While the subprime mortgage crisis has taken a heavy toll on the American economy, a potential crisis in the credit card industry may cause even larger disruptions.
The U.S. economy started down the road to the present crisis in 2007, when fueled by excessive risk taking and spurious lending by banks and a downturn in the overall jobs market, an increasing number of people with subprime mortgage loans — that is home loans made to people with poor credit — began to fall behind and eventually default upon their loans. These defaults sent shockwaves throughout the economy, causing major financial institutions to collapse and exacerbating what was already shaping up to be a severe recession.
While the worst of the subprime mortgage meltdown has passed, a similar meltdown in the credit card industry may be looming. The very bad practices that have led to a meltdown in the mortgage market — spurious loans and excessive risk taking — have also been very much in practice in the credit card industry. To put it in plain terms, the credit card companies have issued cards with sky-high rates and larger than prudent credit limits to customers whose credit history and ability to keep up with payments was dodgy, at best.
American consumers have nearly $1 trillion in credit card debt, and economists fear that a substantial portion of it is just as toxic as the subprime mortgages that helped drag the economy down in 2007-2009. Because of their near-ubiquity in the U.S. economy, the potential credit card meltdown threatens the American way of life because it could severely damage the American middle class, the nation’s largest socioeconomic group and the engine of consumer spending, which accounts for more than two-thirds of the U.S. economy.
According to experts, credit card companies have already been taking heavy losses as customers become delinquent on payments and begin defaulting. Industry reports show that in 2009 Bank of America, the nations No. 2 credit card issuer had about nearly $3 billion in toxic credit card debt. BoA’s total credit card portfolio stands at about $184 billion. As a result of delinquencies and debts, the company has had to cut its dividend by half and raise nearly $10 billion in new capital.
In the early months of 2010, charge-offs, or debts credit card companies designate as uncollectable, spiked sharply. Many economists expect that the charge-offs will level off later in the year, but if they don’t, it can result in a variety of negative impacts.
A mass amount of charge-offs can result in a credit freeze. This happens when banks and lenders like credit card companies become extremely risk adverse and severely tighten their rules and regulations concerning lending. Because many consumers use credit cards for purchases, and many businesses also require credit cards to make purchases, an increase in interest rates or a decrease in available credit via credit cards can result in people and businesses being unable to buy things, which negatively impacts the economy, a drop in banks and credit card issuers profitability because they’re doing less business and business will have less access to an important source of capital.
Even worse than a credit freeze, however, would be the insolvency and collapse of financial institutions as a result of toxic credit card debt. The subprime mortgage debacle hammered the financial services industry in 2008 and 2009, causing the collapse of many banks and financial institutions. These collapses had a seismic effect throughout the economy, resulting in the mass layoffs and weak economic conditions that persist to this day.
The U.S. government has begun to act to stave off another economic crisis. The recently passed CARD Act will work to curb some of the abusive interest rates and fees levied by credit card companies, and provide the industry with stronger regulation to prevent the type of behavior that led to the subprime debacle. The government has also passed a stimulus package, and a jobs bill aimed at putting people back to work, thus making them much more likely to pay their credit cards and not become delinquent.
While these are steps in the right direction, according to economists, the potential for a credit card meltdown remains if a significant number of people fall behind on monthly credit card payments and default. Also, the government’s ability to react to such a crisis is likely limited, as it has already spent substantial amounts of money bailing out the auto and financial services industry, and as public opinion has turned against such bailouts.