How to Destroy the Credit Card Industry

Remember 2007? We called this the "subprime mortgage crisis," assuming the risks were contained to one relatively small section of the economy.

But as Nouriel Roubini pointed out last September, "We don't just have a subprime mortgage lending system. We have a subprime financial system."

And so it went: Subprime spread to Alt-A mortgages, which spread to prime mortgages, which spread to auto loans, which spread to student loans, which spread to corporate paper, which spread to …

Credit cards
Yep -- credit cards. Their problem is a controversial one because millions of Americans are not only losing their jobs and seeing their wealth go up in flames, but watching their credit card interest rates go from 8% to 25% or more. That's terrible. It's infuriating. It's frustrating, and you can't blame anyone for being peeved about it.

Not surprisingly, Congress is slogging through new regulation that will, among other things, hinder the "abusive and unfair" practice of banks jacking up interest rates on existing credit card balances.

Regulation, meet confusion
In fact, Senator Bernie Sanders of Vermont went so far as wanting interest rates on credit card balances flatly capped at 15% -- a proposal that was recently voted down by his peers.

Legions of consumers are now upset that these interest rate caps were rejected as part of credit card regulation moving through Congress. "Enough is enough. People are hurting. It is time to stop the rip offs by banks," says Sanders' website.

But there are two sides to this story. Forcefully reining in interest rates on existing balances -- especially to a rate of 15% -- could disastrously backfire if it's intended to help consumers whose problems are ultimately linked to a lack of credit in the economy.  

Confusion, meet insanity
The interest rates that card companies charge consumers aren't simply a profit-making tool. It's a tool to offset the percentage of loans that aren't repaid -- net charge-offs, they're called.

These charge-offs are exploding to historic levels right now and are all but certain to keep rising as unemployment grows. In the latest month alone, here's how major card issuers have fared:

*Decrease is slightly misleading. Capital One recently changed the accounting method it had been using for charge-offs, opting to wait longer before deeming its receivables dead. 

Worse, these numbers are likely a pittance of what's to come. Since unemployment typically lags the end of a recession, the nastiest days for credit card companies are almost certainly ahead of us.

In fact, the Treasury's own recently completed stress test assumed that banks could face average credit card charge-off rates of 22.5% by the end of 2010, which annualizes out to, coincidently, 15%.

2+2 = oh … I give up
Hence, the same government that's demanding banks prepare for card losses as high as 15% a year -- a number that may very well become woefully optimistic -- has thrown around the idea of capping the amount at which banks can offset those losses at the same number. Factor in operating costs, and simple arithmetic tells you that such a law would push the entire credit card industry into bankruptcy in short order. I mean, honestly, when you charge your customers 15% and write off the same amount as losses, you can't keep the doors open very long.

More importantly, banks would react to such regulation by eliminating consumer credit like there's no tomorrow, reflecting that new regulations make their business economically unviable. Remaining credit would evaporate almost immediately. In a recession where the chief complaint is that "banks aren't lending enough," this seems thoroughly insane.

Complex problems, complex blame
Few doubt that banks shouldn't be allowed to run around a trillion-dollar free-for-all. But as soon as you impose regulations that guarantee an industry will lose money, you're doing more harm than good to the consumers you're trying to protect.

President Obama recently said of credit card companies: "These practices, they've only grown worse in the middle of this recession, when people can afford them least."

True. But with losses piling up faster than ever, banks can't afford not to impose these practices. We have a crisis where banks need healthy consumers, and consumers need healthy banks. Both need cooperation from each other. Obliterating one side and hoping for the best won't get us very far.  

For related Foolishness:

• Get Ready for Credit Card Hell
• First, Fire All the Bad Bankers
• If You Think the Worst Is Behind Banks, Read This