We all know by now that the credit crisis was sparked by mortgage losses. As a result, investors have yet to pay much attention to the potential losses on other forms of bank lending, including credit card loans. They should. In particular, investors should be tracking banks' net charge-off rates.
"Their what?" you ask.
Charge-offs are loans that banks write off because they don't think they'll be able to collect on them. Dividing the charge-offs by the amount of outstanding loans yields the charge-off rate.
Two reasons to track charge-off rates
Why should you be paying attention to charge-off rates? Because credit card losses are gathering steam, and because there is reason to believe the loss rates could ultimately exceed those witnessed during other credit-cycle bottoms.
At the end of 1990 -- the tail end of the last major recession -- credit card loans and related plans represented 3.5% of personal consumption expenditures; by the end of 2007, that figure had risen to 4.5%. "A tiny one-percentage-point increase!" you may scoff. Well, that tiny percentage-point increase adds up to more than $300 billion in added debt.
Mr. Wealth Effect, meet your nemesis!
The orgy of increasing personal debt that took place during this decade is directly related to the housing bubble, through the "wealth effect." People raised their level of consumption, bolstered by a rise in their wealth that came from increases in the value of their homes. (Just replace "home" with "stock portfolios" to describe the late 1990s instead of the mid 2000s.)
In plain language: "Honey, the house has almost doubled in value -- let's buy a Mercedes and go on vacation to St. Barts. Heck, let's just swing for the comprehensive lifestyle upgrade!"
The only way to spend increases in wealth that are caused by rising home prices is to "charge it" -- i.e. take out a home equity loan to monetize the rise in value and/or put your purchases on your credit card.
All is well as long as housing prices are rising. Now, the U.S. consumer is getting acquainted with the negative wealth effect. With housing prices down substantially from their peak and threatening further declines, the money well that was thought to be ever-flowing (remember the old chestnut about how housing values could only ever increase?) has dried up.
Indeed, between drops in home prices and stock values, broker ISI Group estimates that household wealth could drop by 14% this quarter -- the largest such drop ever recorded. There is no getting away from this reality: People are adjusting, as they find they can no longer go around devouring goods and services on credit.
The economy gets thrown for a loop
The bad (or worse, really) news is that this phenomenon creates a feedback loop. As consumers rein in their spending, the demand for goods and services falls. Businesses scramble to adjust to lower levels of demand by reducing their output of goods and services and shedding workers. Presto! Unemployment goes up, and this puts even more pressure on consumers' ability to spend -- or pay off credit card debt.
The following table shows that charge-offs on credit card loans crept up during the third quarter and are already up sharply over the previous year's period. As we head into recession, expect the feedback loop I described above to gain steam and charge-off rates to increase further.
Net Charge-Off Rate, Credit Card Loans
|
Q3 2008 |
Q2 2008 |
Q3 2007 |
|
|---|---|---|---|
|
US Bancorp |
4.85% |
4.84% |
3.09% |
|
JPMorgan Chase |
5.56% |
5.66% |
3.89% |
|
Bank of America |
6.40% |
5.96% |
4.67% |
|
Wells Fargo |
7.20% |
6.95% |
N/A |
|
American Express |
5.7% |
5.1% |
3.2% |
|
Citigroup |
7.02% |
6.18% |
5.00% |
|
Capital One |
6.13% |
6.26% |
3.85% |
Source: Capital IQ, a division of Standard & Poor's.
Don't confuse the business and the stock
Although another wave of bank losses may sound like disastrous news for bank-stock investors, it's difficult to gauge the ultimate impact on stock prices. To do that, you'd first have to make a call on the extent to which losses are already priced in. The market is a discounting machine; stock prices are derived from estimates of future earnings.
(Confusing business impact and stock-price impact is the most common fallacy that financial journalists and investors commit. I see daily examples of this in the media.)
So where do I stand on this separating business and stock-price impact? I believe that investors aren't fully discounting potential losses on credit card loans yet -- or on auto loans, while we're at it. HOWEVER (and it really is a big "however"), the level of attention and anxiety surrounding expected mortgage-related losses may be enough to compensate: By expecting a complete apocalypse in mortgage loans and securities, investors may have created a cushion in the stock price that can "absorb" credit card losses, as well.
If that's the case, additional credit losses won't necessarily result in further stock-price declines.
Don't bet on or against the sector; focus on stocks
Still, I hesitate to make pronouncements regarding the entire banking sector. If you have a multiyear time horizon and some tolerance for volatility, you'd be better off sifting through the wreckage for individual names.
My suggestion is to look for well-run banks that have traditionally outperformed their peers in periods of mounting credit losses, and whose stock prices have been dragged down along with the sector. If you're able to identify those situations, you can turn the industry's rising tide of credit losses into your stock gains.
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