Credit Cards: I was Wrong

Some months ago, someone posted here about a fear they had that "the credit cards would stop working". At the time, I was a trifle arrogant and dismissive, suggesting that this wasn't realistic.

I can't remember who I directed that post at, whoever you are, I'm sorry. While this is a tiny, tiny card issuer, the "Early Amortization" (read the article) is just incredible from a financial perspective.


From Bloomberg

May 12 (Bloomberg) -- Advanta Corp., the issuer of credit cards for small businesses, will shut down accounts for its 1 million customers next month and seek to pay off securitized debtholders early as the recession pushes defaults higher.

Lending will cease June 10 as part of a plan to preserve capital after uncollectible debt reached 20 percent on some cards as of March 31, the Spring House, Pennsylvania-based firm said yesterday in a statement. Advanta will use as much as $1.4 billion to pay investors as little as 65 cents on the dollar to buy back securitized credit-card loans. That would be the first so-called early amortization of a trust since 2003, according to JPMorgan Chase & Co. analyst Christopher Flanagan.

“Early-amortization has been viewed as a catastrophic event for issuers,” Scott Valentin, an analyst at Friedman Billings Ramsey & Co., said today in a research note. “Given that all credit-card accounts in the trust will be shut down to future use, we expect losses to increase as the cards have substantially less utility to cardholders.”

Advanta has reported three consecutive quarterly losses and has seen its shares plunge from about $30 in June 2007 to $1.13 at the close of New York trading yesterday. The U.S. jobless rate reached 8.9 percent in April, a 25-year high, squeezing sales for small business owners. The economic slowdown affected Advanta’s customers across the country, Chief Financial Officer Philip Browne has said.

“We’ll be shutting down accounts for future transaction activities, but many of the customers will maintain balances and pay us off over time,” Browne said yesterday in a telephone interview. “We’ll have to service and collect on that, and that will be the first order of business for the company.”

Martin,

Could you please explain what this might mean to the average Joe?

Thanks.
-Blast

The current financial crisis was brought about by the collapse of the mortgage backed securities bubble bursting leading to the bankruptcy of many of the Trillion Dollar Asset sheet banks around the world requiring the bailout from central governments across the world. You know the odd trillion dollars here, trillion dollars there.

This wasn't the only bubble out there in the financial world, there was the Credit Card Bubble and then there is the Derivatives bubble which equates to around $190,000 per person on the face of the planet, which you can imagine dwarfs both the Credit Card bubble and the Mortgage backed securities bubble. The Derivatives bubble is essentially just future bets placed on future bets based on the premise that Mortgage backed securities and Credit Card bubbles will grow ever bigger and better.

Looks like the start of the beginning for the end of the Credit Card bubble. Round 2 ding ding.

I don't think that a single company with a million customers closing down is gonna bring the economic system down with it.

Isn't this what some folks have said needed to be done anyway? Let the companies fail that are going to fail?

I've never had an Advanta card but I do seem to recall that they were or are a place that specialised in higher risk, higher rate credit cards? They took a chance, made what I'm sure was plenty of profits for a while and now they get to pay their own creditors 65 cents on the dollar for their debts. Sweet deal. Given the loan shark type behaviour on the part of some credit card issuers it sounds like they're getting a much better deal than they probably ever offered their own customers.

Well, or it could simply serve like a canary in a coal mine or be the tip of an iceburg. It may not bring down other companies with it, but other companies may be in similarly dire condition and just haven't had to go this far yet.

Actually, as we saw last Fall, psychological factors can be just as important as financial factors. I think most high finance folks thought it was impossible for overnight credit markets to freeze up overnight, but that's basically what happened when fear and suspicion, and not hard financial news, caused everyone to hold onto their purse strings really, really tightly all of a sudden.

You could probably put commercial real estate into that race, too.

Should have added this to my last post, while it may be obvious Advanta will still be earning finance charges on all that money they've lent out. It's not like all of their customers have reneged on the deals that they made when they used the Advanta credit cards. A million accounts, minus the thousands that have or will default is still a decent number of accounts with payments coming in every month and they won't be lending any more money out on top of it.

There's a very good reason why you don't see many credit card issuing banks actually going out of business. They are for the most part extremely profitable companies.

One thing we have to realize.

All credit-card debt is non-secured debt. Meaning there is no collateral backing up the debt, unlike a car loan where they can come repo the car, the credit card companies are pretty much hosed when it comes to collecting their debts. In a bankruptcy it is not uncommon for credit card companies to never be paid off.

While in many, if not most, of the country it is either illegal or highly frowned upon to run up a credit card knowing that you are about to declare bankruptcy, it happens every day. And the rest of the credit card holders have to pay for the losses. Corporations will pass along their costs to the consumers however they can.

I know that many people have seen a reduction in their card limits, new fees tacked onto the cards they use, and some have had their rates increased for being even one day late with a payment. MOre reason than ever to wean yourself off the plastic.

