Because credit cards are accessible to just about anyone, even people with low credit scores, they tend to be the riskiest types of loans that banks make. This was one of many observations that investors could take away from the results of this year's stress tests.
One exercise the Federal Reserve goes through when it conducts the annual stress tests is to forecast default rates across different types of loans. On one end are first-lien mortgages -- basically, your run-of-the-mill residential home loan. On the other end are commercial loans -- both for operating purposes and to finance real estate projects.
Credit card loans tend to be riskier than other types of loans. Image source: Getty Images.
Each of these loan types has unique risk characteristics. Residential mortgages, for instance, are secured by real estate, which limits a bank's downside in the event of a default. The same is true for commercial loans, which tend to be secured by a company's cash flows.
It's for this reason that credit card loans are so risky, as they aren't secured by anything other than a person's promise to pay. And because it's so much easier to get a credit card than it is to get, say, a mortgage, it also means that the quality of borrowers who qualify for credit card loans is lower on average than other types of borrowers.
You can see the impact of this by looking at the Fed's estimates in this year's stress tests of how these different loan types would perform through an economic downturn similar to the financial crisis. As the chart below shows, based on the central bank's projections, credit card loans would experience a 13.7% default rate, which is nearly twice the default rate of the runner-up, commercial real estate loans.
Data source: Federal Reserve. Chart by author.
This is an important chart for investors in bank stocks to keep in mind. I say that because each bank has a unique concentration of loans and thereby a unique risk profile.
Three banks/financial services companies that come immediately to mind are American Express (AXP +1.89%), Capital One Financial (COF +1.96%), and Discover Financial Services (DFS +0.00%). All of these banks have heavy concentrations of credit card loans.
Essentially all of American Express' loans are associated with outstanding credit card balances, 79% of Discover Financial Services' loans are classified as such, and Capital One weighs in at 44%.
This isn't surprising given that these companies are, first and foremost, credit card issuers. Even Capital One, which has diversified away from a singular focus on credit card loans, still allocates roughly half its loan portfolio to the segment.
The benefit to an outsized concentration in credit card loans is a higher-yielding loan portfolio, as credit card balances tend to generate double-digit yields. Discover Financial's credit card loans pay 12.7%, Capital One's pay 15%, and American Express' net interest yield on card member loans (i.e., after funding costs are subtracted) is 11.1%.
By contrast, the typical 30-year mortgage yields around 4% today, while the prime rate for corporate borrowers isn't much higher, at 4.25%.
The point in all of this is that the performance of banks with heavy concentrations in credit card loans is likely to swing more violently with the credit cycle. When the economy is great, the high yield paid on outstanding credit card balances will pad the pockets of companies like American Express, Capital One, and Discover Financial. But when things take a turn for the worse, the defaults on credit card loans can cause an abrupt change in fortune.
