Credit Cards: The Next Financial Crisis?

July 25, 2008 — -- Paul Takhar has $50,000 in credit card debt. The California man said that since his real estate business went south, he's relied on his credit cards to survive. But lately, making payments has grown tougher because the interest rate on one of his cards has increased.

He said he tried to negotiate for a lower rate, but had no luck.

"I'm going to try to make the payments as long as I can," he said. "I'm struggling."

Takhar's experience is not unique.

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With banks limiting home equity lines, gas and food bills on the rise, and homeowners struggling to make their mortgage payments, some Americans are turning to credit cards to make ends meet. Many, however, are finding their cards more expensive to use as credit card companies increasingly raise interest rates, lower credit limits and cancel inactive accounts.

It's all happening, some industry watchers say, for a good reason: The companies are trying to avert a crisis.

In the first three months of the year, commercial banks in the U.S. took losses on 4.7 percent of their credit card loans, up from 3.9 percent the year before, according to the Federal Reserve.

In the last two weeks, major credit card players like American Express, Capital One, Citigroup and Bank of America have all reported larger losses from unpaid card bills. American Express saw second-quarter profits from its U.S. credit card business fall a stunning 96 percent from $580 million in the spring of 2007 to $21 million this year. (Overall, the company reported $655 million in second-quarter profits.)

"The credit card companies have really found themselves in a huge, huge hole," said Robert Manning, the director of the Center for Consumer Financial Services at the Rochester Institute of Technology.

Manning argues that banks themselves, not credit card users, should shoulder much of the blame for rising delinquencies and defaults. As the financial slump took hold, he said, banks started relying on their profitable credit card arms to compensate for losses in other divisions such as mortgage lending.

This practice, he said, came at a price -- revenues were being bolstered, in the short term, by drives to offer higher credit limits and more credit cards to higher-risk borrowers.

Credit card lending became "a bit too aggressive," said John Ulzheimer, the president of consumer education for Credit.com, a credit card information site. "People were getting credit vehicles maybe they should not have been getting. Those bad issuances of cards are, in many cases, coming home to roost right now."

Sink or Scramble?

Manning said it was important to note the distinction between companies like Mastercard and Visa and banks. While Mastercard and Visa are prominent card names, they're largely marketing operations that don't actually extend credit. That falls to financial institutions like American Express, Capital One, Citibank and Bank of America, which issue Mastercard and Visa cards, among others.

Analysts agree that credit card troubles alone likely won't be enough to topple any one bank in the same spectacular fashion that subprime mortgage losses led to the collapse of Bear Stearns.

But Ron Ianieri, the chief market strategist for the investor education company Options University, said that for banks already suffering from other financial woes, more trouble on the credit card front "could be enough to be the straw that breaks the camel's bank."

"I don't think a credit card crisis would be strong enough to collapse a bank under normal conditions, but these aren't normal conditions," he said. "These banks are teetering right now as it is. One more push -- it doesn't have to be a big push -- and it could knock them off the top."

Analysts like Ulzheimer, however, don't see the need to ring any alarm bells and neither, apparently, do the banks.

"We obviously do not know the extent of the current downturn, but the position of our company today is financially sound and competitively strong," American Express CEO Ken Chenault said in a Monday conference call on the company's earnings.

A similar message came from Richard D. Fairbank, the CEO of Capital One, which saw its second-quarter earnings plummet to $452.9 million from $750.4 million last year.

"We remain well-positioned to navigate the near-term economic challenges and to deliver strong shareholder value," he said in a statement last week.

Ulzheimer said that, unlike their mortgage divisions, banks' credit card arms can move quickly to reign in their losses by raising card holder's interest rates and lowering their credit limits.

This happens, he said, when companies realize -- thanks, in part, to monthly credit report reviews -- that a cardholder's ability to make his or her monthly payments may have been jeopardized.

"They have the ability to modify the terms almost on the fly when they see you are more of or less of a risk," he said.

He said companies are also increasingly moving to cancel unused -- and thereby, unprofitable -- accounts to eliminate the costs of maintaining those accounts.

Not all banks pursue the same strategies. A Capital One spokeswoman told ABC News that the company hasn't raised interest rates for any customers since last July.

Interest Rate Rants

Some bottom-line conscious moves have met with blowback. Bank of America came under fire for raising interest rates above 20 percent for some its customers earlier this year. Critics cried that the rate increases were arbitrary and that those slapped with the increases included customers with a history of on-time payments.

Bank of America spokeswoman Betty Riess told ABC News that, last year, 94 percent of the bank's customers saw their interest rates drop or stay the same.

When interest rate hikes do take place, she said, they are decided on a case-by-case basis. She noted that the bank takes into account "external credit criteria" – such as how many loans a person has taken out elsewhere and whether they've defaulted with other lenders – in determining a rate increase.

The bank's careful calculations are of little comfort to customers like Paul Takhar, who has a Bank of America card.

"I think they're taking advantage of the situation. Their interest rates are ridiculous to begin with," he said.Ulzheimer says that, overall, Credit.com has recently been "buried" in complaints from disgruntled credit card customers.

More are likely to come – Ulzheimer said he expects banks will be grappling with credit card woes for a least another year.

In the meantime, banks should consider reducing how much they expect delinquent credit card holders to pay back – that's Manning's take. He says that banks stand to recoup more that way.

"It makes a lot more sense to come up with a repayment plan of 50 percent rather than 80 percent and push people into bankruptcy," he said.