I guess in the shortest possible explanation, this is all about a second wave of massive devaluation of debt-backed assets - not as big as the housing crash, but still another potential trillion dollars or so in imaginary money owed to real people, pension funds and 401(k) plans that's exceedingly close to vanishing.

If you have a 401(k) with a mix of stocks and bonds, remember that the value of some of those bonds are made assuming that someone, somewhere, keeps paying their credit card bills, keeps paying their mortgage, keeps buying cars on credit.

The average American Household owes $8,400 in credit card and other revolving debt, but through the magic of Bretton-Woods finance, that debt can represent well over $32,000 is "asset values" by the time it's recorded on various company balance sheets. It's all about the idea that the amortization of debt causes positive cash-flows for someone else.

There are several things that are at work here.

First of all, there's the basic fact that 1 million credit cards are about to be turned off all at once because the issuing company is in trouble. This is very different than the tactics being used by other issuers - credit line decreases, balance chasing, interest rate boosts, and of course fees. In those cases, they WANT customers who are on shaky ground to balance transfer out or simply pay more in interest to cover the losses of other defaults.

Your bigger, safer card issuers are happy to drop the bottom 15% of their customers, and even a 10% default rate is survivable if many of the other customers are paying more interest to cover the losses.

The main reason this card shutting down might matter to you is if you have a card with a small issuer like this and you're relying on it to manage your cashflow, even if you pay on time every time, even if you don't carry a balance, your credit facility just vanished - and getting credit might not be possible at all. If you can't gain access to the most rudimentary levels of credit - for things like buying supplies or paying for shipping - you might not be able to stay in business.

If this was just for a company that issued personal cards, that would be one thing, but this company serviced smaller businesses and they hit a default rate of 20%. That's massive and reflects a deeper level of financial trauma.

In addition, this shutdown not only affects the good and bad cardholders, it affects (in a tiny way, but still) the bond market, as they are basically telling the bondholders, "whoops you bought total junk" and they are poised to pay back only $0.65 on every dollar invested. yes, there are "junk" rated bonds all the time, but this is the first of what will be a new and fairly miserable effect of the "tightening credit market"

As an aside - Visa recently reported that the majority of all Visa card transactions were debit card transactions - NOT credit cards. Payment processing systems will do fine. It's the issuance of credit that's changing.

If you need credit to operate your business or your home, this would be a good time to look at your actual ability to simply pay your bills and see if you could actually do it without the credit float.

Anyway, I'd suggest that my previous statement that "credit cards are accepted everywhere" while still true does not matter to a million cardholders who now have some useless plastic in their wallet.

I brainstormed a quick solution for the commercial real estate market. If someone could raise the capital, then buy up vacant warehouses, office buildings, even hotels and turn them into minimum security contract detainment facilities. Hire non-union labor at $12 an hour, no benefits, and no quals needed (other than rudimentary psycho screening maybe). Charge the local governments a monthly head fee and then run the place like a boot camp, and put all the inmates to work doing cheap assembly type stuff.

If someone were properly connected, I just bet those facilities would all be filled by Christmas time.

Most Americans carry more than one credit card. Hopefully these businesses do, too.

And my bet is that this is not the beginning of an avalanche but is just a small rock tumbling down the hill.

Thanks for the heads-up, interesting article.

Yep, more privately run prisons, that's the answer...with minimum wage untrained guards no less.

We could use them to warehouse all the folks who are defaulting on their credit card bills.

What was the question again?

Martin, this sounds like they are declaring bankruptcy, without going through the formalities- am I wrong in that?

If so, I figure it is only a matter of time before one of the larger issuers folds. *shrugs* As much as I might miss the opportunity, I'm more convinced than ever that they just aren't worth the hassle.

No they are NOT going bankrupt, they are simply stopping the credit card issuer business - in an effort to stave off any further losses from defaults.

OK, so they aren't telling their customers "so sorry, we're done", they are just not taking on new customers?

There is a difference between closing and/or No Longer Issuing new credit, and Bankruptcy

Bankruptcy means they are not paying back THEIR creditors, which it sure looks like they are planning on doing

I know the difference. *grins* I just had missed the part about them paying back their creditors, and you can't do that without business. It had sounded to me like they were just shutting down.

MIGHT MEAN? The first time a business is not paid for having accepted one of these cards it MIGHT MEAN A FLASH FIRE!

The first time businesses are not paid by credit card companies will be the end of plastic as we know it.

I will jump for joy!

If you want to get real paranoid, think, just who is the largest creditor for a credit card company?

Not to kick a dead horse, but this quote from the Philadelphia Inquirer caused me some distress.

http://www.philly.com/inquirer/front_page/20090512_Advanta_Corp__suspends_credit_cards.html

The quote of interest in the article is -

"Advanta, the nation's 11TH LARGEST CREDIT-CARD company, is unusual in that it does not offer personal credit cards.

