The Availability and Profitability of Credit Cards
Credit cards serve a dual purpose in our economy. First, they are a means of payment in lieu of cash or checks. Used in this way, credit cards simplify people’s day-to-day transactions and cash management needs. At the same time, credit cards are often used by individuals and small businesses for short- or medium-term unsecured borrowing. Individuals may use the revolving balance of a credit card to finance large purchases ahead of their income. Small businesses may rely on credit cards for their working capital needs.
Because they are not secured by marketable assets and have uncertain repayment periods, credit cards often carry substantially higher interest rates than secured debt like mortgages and auto loans. The rates can also serve as a barometer for the broader risk profile of consumers as well as the availability of credit to them. Interest rates for credit card holders have increased over the past two years.
Rates must compensate credit card issuers for the charge-offs they take on uncollectable balances, which is why they are a gauge of credit risk. Charge-offs can be particularly problematic during recessionary times, and the current recession is no exception. Charge-off rates have crept steadily upward since the recession began in late 2007. More recently, charge-offs dropped a bit and rates rose, which led to a slight rebound in credit card issuers’ excess spread (a measure of profitability) of 2 percentage points in July.
Liquidity in the market for credit card debt—and in the overall bank credit market more generally—also factors into the availability and cost of unsecured credit. Last fall, both the market for short-term bank funds, gauged by the LIBOR rate, and the market for securitized credit card receivables seized up, meaning banks could only fund new credit card debt at high interest rates. In many cases, financial institutions chose to severely restrict the amount of new credit extended in order to conserve capital. For the five months between September 2008 and March 2009, no asset-backed securities (ABS) secured by credit card receivables were issued, and spreads on existing securities spiked from around 1 percent to nearly 8 percent.
In order to restore the flow of new credit, the Federal Reserve included credit cards in the securities that were eligible for its Term Asset-Backed Securities Loan Facility (TALF). So far this year, $23.8 billion—or 60 percent—of the $40 billion in credit card ABS debt issued has been submitted to the TALF for financing. The liquidity improvements have brought down credit card funding costs for issuers and helped temper the contraction in newly extended credit.
Current demand for credit cards is subject to potentially countervailing forces. On the one hand, individuals are saving more, and may be looking to cut their debt loads by funding purchases with cash rather than credit. One measure of consumer indebtedness, t he consumer financial obligations ratio, which is the ratio of consumer debt payments to disposable personal income , was 5.82 percent last quarter, down from levels around 6.60 percent in 2003-2005. At the same time, unemployment continues to rise, and many people are remaining unemployed longer, which could lead people to draw on their credit card lines (if they haven’t been reduced or terminated) to meet monthly expenses.
The total amount of outstanding credit card debt held at commercial banks has fallen 9.1 percent since its peak in December 2008. This contraction may, in part, be a response to demand fluctuations, but it could also be the result of supply-side considerations, namely the funding issues and credit quality degradation previously alluded to. Nearly half of all unsecured revolving credit is held in securitized pools, suggesting that policy efforts to stabilize the ABS market can have significant effects on the overall supply of credit card debt.
One other factor that may be affecting the supply of credit card debt now and in the long run is Congress’s recent passage of the Credit Card Accountability Responsibility and Disclosure Act of 2009. Among many other things, the Act places new restrictions on the supply of credit card lines to individuals under 21 years of age, and prohibits certain interest rate variability practices previously used by issuers. Insofar as these latter changes limit fees or high-frequency risk repricing, extending credit to certain borrowers may become unprofitable, which would cause supply to contract accordingly.
Credit card funding costs are improving after policy intervention into the ABS market, but concerns about credit risk, as well as supply and demand factors, will potentially alter the volume and pricing of credit cards in the near term. Perhaps these market and legislative changes will lead to renewed interest in credit alternatives such as unsecured personal loans, which are often subject to a more rigorous underwriting process than most credit cards.