consumers using credit not only to buy big-screen TVs and patio furniture, but also to pay their mortgages and shop for groceries.
"There's a significant risk to people who are using credit cards to help them try to bridge the gaps that they're facing," says Sean Snaith, director of the University of Central Florida's Institute for Economic Competitiveness. "The reality is the economic picture isn't going to clear up instantaneously."
Meanwhile, the banks that underwrite the credit card debt stand to lose as the delinquencies continue to rise. Standard & Poor's on Monday issued a dour forecast for banks in 2008, in part because of their exposure to bad debt.
Ianieri ranks his "starting five" in terms of exposure to risky debt: Lehman Brothers , Citigroup , Bank of America , UBS and Merrill Lynch .
"It's a disaster, it's a time bomb," Ianieri says. "The credit crisis is a lot more severe than it's being made out to be. I think the government is doing everything it can to keep the severity of this situation under wraps from the general population. I think they're just trying to bide time for these banks."
For the credit card companies, though, it's a different story.
Little to Lose
Visa and Mastercard back comparatively little of the credit actually issued through their cards, meaning they have a low level of risk for defaults and other payment issues. They get paid a fee each time someone uses their cards, and the banks that issue the cards assume responsibility for the debt.
As such, investors and analysts are fawning over the two companies in the face of consumer cash issues and the growth of emerging markets, where credit cards are only beginning to find popularity.
"The reality is probably some of it is hype, but some is based on fact," Snaith says. "'Check or cash' has been replaced by 'debit or credit' and that's going to be a continuing trend not just in the US but spreading worldwide."
In a note issued last Thursday, Lehman Brothers raised its outlook on Mastercard, escalating its price target to $335 from $300. Other analysts have joined in the enthusiasm, with Stifel Nicolaus on Tuesday jacking up its price target from $312 to $367.
Visa has gained from the enthusiasm for Mastercard. As of noontime trade Tuesday, both Visa and Mastercard were up more than 12 percent since May 23.
"They have no risk. It's per transaction," says Nadav Baum, managing director of investments at BPU Investment Management. "That's why Visa and Mastercard are bucking the trend when it comes to the other financial companies. Even though they group them as a financial company, they're really not."
Lehman analyst Bruce Harting, in his research note on Mastercard, pointed out that the company believes it can duplicate its US business model in countries including Brazil, Hungary, Poland, Russia, India and China, nations where it projects 39 percent revenue growth.
Similarly, Americans shopping abroad might be more inclined to use their plastic as the dollar begins to gain ground against other currencies. A purchase in euros now could cost fewer dollars by the time the next monthly bill rolls around if the US currency continues to appreciate.
"That's another reason why Mastercard and Visa will continue to do well," Baum says. "It's all hand-in-hand."
Finally, there are the responsible consumers who pay their bills in full every month and are joining the legions of people who no longer want to carry cash. They enjoy taking advantage of the rapid growth of retailers and restaurants offering debit options, plus using points they can accumulate by utilizing their cards.
"The danger is in painting with a broad brush and casting all consumers as reluctant or unable to spend," says Greg McBride, senior analyst at Bankrate.com. "There are a lot of consumers that are not in the state of distress and can continue to spend in a manner that's not very different than a year or two ago when the economy was stronger. The card-holders that pay their balance in full every month, the incentive is for them to use the cards as much as possible."