Advanta's percentage of loans written off as uncollectible, at 20 percent on March 31"

That's why I posted it. It's a canary in the coal mine of debt as a product.

One of my consulting clients is a small air cargo company. They were recently complaining to me because Amex had suddenly imposed credit limits on their platinum card that they have had for 25 years. As they use this card to pre-purchase fuel at various airports, they were quite unhappy to learn they were now 50k over their limit, even though the bills had always been paid on time for 25 years. Needless to say the Amex card was soon canceled. It can be difficult to do business without a reliable source of rotating credit.

As other indicated, some large changes will be coming to the CC Market in the near future.

Greg

It's more complicated than that, but it's part of it.

For another maor par of the story chck out the value of dollars in yuan and see if you note a change in the trend in August 2008.

As a small business owner having to change/update credit cards that are used monthly is a MAJOR PITA. I can only imagine businesses slightly larger than me who use their card who now have to change 20, 30 or so + accounts due to this.

If some businesses don't do this in time or catch it they could lose business because something they rely on isn't auto billed, etc.

Either way it's going to be a PITA for business owners to update.

And it would appear the scale of the financial disaster has been greatly under reported in the general media circles with the Federal Reserve unable to account for $9 Trillion of off balance sheet transactions since Lehmans Brothers Investment Bank went bankrupt.

http://www.youtube.com/watch?v=cJqM2tFOxLQ&feature=related

I was listening to Bloomberg radio Thursday - there was a panel discussion with Jack Welch and a bunch of other business heavyweights. The all used the term "game" to describe the economy - "back in October, we were afraid the game would be over" and "we had to keep everyone in the game, so I think what the Fed did was right on" - stuff like that.

We are now officially living in a financial world that is - literally - unknowable. There's no good reason why it should be POSSIBLE for 9 Trillion dollars to be absorbed into the market without a trace and there's no good reason why fractional reserve currencies should work - except that we all agree to the rules of this game, and we're all of us perfectly well aware that if we all decide to stop playing - or if enough of us get kicked out of the game via unemployment, we have absolutely no idea what that would be like, but we know it won't be good.

The best description I've ever seem for a Worst Case Scenario is here over at the very good SeekingAlpha.com

Keep posting like that and someone will think you are an "Austrian school" economist or a similar subversive type. Have you been reading at mises.org?

It is a game to folks like Welch. Do you honestly think that folks like him haven't insulated themselves against everything but a literal worldwide economic collapse?

Once you get a few million in the bank or wherever, it's a game to keep it growing and protected against taxation, you move it around, invest it in a wide enough variety of instruments and unless that worldwide collapse happens, or your a complete idiot, you'll never be broke and thus you treat it as a game.

There's a fascinating story in today's L.A. Times about Michael Jackson's financial woes. He's getting bailed out yet again by some financier types who think that they can prop him back up, put him on stage and make a few hundred million off of a concert tour. Jackson himself has gone thru hundreds of millions of dollars, been sued by everyone and their brother for everything from sexually abusing children to failing to live up to performance contracts yet he not only survives, he's got other people willing to invest in him, in our world he'd be broke and on food stamps, in his rarefied world, it's all just a game.

I ran across this interesting article on Newsweek over the weekend about "quants"--the uber math geeks who used their mathematical models in quantitative finance to parlay "nothing" into billions of dollars of profit from all manner of derivatives, like the infamous credit default swaps. Although upper management is the target of most people's ire, very little attention has been paid to the math geeks who "enabled" all this unrestrained greed and risk-taking.

One interesting angle to this article is the effort--a crusade really--of one former Wall St. quant to train a new generation of quants who create mathematical risk models based more in line with reality, and not just abstract math, which in many ways is a game. Tweak your hypothetical model enough and in theory, we can't lose money!!! That's basically the sentiment and rationale that helped stoke the derivatives bubble.

I remember watching Alan Greenspan being interviewed for a CNBC program ("House of Cards" was it?) and he made the comment that he has an extensive mathematics background, has dozens of math PhD's available on his staff, and even they couldn't make heads or tails of the mathematical rationale behind these financial instruments. Or remember the almost-financial-collapse-that-never-happened in the late 90's with Long Term Capital Management? They used these models heavily. They even had not just one, but two, Nobel prize winners in economics on their board, and they almost failed spectularly, but were bailed out at the last minute by quick Fed-coordinated action and the help of Wall St. There was talk that LTCM's failure would trigger a global crisis because it was just so big, if it were allowed to fail. Really, that was a foreshadowing of what could happen as these models spread beyond just the elite circles of hedge funds like LTCM in the 90's, and onto Wall St. and even Main St. in the last 5-10 years.

The Austrians are not all that much better, IMHO.

No, I'm more a follower of http://www.paecon.net/ - although they didn't publish in 1Q 2009...that's worrisome. The spin-off site http://www.toxictextbooks.com/ is a must-read.