Friday, August 24, 2007

What's in the cards?

More than a year and a half back, on 2/17/06, an Eyes Not Sold post on credit issues included the following: "In 2004 37%of all consumer mortgages were adjustable rate and of that 88% of the lower credit score was adjustable". The rate reset issue was raised and then it said, "Credit cycles always come around. It's been awhile. They always are the result of excess. It may be months and maybe a year year or more, but it's hard to see how significant consumer credit defaults in mortgages and credit cards are not in the cards..." You get the point. This raises a few questions:
---Why have the significant issues in the sub-prime mortgage business been such a shock to the regulators, media, politicians and even some investors? With publicly available information it was not hard to see that there was danger unless the economy roared ahead in an unprecedented way.
---What has happened to credit cards? Well, they're ok, with delinquencies and charge-offs stable and payment rates just fine. Credit card companies in general are doing well in this environment with high balances that are being serviced. Their main gripe may be that they're not getting enough late payment fees, as they have raised them so many times that consumers now are forced to pay attention.

The mortgage business and the credit card business had taken two different paths in recent years. Mortgage extended its product reach to a broader segment of credit scores, extended distribution of product to new sets of investors and with new structures, and developed products that effectively had very low barriers to entry. The credit card business is working on roughly the same model that it has had for at least 20 years. There have been a few new wrinkles, some new costs for the consumer, and incentives to use the card more often and more widely but, generally speaking, the business has just evolved, fine tuning its business model.

The changes in the mortgage business and the aggressive sales efforts that it engendered put the industry in a vulnerable position. Then interest rates rose from abnormally low levels and house prices stopped rising. It did not require a recession or higher unemployment to trigger the problems. The credit card business, despite the risks associated with the consumer's high debt levels, will likely begin to experience out of line losses only when and if the overall economy enters a recession. To some it has seemed counter-intuitive that people would pay their credit card bills and at the same time walk away from their homes. Given the mortgage product offerings to those with lower credit scores, however, it was a business on a hairtrigger. If an individual was behind on their mortgage payments on a house that was rapidly losing or had lost its equity but in good standing on their credit card, their source of liquidity, the right economic choice may be difficult but it's as clear as the nose on my face. Where we are now unfortunately makes sense and was pretty much foreseeable. What could not be predicted was the overall credit contagion that this would cause and that the bears have been reveling in.

Also unfortunately, though, it seems likely that the credit card business will eventually have its own set of problems. In recent months credit card balances have been rising as the mortgage refi market is shut down. With the stress in the financial system and the consumer's continuing decline in purchasing power by any global measure(meaning the dollar is not doing well at all), even a mild recession could begin the tilt toward a higher level of charge-offs. Add in the beginnings of a populist mentality among consumers as a result of the mortgage mess, political rhetoric and media finger pointing, and then consider that as a result of promotional efforts the consumer now puts their groceries, a cup of coffee, and a Big Mac on their card(totally different from just 10 years ago), and a troubling scenario could develop.

The overall picture is one in which the major changes in the mortgage business and the negative results of those changes and its ramifications could be leading us into at least a mild recession. If it does the credit card business will likely be challenged. This should surprise no one.

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