House of Cards
Consumers Turn to Credit Cards Amid the Mortgage Crisis, Delaying Inevitable Defaults
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The U.S. credit card market is showing signs of trouble just as the home mortgage crisis surges to unprecedented heights across the United States and throughout the global financial marketplace. Against the backdrop of record-high numbers of home foreclosures, lenders are tightening mortgage lending standards, making it harder for families to maintain their consumption in the face of weakening income growth. At the same time, credit card issuers present their all-too-convenient lending product as a much needed but inevitably dangerous pressure valve for cash-strapped borrowers.
As borrowing in the mortgage market slows, credit card borrowing is accelerating—a dangerous trend because borrowers still face weak income growth. That means the credit card market could eventually run into the same problems that now afflict the subprime mortgage market.
The lending industry that no longer aggressively issues subprime mortgages continues to aggressively market credit cards, especially credit cards with subprime-like lending terms, such as a variety of higher fees that are poorly disclosed. In the end, more and more borrowers could end up defaulting on their credit card debt because they do not fully understand the terms and conditions of their new plastic, which could prove detrimental to their financial health. Déjà vu all over again!
The consequences could deliver further uncertainty to financial markets and additional turmoil to the economy as more consumers file for bankruptcy, driving down the value of securitized credit card receivables. Evidence of these consequences is now emerging. Specifically:
- Growth in mortgages slowed as the subprime crisis unfolded, but simultaneously credit card debt began to rise again. Between April 2006 and December 2007, the last month for which complete data are available, inflation-adjusted credit card debt accelerated at a rate four times faster than between March 2001, when the last business cycle ended, and April 2006. This increase in credit card debt compensated for a substantial part of the slowdown in mortgages.
- Banks tightened access to mortgages, but at the same time continue to aggressively offer credit cards. Lenders tightened mortgage standards in 2007 more than at any point since 1991. At the same time, lenders continued to push credit cards with a particular emphasis on subprime-like credit cards.
- High fees, heavy interest rate burdens, and complex terms may lead to increased default. Credit card debt tends to carry substantially higher costs than other forms of credit due to myriad fees in addition to high interest rates. The result is that many borrowers unwittingly slide deeper and deeper into debt as they fall prey to the lack of transparency in credit cards.
- Already the share of credit card debt that is written off by banks has risen sharply. Between March 2006 and September 2007, the last month for which this data is available, the share of credit card debt that was charged off by credit card lenders rose from 3.0 percent to 4.0 percent—a growth rate of 34. percent in less than two years.
- Increased defaults could unravel the $915 billion in securitized debt backed by credit card receivables, just as delinquencies in the housing market unraveled the $900 billion in mortgaged-backed securities. Just like mortgage-backed securities, credit card debt is packaged and sold to investors. An increase in defaults could lead to losses not just for the credit card lenders, but also for pension funds and investors who bought the debt.
A possible unraveling of the U.S. credit card market, with all the attendant costs to global financial markets, could be partially nipped in the bud with improved transparency for credit cards. Policymakers should take two approaches.
First, implement a credit card safety rating system that can give consumers better information about their credit cards and thus help them make better decisions. This system would be similar to the five-star crash test rating system for new cars. Credit cards would be awarded stars based on a points system, with cards earning points for consumer-friendly terms and losing them for terms designed to get consumers into trouble.
Such a system has already been introduced in the Senate by Sen. Ron Wyden (D-OR) as the Credit Card Safety Star Act. The safety rating system would not preclude additional regulation or legislation that will eliminate other features that may be considered abusive or unfair.
Second, in addition to a credit card safety rating system Congress should go further to mandate a higher level of fairness in credit card terms. Several members of Congress have introduced bills that would do that. Rep. Carolyn Maloney (D-NY), with the backing of House Financial Services Committee Chair Rep. Barney Frank (D-MA), recently introduced the Credit Cardholders’ Bill of Rights Act. This bill takes a balanced approach to banning several of the most abusive credit card practices.
Another balanced approach was introduced by Sen. Carl Levin (D-MI) as the Stop Unfair Practices in Credit Cards Act, which also contains limits on many of the most unfair practices. These bills would eliminate the most common pitfalls consumers face and could help them make better decisions with their debt.
In the pages that follow, we will examine in detail the relationship between slowly growing U.S. mortgage markets, the suddenly aggressive growth of credit card debt, and what both trends could mean to borrowers, their lenders, and global financial markets. With this analysis in hand, it becomes increasingly clear that the credit card disclosure reforms we suggest are timely and necessary.
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