The Credit Card Death Spiral

The stress tests are done. The results were so-so. Financials are up.

Unfortunately, foreclosures are still climbing, credit card defaults are growing and could out-pace unemployment, and no one knows how to value toxic assets.

But the bank crisis has been solved! Yep, and I'm the king of England.

Just as we called back in July 5, 2008, credit cards have and will continue to take it on the chin.

But not many people listened:

"AXP will be fine," one reader said. "You're blowing the consumer issue out of proportion."

"Ian Cooper has no brain." "I think Ian Cooper is an idiot," said another reader.

But those "smart readers" who listened and shorted American Express did quite well, as the AXP stock plunged from $35 highs to about $10. . . only to rebound on false financial optimism.

 

 

However, the recent elevated price levels give us an even better position to go short, as we'll soon be doing in Options Trading Pit. And it's all thanks to consumers who are building up massive amounts of debt without the means to pay it back.

You see, it's far more difficult for millions of Americans to dig their way out of debt now that once-relied-upon options, such as home equity loans, are no longer readily available. And an 8.9% unemployment rate in the U.S. doesn't make the credit card outlook any better.

Why Credit Cards Will Continue to Fall

As the unemployment rate mounts, so will credit card defaults. . . and the outlook isn't much better.

Experts are predicting millions of Americans will not be able to pay credit card debts, leaving a big hole for troubled banks that are trying to recover.

Worse, the bogus stress tests released last week suggest the banks could "expect nearly $82.4 billion in credit card losses by the end of 2010 under what federal regulators called a 'worst case' economic scenario," according to the New York Post.

However, if unemployment rates hit 10%, defaults could explode. At American Express and Capital One, for example, about 20% of the credit card balances are expected "to go bad this year and next," according to the stress tests. As for Bank of America, Citigroup, and JP Morgan Chase, we're talking about 23%.

And the last thing the financial sector needs to feel is further squeeze, as Americans have accumulated some $970 billion in revolving consumer debt since the end of September 2008, up 3.4% from the close of 2007.

Sure, the credit card industry is typically resilient during our economic slowdowns, thanks to pricing flexibility. And the traditional thinking is that as the economy sours and consumers become late on payments, credit companies can boost earnings through late fees and higher interest rates. But that may no longer be the case as the Obama Administration looks to overhaul the industry.

The jig is up. 

Defaults are growing. Charge-offs have been pushed well beyond expectations. And losses are far out-pacing what companies were hoping to account for with extra card fees and higher interest rates.

And despite the recent rally in financials, nearly all credit card lenders are facing mounting losses as more of their customers fall behind on payments or default on loans. According to Forbes.com:

As unemployment has risen sharply, credit card defaults have also climbed. During recessions, credit card losses tend to closely mirror unemployment rates, though some analysts now believe default rates will move even higher than where unemployment rates might peak in the coming quarters.

It's already happening at Citigroup. The company's 10.2% credit card charge-off rate for Q1 has already broken the correlation to unemployment. . . showing no signs of improvement.

The outlook is so bad that Advanta Corporation is shutting down accounts for one million customers next month as the recession pushes default rates even higher. Lending will draw to a close on June 10, 2009 as part of the company's plan to preserve capital, since uncollectable debt reached 20%.

As a result, major credit card issuers have been approving fewer applicants, lowering credit lines, and closing out unused accounts. Even Meredith Whitney expects lenders "to cut the lines of credit they extend to borrowers by a total of $2.7 trillion through 2010. That is equivalent to a 57 percent reduction in the credit they made available two years ago at the height of the boom," says The New York Post.

Things are bad. And they'll only get worse for credit issuers like American Express and Capital One. We've been saying this since last year to anyone who'd listen...

However, if you must own a credit card stock, buy Visa and/or MasterCard.

They may suffer, too, on slower consumer spending. But they don't have to worry about consumer debt. They don't have any. They only process cards.

Reader Mailbag

Before we sign off. . . Let's go over some recent question from my readers. Here's one from Russell K.

"Ian, what advice do you have for those of us just starting out with options?"

Study, read, practice, and back-test on paper. A good place to start is my options volume primer. 

Study lots of charts ― that's where the answers are. Every day, I study 20 charts in after-hours, examining the trends that took certain best stocks for 2010 up or down.

Don't get bogged down with indicators. Find those that work for you. It took me months to find the right combination of Bollinger Bands, W%R, and candlesticks, in addition to trading news. And that's what works for me.

Don't jump from strategy to strategy. That doesn't mean you shouldn't refine, but pick something and stick with it.

Don't copy someone else's habits or try to become the next Warren Buffett. Read, study, learn, and repeat.

Get your mind in focus to trade.

Have a time-tested method and stick to it.

Have stop losses in place. And have trailing stop losses set up to lock in gains on unexpected pullbacks.

Manage losses well.

And never risk the house. There's never any such thing as a sure winner.

I hope that was useful. If you have further questions, please send them in. We're more than happy to help.