Credit Card Derivatives: Facing Reality, One Step at a Time

The amount of single-minded focus that the media has placed on the mortgage market and the collateralized debt obligations surrounding it is nothing more than a fad. I don't mean that the problem is a fad - far from it. This is part of something bigger that is here to stay for many years. But the media pays attention like an industry with ADD. Journalists have grabbed on this because it was big and bright, essentially as it latches onto a story about a celebrity or the murder of a pretty coed.

But the financial crisis is much more than mortgage-based CDOs and the London inter-bank rates. According to whom you ask, the derivatives market has hit between 1 and 1.25 quadrillion dollars. Yes, a thousand trillions. That is so massively beyond the size of the 50 trillion GDP of the entire world as to be stunning and scary.

We've seen two shoes drop in mortgages and credit default swaps (which is continuing to evolve as more defaults happen and more institutions become liable for the "insurance" they offered). Chances are strong for future rounds of stock market plummets as companies continue to need cash to cover their positions and sell securities to get it.

The next one is likely credit card derivatives. As I've mentioned before, there's an entire bond market created in the bundling of credit card and auto loan debt. I have yet to find a good estimate of the total market size. But consider this: a large part of the quarterly $5.29 billion write-off that AIG took in the last quarter of 2007 was for credit card derivatives exposure, possibly through credit default swaps. And around the end of September, Citi said that it "faced up to $10 billion in credit losses, partly because of rising credit card defaults."

Subprime mortgages got into enormous trouble with, what, a ten percent default rate? Last quarter, U.S. banks charged off 5.47 percent of all credit card loans, or about $50 billion. That was up from 3.85 percent in 2007.

To be sure, credit cards don’t represent a huge portion of assets for most banks. For example, they comprise about 14 percent of all consumer loans and leases at Bank of America, the country’s largest credit card issuer. The main problem, Nishikawa said, is that “everyone is so weak after what happened with mortgages that another blow to a consumer product would be hard to handle.”

Consumer groups have long complained that credit card issuers push cards onto people who don’t need them or can’t afford them. They say rising credit card defaults —- just like mortgage defaults —- are largely the fault of banks who lent to risky borrowers.

Innovest estimates about 30 percent of Bank of America’s credit card loans are to subprime borrowers —- second only to the failed Washington Mutual Inc., which had almost half of its credit card loans held by subprime borrowers.

What that story doesn't say is that in the event of a mortgage default, the bank still owns the property -- probably not longer at the value the bank had assumed when writing the mortgage, but still something. Credit cards? Totally unsecured. And when auto loans go bad, the car has lost enormous value once driven off the lot.

Even if the credit card and auto CDOs are smaller than CDOs based at least in part on subprime mortgages, the impact they'll have has the potential to be far larger.