Wednesday, May 20, 2009

Collapse of the Credit Card

Last week’s announcement by Advanta that it was getting out of the credit card business on June 10 was more than it appeared on the surface. To cardholders, it might have looked like a credit company running away from potential losses as the economy deteriorates. But on closer inspection, Advanta was forced out of the credit card business when it lost the confidence of investors, mostly pension funds and hedge funds. And the same thing could happen to the largest credit card issuers as soon as a year from now. At the same time, the whole credit card industry is in rapid decline.

The credit card situation defies the usual intuition about economics. If cardholders are getting shafted, the banks must be making a fortune, right? Not exactly. Advanta’s small-business credit card business was struggling by the end of last year, and deteriorated rapidly in the first quarter of this year as 13 percent of customers, small businesses, failed to make payments on their accounts. Finally, its securitization trust, which it uses to sell its credit-card debt to investors, failed. At that point, Advanta had to choose between bailing out the securitization trust and turning it over to investors. The former choice would have left it penniless; the latter leaves it with no mechanism to fund its future credit card transactions. The securitization trust shuts down June 10, so that is the last day Advanta cardholders can use their credit cards. And then Advanta will have no more income, but at least it may avoid bankruptcy if enough cardholders pay off their balances over the next few months.

Advanta may have accelerated the decline of its credit card portfolio by changes in terms that alienated cardholders, but the giant credit card issuers haven’t exactly been friendly to their customers in the past two years either. And other banks depend in the same way on securitization trusts. Bank of America and Citigroup have been forced to bail out their securitization trusts this year, but might not be able to do so again at this time next year as the economy declines and unemployment rises. Rising unemployment historically has led to higher default rates on credit cards, the exact problem that killed Advanta’s credit card portfolio.

The Federal Reserve’s new rules on credit cards, ironically, may not go into effect until after the industry is already well on its way to collapse. The relatively modest Federal Reserve rule changes are scheduled to be in effect next July, and the Senate has approved a package of reforms that could move that up to February, while also tightening rules about credit for cardholders under 18. At the rate consumers are moving away from credit cards and banks are canceling accounts, though, the credit card business could be a third smaller by then. As I noted two weeks ago, credit card transactions are falling so rapidly that the debit card business surpassed it around the beginning of this year. It is a trend that Advanta’s failure will accelerate. As many as a third of Advanta’s credit card customers may not be able to get replacement cards from other banks.

Regardless of the details of any credit card reform, the New York Times says banks are planning to boost transaction fees and reinstate account maintenance fees on most credit cards. The Times quotes one banking industry figure describing the one third of cardholders who don’t pay any fees in a given year as freeloaders: “Despite all the terrible things that have been said, you’re making out like a bandit.” For those cardholders who do pay fees, the fees on credit card accounts (not including interest charges) are estimated to exceed $20 billion this year.

But as banks impose new annual or monthly fees on credit card accounts, consumers’ instinctive reaction is likely to be to close most of the accounts. The number of active credit card accounts could fall by more than half from that effect alone — and that’s before you look at what could happen if one of the biggest credit card banks or its securitization trust failed.

Businesses need to adapt to the changing payment environment. I can’t imagine there are many businesses left that assume everyone has a credit card, but if there are, they will have to come up with a workable alternative for those customers who lose their credit card accounts.

As credit cards decline, banks may relinquish the central position they have held in the credit card business. The transaction processing side of the business remains profitable, and it may have to find a way around the banks as the banks continue to pull out of credit cards, so that consumers can continue to make card purchases.

The bigger concern, though, is what will happen to the economy. Credit card spending is what has led the U.S. economy out of all of its recessions in the past 25 years. As confidence returns toward the end of a recession, consumers spend more freely on credit cards, and this is what gets the economy moving again. The decline of credit cards dampens the hope of an early recovery from the current recession. What will happen to the economy when confidence returns, but the credit cards are no longer there?