Credit Card Defaults: Disaster Looming?

Over the course of the past few months, much digital ink has been spilled covering the massive increase in auto-loan defaults. Calling it in a “Car-magggedon”, analysts have discussed every aspect of the issue.

Articles covering auto loan defaults have appeared in every major publication. Here is Wall Street Journal. Here is New York Times. Here is Bloomberg. If you don’t know that auto loan defaults are on the rise, it’s because you aren’t paying attention.

Whether we should be worried about an “auto bubble” is for someone else to write about. The only point I’m making here is that auto loan defaults seem to be on the rise and we all seem to know about it.

But, are auto loans the only consumer loan category that we should be worried about?

Credit card losses are increasing. At an alarming rate.

The four largest credit card issuers in the United States are JPMorgan Chase, Bank of America, Citibank and Capital One.

These are four well known banks. They have a combined market cap of over $700 billion. Their total credit card cards are responsible for nearly $1.5 trillion in annual spending. To measure this in context, total US credit card spending in 2016 was about $3 trillion.

To put it mildly, these four banks are a big, big deal when it comes to consumer spending.

All four seem to be in trouble with significant increases in loan losses. Yet, no one seems to be asking questions.

Let’s look at the numbers.

JPMorgan Chase

JPMorgan Chase is the country’s biggest credit card issuer; and it keeps getting bigger. If you haven’t read about Chase Sapphire you should.

In 2016, total debt outstanding on Chase cards increased by 8.9% compared to an increase in credit card accounts of only 2.7% and increase in total retail spending of less than 3%. This suggests, and Chase, has confirmed that each Chase customer is shifting more and more of their spending to Chase cards. But are Chase customers moving spending to cards to get more points or are they using their cards finance things they can’t afford? Chase is an issuer whose biggest growth has come in high FICO customers. These are customers who you would assume would be good at paying their balances. Let’s take a look at JPMorgan Chase’s latest financial report.

12 months ago, Chase had a net-charge off rate of 2.5% on its credit card debt. That means against outstanding loans of around $140 billion, the bank could expect to lose around $3.5 billion. Today, the bank has a net-charge off rate of 3.01%. That’s $4 billion in annual losses. (Actual statement says $3.8 and $4.3 billion.)

In other words, in the last 12 months, Chase’s bad debt on credit cards has increased by nearly 20%. Not surprisingly, Chase’s allowance for loan losses and reserve for loan losses in the past 12 moths have increased by 20%.

This would not be cause for worry if a) JPMorgan Chase wasn’t one of the best credit card operators in the US and a high FICO issuer and b) other banks were not experiencing similar increases.

Capital One

Over the course of 2016, total debt outstanding on Capital One cards increased by 10%. Total purchase volume increased by 14%. But total number of cards only increased by 6%. Again, increase in retail spending was less than 3%.

Capital One, itself, is raising the alarm. Analysts noted that on their last quarterly call Capital One “sounded a lot more cautious”. And for good reason.

The first quarter of 2017 saw Capital One write off 5.1% of its debt as bad debt (compared to 3% at Chase.) This is the highest level of debt write off for Capital one in nearly a decade. And Capital One admits that this increase is caused by consumer behavior rather than a surge in loan growth. To this end Capital One has increased its loss provisions for its credit card unit.

Look at that graph carefully. Anything seem odd. Yup. This is the highest level since 2008!

Unlike Chase, Capital One is thought to be a bit of a subprime issuer. About a third of its cards are subprime cards. And that is cause for concern when you look at the increase in cash volume on the cards. That is 14% increase amount of cash that people are taking out on their credit cards. This is obviously incredibly risky behavior.

American Express

And when you look outside the big four issuers, numbers get even more interesting.

In its latest quarterly release, AmericanExpress, the high FICO issuer, increased its card member loans provisions for losses by 42% versus Q2 of 2016. (Provisions for losses totaled $345 million, up 46 percent from $237 million from 2016.) American Express tells us “the increase primarily reflected strong growth in the loan portfolio and a higher lending write-off rate.”

Okay. Let’s take a look at the first part of that sentence. Is there a strong growth in American Express’s loan portfolio? Over the past year, American Express lost its biggest co-brand deal, a deal with Costco that was worth billions in loans outstanding. And right there on its quarterly statement American Express is telling us that its total card members loans outstanding was up only 10%.

So a 10% increase in loans against a 46% increase in provisions for losses from those loans.

And American Express, again, is a very high FICO issuer.

What about specialty card issuers? Let’s look at one.

Alliance Data

Alliance Data is a speciality co-brand issuer. It issues private label and co-brand credit cards for big retailers like Walgreens, Forever21, Talbots, Wayfair and Pottery Barn. If you’ve applied for a credit card at a retailer, the odds are good that you would have actually been applying for an Alliance Data card.

According to its latest quarterly release, loan losses at Alliance data are up 26% over the past 12 months and its principal loss rate is up to 6.1% (increase by nearly a full percentage) and its delinquency rate is up to 5% (an increase of almost 10% or 50 basis points.)

Does it mean anything?

It seems that loan losses are increasing in every sector of the credit card business, in general issuing (Chase), in sub-prime (Capital One), in high end cards (Amex) and in speciality card (Alliance Data.)

It, of course, must be said that loan growth in the credit card world has not increased by much in 2012–2015, so maybe increasing losses to 4–5% are not as big a deal. Maybe this is a return to normal. That is not a bad argument.

But there are four factors that should make us think there is something here.

First, it is incredibly important to remember that loan losses are a trailing factor. Before a loan loss occurs a customer has to apply for a card, spend money, refuse to make minimum payments and then avoid the bank’s basic collection efforts. And thanks to better software, banks are getting better at issuing cards and collecting on bad loans. Under normal circumstances, one would expect that these improvements would lead to lower losses.

Second, and this cannot be overstated, millennials hate credit cards. The adoption rate for credit cards for those under 35 is only 33%. That means that as years pass loan risk gets concentrated into a smaller and smaller segment of the market — and a segment of the market with lower and lower future income potential.

Third, student loans are now eclipsing credit card debt. But student loans are not easily avoided. You can’t just declare bankruptcy and get rid of student loans. So when people go bankrupt, it is their credit card debt that is written off first.

Fourth, the CARD Act (or The Credit Card Accountability Responsibility and Disclosure) passed in 2009 in response to the last financial disaster created significant rules around disclosure and delinquencies. We are not living in the old days when anyone with a pulse could get a credit card. Credit cards have gotten harder to get. Presumably this means, again, that defaults should be going down.

It is difficult to say whether banks are acting irresponsibly. It is almost certainly true that the banks mentioned above are not. JPMorgan Chase, Capital One, American Express and Alliance Data are incredibly well-run operations. They are the cream of the crop. The concern is this: if these banks are seeing 10–40% increases in losses, what is happening at banks that are less well run? What is happening at banks that are well-run, but issue cards only in sub-prime?

Are we all missing a looming credit card debt disaster?

Many thanks to Aaron Frank (@arfrank) for helping with this post.