Thursday, December 10, 2009

Step Away From the Credit Card Time Bomb

I keep hearing from people who tell me they have given up their credit cards, or are trying to. Living without a credit card is the subject of a new story released last night, which offers profiles of five people who are adjusting to life without credit. I wrote my own account of a month without credit cards in June. This trend is spreading, and I see it as a good thing. A credit card, right now, is the financial equivalent of a time bomb, so it’s a good idea to take a few steps away from it.

The credit card time bomb hits different people at different times. Thousands of people have been forced into bankruptcy, or at least into poverty, by having their credit card interest rates increased to around 30 percent. Others learn only when their card is declined that their bank has canceled their account or lowered their credit limit to the current balance, so that suddenly, no more credit is available. Next year’s credit card reforms provide a slight measure of protection for cardholders, but it comes too late to restore the old idea that credit cards are safe to use.

As I have written before, the credit card industry is facing disaster on two fronts. The transaction side is on the verge of collapse, and the financial side is in dire straits as well.

Fraud, organized crime, and security lapses could bring down the transaction side of the business any day, without warning (and this affects debit cards too). Credit card security breaches keep getting larger. Five years ago, a leak of one million credit cards seemed large. This year, one incident allowed criminals to gain identifying information on 300 million credit card accounts. In the next step in this escalation, I believe criminals will gain access to every credit card there is. The industry knows of this risk, but has plans to phase in the needed changes over a period of five years or more — and even then, there will still be gaps. It will be too late to matter. I fully expect to wake up one morning next year and hear that the Fed has ordered the credit card transaction network frozen because of fraudulent transactions on a scale too large to track. You’ll go to the gas station that morning, and the card readers on the gas pumps will be taped over. The gas station, and every other business, will need you to pay in cash.

The flaws in the credit card transaction network are more than enough to bring down the entire system, but the financial problems the industry faces may do so first. Advanta, previously one of the largest credit card banks, has already been forced to shut down when investors lost confidence in its cardholders (and that failure in turn hastened the collapse of CIT Group). Credit card banks depend entirely on investors who buy credit card debt securities, and this securitization process could fail next year for any bank that issues credit cards. The accounting rules for credit card securitization are changing, but even without that change, investors have reason to be leery of credit card debt. Banks have been changing the rules of their credit cards in a way that has driven away many of the best customers while driving many of the worst customers into default, a trend made worse by the worst unemployment in more than a generation. With this change in the customer mix, any bank that used a scattershot approach to increase its cardholder base over the past decade is likely to see a collapse in its credit card funding next year.

Even if the securitization process holds up, a bank ultimately has to make a profit on its credit card business. With the best customers paying down their balances, that will be hard to do. The total of U.S. credit card balances have increased year after year every year since the names Visa and Mastercard were invented — until this year. Now, suddenly, card balances are falling rapidly, with each quarterly report showing balances 1 to 2 percent lower than the quarter before. If credit card balances decline 6 percent this year, it does not mean credit card profits will be 6 percent lower. A decline as rapid as this is enough to squeeze all the profit out of a passively managed card portfolio.

With so much stress across the credit card business, everyone needs to stop taking credit cards for granted. For businesses, this means not relying on customers who pay by card. Thousands of businesses require customers to pay for all transactions by card. If the credit card transaction network has to be shut down and rebuilt, any such business could see its revenue fall to zero, not just for a few days, but for weeks. In a time when business credit is almost nonexistent, I have to believe that most of those businesses are not prepared for that.

For consumers, the problems with credit cards don’t merely mean that it’s important to pay off credit card debt. That has always been a good suggestion, but the more important thing now is to stop depending on credit cards (and debit cards too) to make routine payments. You might wake up tomorrow to find that all the credit cards in the country, or just yours, have turned into ID cards, no longer useful for paying for anything. You will need cash. You will need to go wait in line at the bank. Are you ready for this? Travelers are affected the most. Plan your travel so that you will be able to get home even if credit cards stop working along the way.

I realize how tricky this will be. Credit cards have been so reliable for so long that people use them unconsciously. It’s not so easy to take an unconscious habit and make it conscious. It is so difficult that the five people profiled in the story decided they had to give up credit cards entirely. But a conscious approach is what the situation calls for: to think before you use your card for anything. — So that the day the credit card time bomb goes off, you can keep going.