Sunday, April 26, 2009

The Credit Card Dilema

Over the past few years credit card companies have increased their business tremendously. These companies would relentlessly send out cards in the mail with a letter saying you have been pre-qualified and all you have to do is go to the store and start spending.

As these cards turned on the debt started to build. To make way for new loans the credit card companies sent their debt to Wall Street banks. These banks packaged up the debt, put a AAA credit rating on it, and sold it to investors around the world. (This is the same process they used for mortgage loans)

Then, just like mortgage loans, investors stopped purchasing the debt. If investors stopped purchasing the debt, then Wall Street was unable to buy the debt. If Wall Street was unable to buy the debt, then the credit card companies would have to keep the debt on their own books. This is not a problem, the companies just have to be a lot more careful now who they send the cards to. If the debt goes bad, then the losses are on their books.

Recently, the losses have started to build. In order to compensate for the increase in defaults the companies have started to increase fees across the board. Similar to an insurance company who insures homes down in Florida, in order for them to stay in business they have to charge higher fees knowing the likelihood of losses is high.

This week the government has stepped in and announced they will not let these companies raise their fees. They claim it is unfair to the American public who took the free money, spent it, and can't pay it back. The government thinks that with the fear taken away of these higher interest payments, Americans will keep on spending.

Unfortunately, it will have the reverse effect. If credit card companies cannot charge these higher fees to offset losses, they will just stop lending across the board.

Their is a third part to this story, however, and its role will begin to grow as this tale unfolds. In order to induce these credit companies to begin lending again, the Federal Reserve has begun purchasing credit card debt. They have now become the secondary market that existed before.

With the fear of defaults once again taken away, the credit card companies will be able to make loans to any willing American who will turn on a card. If the losses go bad, then it will happen on the Fed's balance sheet.

I hope it is obvious that this scenario has the ultimate recipe for disaster. You cannot just paper over losses will printed money. With the public looking one direction at the discussion over fees being charged, they are missing the real story happening out back as these loans are being offloaded to the Fed.

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