Subprime Lending and the Credit Card Market

Gabriel Tavarez

The sub-prime credit card market is expanding; on its face its growth seems to be fueled by the ongoing recession.  A deeper look into the issue shows that although the recession is a contributing factor, it is likely not the key factor fueling the growth of this market segment in the credit card industry.   Instead banks’ inability to resell debt into bond markets, and the banks’ analysis of the cost of doing business, are primarily responsible.

It’s impossible to disregard the global recession as a factor in anything finance- or economy-related, so a brief examination of the impact of the recession is essential. The collapse of the real estate market and the corresponding calamity across Wall Street caused the greatest loss of wealth in history. In fact, US families lost an estimated $11 billion in wealth in 2008.  Despite the losses there is no documented evidence reflecting that US consumers’ credit ratings have changed materially, in fact the average national credit score rates the US consumer as a ‘good’ credit risk.

The rise of securitization fueled the expansion of credit card debt in the US during the credit boom of the early and mid part of this decade. Securitization is a process by which banks convert receivables into cash, by converting pools of debt into bonds which are then sold to third party holders. Those third party holders are then entitled to the future payments on those accounts. Securitization allowed credit card issuers through the early part of this decade to lend, create pools, convert to bonds and cash out with relatively little risk. Bankers could lend, re-sell and cash out without worry; they traded the risk once they created and sold the bond. A key statistic, in 2006 revolving debt (98% credit cards) stood at $900 billion for US consumers.  Of the $900 billion in revolving debt over $414 billion was securitized. By second quarter 2011 revolving credit card debt stood at $789 billion of which only $40.7 billion was securitized.

The evaporation of the bond market for credit card debt has forced banks to re-think their product strategy. While the credit worthiness of the average US consumer has remained stable, the profitability of a loan to a prime consumer has gone down. During the credit boom it was acceptable to generate less profit per credit line granted. The risk of default was passed along to the bond holder, and the line of credit once packaged and sold generated cash. The inability of banks to re-sell into the bond market has forced them to adjust interest rates to match risk, and boost profits.

Interest is a risk management instrument; as such its fluctuations are dictated by market forces.  The credit card market has forced banks to increase interest rates, and fees in order to properly account for potential losses in their portfolios (something that wasn’t critical to their success when they were able to sell the debt). This move toward higher charges has pushed prime consumers out of the market and has predicated bank product strategy toward sub prime consumers. This change in strategy has had a direct impact on consumers, forcing them to make decisions on what they are willing to pay in order to borrow.

The shift in cost for borrowing has increased dramatically for prime consumers – American Express recently increased interest rates on its Gold Delta Skymiles and Platinum Delta Skymiles products from a flat annual percentage rate of 14.5 to a range of 15.24 to 19.24.  These dramatic shifts in the cost of borrowing are reflective of the increased risk of the credit card product.  These radical shifts in pricing have pushed the very best consumers out of the credit card market; prime consumers have stopped using the cards.  There hasn’t been a commensurate increase in interest rates for sub prime credit cards as they were always risky, and priced accordingly.

Gabriel Tavarez is currently the General Manager of Preferred Financial Services Corporation.  PFS1 offers debt relief solutions to consumers.