First The Toilet Paper, Next The Credit Cards

125 Years Later this scene will repeat

Can ‘What’s in Your Wallet?’ handle the shock waves from a global shutdown

To understand, we need to go over how the credit business works, and how it isn’t designed to deal with a shock wave from a tsunami of unpaid workers. The credit markets have never faced anything like this.

The Government should be acting aggressively. Lowering interest rates may have fixed the 1930 depression, I doubt it will prevent one today. By the time the government finally sends checks to everyone suffocating from lost income, it might be too late.

How does the credit card industry work? They borrow Treasury Notes from retirees, sell them, then lend that money to credit card holders. I’m calling these investors “retirees”, the people who put up the capital, because I want to drive home the point that credit card debt — it’s between each other.

Since the notes pay 2%, we must at least pay that back to our retirees who invested their T-Bills. That won’t be a problem, because the card holders are charged 16%. They pay our retirees another 2% for lending us their T-Bills, which leaves them with a 12% profit. Win-win!

After losing money to fraud, the biggest problem we need to handle is credit card holders who can’t make their payments. When they have trouble, we could renegotiate their payments individually, until they’re back on their feet. But that would cost a lot of money in support. If we make an exception for one customer, why not another? It gets too complicated. So if someone can’t make their payments we simply write the loan off completely. That’s called a “charge-off”.

Because we have 12% profits to play with, it’s easy to model our loan ratios so that our charge-offs never exceed our profits. To date, they rarely do. Credit is like a virus. It needs to infect as many hosts as possible, but not kill so many that it dies off itself.

The velocity of the economic collapse has changed the lethality of credit card debt.

After the 2007 financial crises, charge-offs got bad, but not to the point that the credit card companies couldn’t recover. In general, if charge-offs increase from 3% to 4% say, they increase the interest rate charged to their customers from 16% to 17%. That hasn’t been necessary. Lower interest rates from the central banks have protected credit issuer margins.

Anyway, the industry proved, after the 2007 financial crises, that its business model can deal with a few years of large, but slow charge-offs. What the credit card industry hasn’t been tested against is those charge-offs hitting them, not in a few years, but all compressed into the span of a few months.

In the 2008 crisis, credit card defaults rose from around 4%, quarterly, in the Fall of 2007 to 10% in the summer of 2009. They started to decline at the end of 2010. What’s important here was the gradual change in charge-off rates.

Charge-offs in a slow moving financial crisis

In the current situation, economic conditions are deteriorating by the week. What would charge offs look like if we analyze it monthly? I estimated monthly rates using the FRED data and then calculated the rates if they compressed because of the speed and depth by which the global economy is falling.

Note the steepness of the charge-off curve

What this chart may indicate, is by June of this year the credit card companies could be in a charge-off predicament it formerly took them 2 years to reach.

The same way we want to flatten the infection curve of the coronavirus so we don’t overwhelm our hospitals, we want to flatten the charge-off curve of hundreds of millions of people, globally, who have all lost income at the same time and must scramble for cash.

If a charge-off shock wave hits the credit markets, credit businesses will have no choice but to limit lending. That’s because when the charge-offs exceed their profits, the retiree owners of the treasury notes will want their original investment (T-Bills) back until economic conditions are safe again. Keep in mind, credit card companies are marketing companies. The money they loan isn’t theirs.

In a perfect world, we could prevent this problem from happening by freezing credit card accounts until the economy starts up again. The problem is that most people want to keep borrowing, especially now, because one, they believe they can make up enough of that income to recover; and two, they don’t believe there are enough people to bring down the system.

We can see the same behavior about the coronavirus. People still crowd the supermarkets because they don’t believe they’ll personally get the virus and they don’t believe one crowded supermarket will doom society.

What if people stock up on cash through their credit cards like they stocked up on toilet paper and food at the supermarket? Let that thought sink in.

Right now there is about $800 billion in credit card debt. There are 25 million Americans, with credit cards, who have negative, to zero net worth.

If each of them took out $5,000 in cash from their credit cards because well, they’re not working the hot dog stand at the local stadium, it would amount to $125 billion. I can’t see the credit card companies lending that out in the future.

Furthermore, even before the coronavirus hit, credit card companies were slowing down the issuance of credit cards. With many of their customers currently facing their credit card bills without income, it’s likely that if they were to apply today they would get turned down.

When the run on cash begins, credit companies will have to cut off credit to weaker card holders. This extends to car loans, business loans, student loans, so on and so forth.

If those card holders don’t have income from their jobs and can’t borrow money what next? A 3-month old credit score won’t feed the family. Obviously, something would have to be done. But what?

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I try to write stories that go where the general media doesn’t.

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Max Rottersman

Max Rottersman

I try to write stories that go where the general media doesn’t.

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