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Chadwick: Credit Cards - The Next Crisis

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Credit cards

Watching parts of the House Financial Services Committee interrogation of the CEOs of the major banks and brokerage firms, I found myself fluctuating between being exasperated and bored.

It was reminiscent of so many other similar hearings – Congress educating itself after the fact. It was patently clear that our Government leaders did not understand the repercussions of their own political motives in contributing to the housing crisis they themselves fostered over the last twenty years.

On the other hand, I was heartened to hear the responses from the CEOs being questioned – for the most part, I got the sense that they understood the issues, were determined to solve the problems and to repay the capital infusions from the Federal Government and were investing a huge amount of sweat equity. Importantly, it seemed that many of them had considerably deleveraged their companies, and were indeed making great efforts to lend money. This all lent credence (at least on my part) to the fact that the credit markets are slowing starting to thaw out. That is good.

Despite the serious condition of the US economy today, the financial markets are in far better shape than they were for a few weeks last fall, when on the heels of the Lehman Brothers bankruptcy, the global financial system was perilously close to meltdown. The US (and other) Governments came to the rescue by assuming the role of lender of last resort. TARP I may have a bad reputation, but it did succeed in restoring solvency and avoiding catastrophe.

The problem of the moment is housing.

Toxic assets still cannot be priced, and understandably banks don’t want to risk selling at the bottom of the market. Every time I listen to Bill Seidman, I wish he were in charge again. He oversaw the RTC some 20 years ago, resolving a frightening real estate crisis during the savings and loan debacle, without long term impairment to the economy. Listening to the hearings in Congress yesterday, I came away believing that this real estate crisis, even without Mr. Seidman, has started to turn a corner.

But there is another big problem looming right around the next corner and it is the credit card debt crisis, and it will come home to roost very shortly. Ken Lewis, the CEO of BankAmerica, said as much in Congress yesterday. His words were (perhaps slightly paraphrased). ‘It will be a terrible year for the credit card industry.” While not as bad by a long shot as the global financial meltdown that was averted in October, it is a really serious problem that will only add to the depth of the recession.

Credit card debt is bundled up just the way mortgages are, so as consumers increasingly default on that debt – and they will in a major way – we will have on our hands another case of Humpty Dumpty falling apart and no way to put it back together. As this scenario unfolds later this year, the banks and private issuers will increasingly reduce credit limits to their cardholders and even cancel the cards outright. That “solution” will only exacerbate the recession because it will result in reduced consumer purchases.

The banks and the private label issuers know this is a serious problem and they also know that they themselves are the cause of the problem. In the first place, they gave too much credit to people with insufficient means to pay it back, just as they did with residential mortgages. To add to the problem, instead of forcing overextended customers to pay back the debt, they simply extended them more credit and in return charged higher and higher interest rates, putting their own customers into a modern day debtor’s prison of sorts.

There is a solution and John Mack, CEO of Morgan Stanley , alluded to it in his interview with Erin Burnett of CNBC yesterday afternoon, when he said that he hoped there was a way to lower the interest rates on credit card debt.

Right on! The sooner the better!

The credit card business has been one of the most profitable divisions of the banking industry, in large part because of the usurious rates of interest inflicted on the credit card holders. But with giant defaults looming on the horizon, those profits may soon evaporate. The banks could solve the impending disaster by cutting rates in a major way now, thus allowing credit card customers to pay down their balances more easily. It seems so logical that it is hard to comprehend why it is not already being done. But we all know that so far credit card interest rates have been going in only one direction and that is up.

I keep looking for signs of economic light at the end of the tunnel, and yet this credit card crisis scares me too much to get hopeful yet. If consumers have to spend a significant portion of their discretionary income on credit card interest expense, there simply won’t be enough consumer spending power left to stimulate the economy. And without the consumer to stimulate the economy, how do we get out of this recession?

It’s not a pretty picture.

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Patricia W. Chadwick has had more than 35 years of investment experience. She is the founder and president of Ravengate Partners LLC, a consulting firm that provides advice on financial markets and global economics.