All About Credit Cards

At 3:40 am on Friday morning, Former BestBank owner Edward Mattar took a hammer and smashed out a window of his 27th floor, Denver apartment. He then leaped to his death, landing in the courtyard in front of the building.

Mattar had run out of options. It was either this or face a 14-year jail term for fraud.

The bank, once labeled as one of America’s most profitable small banks, paid high rates of interest to attract deposits, then turned around and issued more than 500,000 credit cards to credit-challenged borrowers. As losses mounted, Mattar and fellow defendants hid the numbers from regulators while receiving performance bonuses.

Giving credit cards to subprime customers was a poor business decision by Mattar, but it is a lesson that Wall Street has yet to learn.

Bill Gross, the chief investment officer of one of the largest bond funds in the world, said this morning that the subprime-mortgage market was a “$1 trillion problem … There are $1 trillion worth of subprimes and Alt-As and basically garbage loans.” He expects another $250 Billion in losses from the subprime mortgage crisis.

It’s because of these massive losses that so many investors have turned away from the mortgage-backed securities that Wall Street has been peddling for years now.

The problem is that Wall Street is addicted to the high rates of return on these risky bonds. They just can’t help themselves when it comes to making a quick and easy buck.

You see low-grade, subprime debt means high interest rates, and therefore high return on investment (assuming the borrower can maintain the payments). That’s what makes it attractive.

So as investors all over the world turn away from buying subprime, mortgage-backed securities, Wall Street has turned to another market that is even riskier.

It isn’t just Wall Street that is addicted to cheap credit. Main Street is too. For years the American consumer has been sucking equity out of his/her home in order to pay for a lifestyle that he/she can’t afford.

But now that overvalued homes aren’t rising in price anymore, and in fact are starting to fall, the overstretched consumer can no longer extract equity to pay the bills.

Normally this would mean that the American consumer would cut back on expenses and start saving money. That’s how it has typically worked in history.

But instead, the consumer has turned to the most destructive of all types of debt - revolving credit.

Unlike mortgages, credit card debt is unsecured. So a default on this kind of debt means a total loss for investors (as opposed to mortgage debt, where a home auction could at least partially reimburse the bond holder).

Turning to credit cards to maintain a lifestyle that you can’t afford is financial suicide. Credit card interest is typically more than double the most risky of subprime mortgages. Once a consumer has gone too far down this path their bankruptcy is assured.

Of course it is also suicide for the lending institution. But like the consumer, American banks are dependent on those high-yield products, despite the near certainty of rising defaults and losses.

So why is the consumer taking this self-destructive path?

As Bonddad has so eloquently explained, wages aren’t keeping up with the cost of living.

The consumer cannot afford the lifestyle that he/she is accustom to. They are already starting to cut back on luxuries, but that isn’t enough. So instead of humbling him/herself, they are taking on debt to meet their basic needs.

Credit card debt growth is accelerating at a time when retail sales growth is slowing suggests that more consumers are turning to their cards to finance their basic monthly cash flow. As I have said previously, it appears that the credit card banks have become the consumer lender of last resort.

But credit card companies are blood-suckers. They are today’s equivalent of a legal loan shark. This is not sustainable and is sure to end in tears.

US banks… are adding to reserves not just for defaults on mortgages, but also on home equity loans, car loans and credit cards.

“What started out merely as a subprime problem has expanded more broadly in the mortgage space and problems are getting worse at a faster pace than many had expected,” said Michael Mayo, Deutsche Bank analyst.

“On top of this, there is an uptick in auto loan problems, which may or may not be seasonal, and there is more body language from the banks that the state of the consumer was somewhat less strong [than thought].”

by Garrett Johnson


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