10/13/08

Don't Forget Credit Card Losses

There's finally talk about credit card defaults. Business Week has a pretty good article on the subject here. Outstanding credit card debt amounts to around $950 billion. About $285 billion of it is subprime, and the defaults are just beginning. As the economy weakens and more people lose their jobs, credit card losses are likely to accelerate. Innovest, according to Business Week, estimates that losses could be higher than $75 billion by 2009.

As credit card debt starts to sour, companies are reducing lines of credit, issuing less cards, and raising their already usurious rates on balances even higher. All this will contribute to a decline in credit card use and profitability. With a lower effective credit limit (whether because their credit line was reduced or their balance is near the limit) consumers will have less purchasing power. This means less swipes at the register. It also means they'll borrow less money.

Banks, like Chase (JPM), Citigroup (C), and Bank of America (BAC), will suffer losses on defaults. Unlike defaulted mortgages, where some of the losses can be recouped through a foreclosure auction, credit card debt has no collateral. They will also lose potential profits because they will be lending out less money. This can become a self reinforcing cycle, as buyers of securitized credit card debt will demand higher yields to compensate for their risk.

American Express (AXP) and Discover (DFS) are in the same boat as the banks above. As they also make money from swipes, less swipes means lower earnings. While American Express has wealthier customers, the downturn in the economy is still having an effect. According to Business Week, the company's provision for losses was $1.5 billion in the latest quarter, up 85%. As almost 98% of Discover's US revenue comes from credit cards, its outlook is not very bright either.

Visa (V) and Mastercard (MA), which issue no debt, will almost certainly be affected too, because of less swipes. Although potentially increased debit card use will likely offset this somewhat, less swipes mean lower earnings.

Disclosure: I don't have any positions in the stocks mentioned above. If the current rally continues, I'll be looking to buy puts on some or all of the following: AXP, BAC, C, DFS.