So, the shadow banking system is blown to smithereens, mortgages have been gutted, and the credit default swap market is up in smoke. What's left to purge out of the financials system?
Easy. Credit cards.
And by purge, I really mean purge. Credit card companies aren't just sitting back and absorbing losses, but frantically slashing existing credit lines in a last-ditch effort to take the risk off their balance sheets.
Meredith Whitney -- who in December predicted existing credit lines would be cut by $2 trillion, or 45% of the total -- has already upped her estimate to $2.7 trillion. That essentially means 60% of all credit card lines could evaporate by the end of 2010. Bye-bye to 60% of the total dollar amount of extended credit.
The cuts mean two things for the industry. First, it's proof positive that lending standards were waaaay out of control in recent years. Card issuers offered credit at levels that could make some subprime mortgage shops look conservative. If you had a heartbeat and a mailbox, you qualified for about as much money as you could ask for.
But those glory days are coming back to haunt the industry in a big way. Charge-off rates are blowing through the roof. (Charge-offs are loans that banks write off because they don't think they'll be able to collect on them.) That isn't a shocker, but the speed at which things are deteriorating is.
For example, here's how net charge-offs at the biggest card companies looked over the past three years:
|
Company |
2008 |
2007 |
2006 |
|---|---|---|---|
|
American Express (NYSE:AXP) |
5.5% |
3.5% |
3.3% |
|
Citigroup (NYSE:C) |
6.9% |
4.3% |
4.0% |
|
Capital One |
6.3% |
4.0% |
3.1% |
|
Bank of America (NYSE:BAC) |
6.7% |
4.9% |
3.8% |
|
JPMorgan Chase (NYSE:JPM) |
5.0% |
3.7% |
3.3% |
|
Discover Financial (NYSE:DFS) |
5.0% |
3.8% |
4.0% |
A big increase from 2007 to 2008, which was to be expected. But look at how much worse the most recent numbers are for a couple of card giants we have data for:
|
Company |
February 2009 Charge-off Rate (annualized) |
|---|---|
|
American Express |
8.70% |
|
JPMorgan Chase |
6.35% |
Data from Capital IQ (a division of Standard & Poor's) and SEC filings.
The default rates at Citigroup and Capital One both steadily approached 10% in February as well. Things are getting ugly quickly. Some analysts think average charge-offs could hit 9% to 10% this year, meaning the increase in defaults that sent card stocks tumbling in the past several months could be just a taste of things to come.
But that isn't even the worst of it
The second, and most important, implication of slashing existing card lines is the impact it could have on card processors Visa (NYSE:V) and MasterCard (NYSE:MA) -- companies that don't take credit risk, but instead make money on each transaction.
The two have been riding a global shift of consumers switching to a cashless society. Their growth potential is huge, the story goes, and investors accordingly bid up shares to multiples that leave little room for error. Even in this market, Visa trades at more than 20 times the estimates for its 2009 earnings per share; MasterCard at about 16 times. While the shares of both have plunged since last summer, the companies are still valued on the assumption that plastic transactions will grow by leaps and bounds indefinitely.
But now that a full 60% of credit lines could go up in smoke, you have to ask how feasible those growth assumptions really are. No, a 60% cut in existing credit lines obviously won't translate to a 60% drop in credit transactions, and plenty of transactions could simply shift from credit to debit. But it will have an impact on the group of consumers whose credit card is their sole means of survival during an unemployment spell -- a group whose ranks are growing by the minute. Factor in a negative savings rate during the boom years, and the amount of consumers who thought a credit card counted as an emergency fund is probably larger than we'd like to think.
Bottom line
Full-service card companies like American Express and Discover already trade like the world is coming to an end -- which it may be -- but Visa and MasterCard are two that could really get creamed if the shift from paper to plastic starts to slow. These are both great companies that have a stranglehold on the industry, but it's dangerous to assume business will flourish indefinitely while the industry as a whole is being flipped on its head.
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