Credit Card Losses: How High Can They Go?
According to data from the Federal Reserve, US consumer credit grew by 5.5% annualized during Q3 the fastest quarterly pace this year. Credit now tops $1 trillion after a multi-year splurge by consumers on auto debt funded by rock-bottom interest rates and relaxed lending criteria. However, now that interest rates are starting to rise again, investors, analysts, and banks are beginning to vent concerns about the state of the American consumers’ balance sheet and credit card losses are among the largest of those concerns, but maybe there is some room for optimism on that front?
Credit Card Losses Rising
Banks have enjoyed years of declining losses from fewer consumers defaulting on debts, but this trend is now starting to reverse. Synchrony Financial was the first major issuer to issue a profit warning on rising losses earlier this year when it announced first quarter provisions for loan losses surged 21% to $1.3 billion compared with the prior quarter -- $300 million more than expected. Management expects the write-off rate for the full year to be around 5% or slightly higher according to Bloomberg.
Citi came next reporting $1.2 billion in losses at its consumer lending business in North America for the third quarter. Most of the losses stemmed from its credit cards division. To add insult to injury, management set aside a further $500 million to cover additional losses. At the same time Citi announced its losses, JP Morgan also told investors that it was increasing provisions for unsecured credit losses.
Still, even though charge-off rates are rising, it's important to keep in mind how abnormal the past ten years have been for borrowers and lenders. Even though default rates have risen during the past few quarters, they're still far below historic levels.
Indeed, according to research from analysts at Credit Suisse, the average charge-off rate of 2.78% reported in Q3 2105 was a 32 year low. What's more, even though the average charge-off rate has risen to 3.91%, it's still 115 basis points below the 35-year average of 4.79%. The banking industry is 19 quarters into what's historically been a period of 20+ quarters of below average credit card losses in a recovery.
This research shows that rather than entering a period of high defaults, default levels are in fact just returning to the long run average. A return to the norm would provide a 2% to 4% hit to 2018 earnings for JP Morgan and Citi, which should be easily manageable.
As the Credit Suisse report sums up:
"Our work suggests the consumer is healthy; this is normalization."
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