Great News! 2009 Credit Card Charge-Offs Exceed $80 Billion

Throughout 2009, outstanding consumer credit balances fell.  This was often described as consumer "deleveraging," or paying off debts.

Unfortunately, this description was wrong.  Outstanding credit card balances fell by $92.2 billion, but $83.27 billion of that drop consisted of charge-offs.  In other words, 90% of the fall in credit card balances were due to write-offs of non-performing accounts.  Consumers haven't paid their balances down. They can't pay at all.

The weakness of credit cards and other consumer lending portfolios has long been masked by the ability to receive more credit.  Balance transfers, home equity loans, and other forms of refinancing have perpetuated the illusion that consumers can handle their debts just fine.  Using debt to pay off debt became the norm.  There is perhaps no better illustration of that than the video below. 

Now that these refinancing options are much less available, the mask has come off.  Unpayable debt is now truly unpayable.  Don't be fooled into thinking this spike in charge-offs is a one-time or temporary event.  It's just the beginning.  We can expect the rate of charge-offs to increase for the foreseeable future.  Despite how gloomy this sounds, an acceleration of charge-offs and other forms of bad-debt write-offs will actually turn out to be a net positive for the economy as a whole.  The economy has been severely wounded by bad debt.  The faster this bad debt washes through the system, the faster we'll be able to move on.

One of the biggest uncertainties of our economy is the question of how much bad debt is yet to be revealed.  For example, we still don't know how many dud mortgages are on the books of the banks and the Fed.  This uncertainty has resulted in a frenetic search for the "bottom" of the mortgage market.  Every time we seem to be getting there, a new wave of foreclosures hits, further undermining confidence.  (For a good example of an anticipated new wave of foreclosures, see  http://www.washingtonpost.com/wp-dyn/content/article/2010/03/11/AR2010031104866.html?hpid=topnews )

A brutal reality of capitalism is that it forces us to realize our losses.  Bad debt in our economy represents enormous losses, many of which are still hidden.  We will not find a true "bottom" until these debts are properly classified, accounted for, and resolved in some fashion.  Wall Street, The Fed, and the Treasury could help by being more transparent on the "toxic assets" that were the first economic dominoes to fall.  

But consumer loan losses as a whole are not so easy to shine a light on.  It's the households that manage to teeter on the edge while maintaining an appearance of normalcy that represent the biggest shoe yet to drop.  "Teetering on the edge" is a large part of the middle class.  Many have already lost their battle with debt but just don't know it yet.

The only way to avoid a long, drawn out tsunami of defaults is to bring all the bad and soon-to-be bad debts to the forefront. A lot of uncertainty would be eliminated if these debts are dealt with in a predictable and transparent manner.  As crazy as it sounds, bankruptcy should be actively encouraged for the those who are legitimately overextended.   Debts would either be discharged or repaid through the bankruptcy courts, eliminating the years of collection calls and lawsuits most of these debtors will eventually face. Household balance sheets would largely be cleared, freeing up cash for spending and saving.  And households would once again be good candidates for responsible lending, giving banks what amounts to millions of new debt-free customers.

The debt that so recently gave life to our economy is now suffocating it.  This debt has the potential to stifle any economic recovery for years. Our bankruptcy courts give us the ability to deal with bad debt using a well-known, transparent process.  We should use them.

Related Note

There were very few aspects of the financial meltdown that could be called honest-to-goodness surprises.  Lenders knew they were playing fast and loose.  So did their regulators, and so did the public.  The fear of a household debt implosion has been kicking around for years.  Consumer advocates, credit counselors, financial educators, and other social organizations have long been warning us of the overextended consumer.

The surprise lies in the order in which the credit implosion is occurring.   The typical overextended debtor has long been assumed to make his or her secured debt payments first and let the unsecured debts slide if necessary.  The mortgage and car get paid, the credit cards wait.  In fact, this is common advice for people with more bills than money.  Keep a roof over your head and wheels for income opportunities.  Bill collectors will ring your phone off the hook and you'll have to deal with the cards one way or another at some point, but credit card payments are not an immediate necessity when funds are limited.

This priority of payments would lead us to expect a large spike in credit card defaults before we see any mortgage problems.  That's not what happened.  Mortgages began failing quite some time before credit cards.  This makes sense on a small scale.  It would not be irrational for cash strapped families about to lose their homes to keep a credit card open for moving truck rentals, storage fees, food, and gas.  But it's doubtful that this scenario has been widespread enough to fully explain the lag between the mortgage meltdown and the ongoing credit card meltdown.  Balance transfers could also explain some of the lag, given that credit card companies didn't begin tightening their standards in earnest until late 2008 and into 2009.  In any case, the failure of mortgages before the failure of credit cards is a stark contradiction of conventional wisdom.  It's an unexpected development that we should try to understand and explain. 

Charge-Off Statistics from: http://www.msnbc.msn.com/id/35805692/ns/business-personal_finance/?ns=business-personal_finance