Credit card firms could take hit if economy dips

Posted on August 30, 2007
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U.S. credit card companies may have sidestepped the problems plaguing the mortgage industry so far, but they’re likely to face higher losses if the economy dips into a recession this year.

Americans are still mostly paying off their credit cards, despite being hit by falling housing prices and tighter mortgage lending conditions, but analysts say they could default on card payments in greater numbers if U.S. labor markets weaken.

Higher default rate by credit card borrowers could undermine the value of more exotic debt products backed by credit-card securities, and further pressure the embattled U.S. asset-backed securities market, possibly raising borrowing costs for companies that depend on it.

“I’ve been looking at this stuff for the better part of a year, and I haven’t seen the spillover,” said Mike Kagawa, portfolio manager at Payden & Rygel in Los Angeles. “We’ve got a 4.6 percent unemployment rate.”

But the situation could be very different, Kagawa says, if unemployment hits, say, 6.0 percent.

That’s looking more possible these days with high-profile players like Countrywide Financial Corp chief executive, Angelo Mozilo, forecasting a recession caused by the U.S. housing downturn.

One potential sign of trouble is U.S. government bond prices, which often move well ahead of data on jobs. The bond market is very sensitive to employment data because of its critical role in wage inflation and the overall shape of the economy.

The yield on the 10-year Treasury bond was roughly 70 basis points below the Federal Reserve’s target for the overnight lending rate on Tuesday.

If this gap widens to 100 basis points, it may portend that economic activity and employment are getting worse.

“I’d be surprised if there were outsized issues in credit cards,” said Adam Compton, global co-head of financial stocks research at RCM Global Investors in San Francisco, which invests about $150 billion.

“Now if the economy slows down enough to bring about much higher unemployment, you’ll get higher credit card losses, no doubt about it,” he said. “But it won’t be the kinds of losses you saw in mortgages, where underwriting was weakened,” he said.

Credit card companies are now being forced to write off around 4.6 percent of payments, compared to a low of 3.5 percent in early 2006, and 7.5 percent in the middle of 2003, during the last recession, JPMorgan data shows.

Bankruptcies and credit card balance write offs by issuers have increased modestly in recent months, but several sources said charge-offs are simply returning to normal after an artificially low period following a change in U.S. bankruptcy law.

“The increase in losses (in securities backed by credit card payments) year over year in 2007 versus 2006 is more a result of technical factors in the credit card market than a contagion effect” from housing, said Jay Eisbruck, managing director at Moody’s Investors Service in New York.

Losses in credit-card securities are “still low by historical standards” of around 5.5 to 5.6 percent, Eisbruck said.

The bankruptcy law that took effect in October of 2005, which was championed by the credit card industry as a way to curb abuse, boosted filing requirements and made it tougher for many individuals to have debts excused.

As a result, Americans rushed to declare bankruptcy under the old rules, which had the effect of reducing the number of bankruptcies in 2006.

In the first quarter of 2007, there were 187,361 non-business bankruptcy filings, up 66 percent from a year earlier, according to the Administrative Office of the U.S. Courts.

Bankruptcies may simply be rising back to normal levels after being so low in 2006, but it’s also the case that a weak housing market is hurting some card borrowers.

“Bankruptcy filings are creeping up because over-leveraged borrowers are feeling the impact of rising interest rates on their monthly payments,” said Standard & Poor’s analyst Bonnie Lee Tillen in an August 6 report.

Still, Standard & Poor’s and Moody’s Investors Service both don’t see any significant contagion from the housing market creeping into the credit card sector, and believe that a recession is still unlikely at this point.

“We’re still expecting losses to increase and then settle in the 5 percent to 6 percent range,” S&P’s Lee Tillen said. “Collateral performance still remains at or near historical bests in most cases.”

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