Profiting from Credit Card Defaults

December 30, 2008 by  
Filed under Investing

Last week I disavowed negativity about the world of personal finance until 2009.  I don’t intend to break that vow today.  However, writing about how we might profit from negative financial projections is actually positive, so I’m going for it.  You can file this as a last minute, end of year stock tip.  Maybe you could still benefit from taking a capital gains loss in 2008.  (Don’t forget that up to $3,000 of that loss is deductible from ordinary income.)

According to data from Moody’s Investor Services, charge-offs on defaulting credit card accounts have steadily risen from near 3% in 2006 to 6.6% today.  That’s a dramatic increase.  What’s worse is that many experts are predicting that credit cart default rates will continue to climb, reaching double-digit levels by 2010.  The logical basis for this prediction is that consumer credit defaults are closely tied to unemployment.  That upward trend is now well established, with no immediate end in sight.

Mr. ToughMoneyLove takes no pleasure in believing that many more American consumers will be unable to make their credit card payments next year.  I will, however, toss in a little “you should have known better” attitude right here – then move on to the positive attitude.

So how do those of us who don’t have to worry about paying down credit card balances make money from news of an avalanche of credit card defaults?    Obviously, a high default rate is bad for banks that issue the cards and hold the balances.  It could get very bad for some, given that the historically high default rate is 7.5%.  We are almost certain to break that record.

So, the first thing we need to do to make money from this prediction is not lose money.  That means dumping stocks in financial institutions who are poorly positioned to absorb substantial losses arising from credit card defaults.  I’ve already dumped the bank stocks that we owned when they cut their dividends.

According to Barron’s, the banks and card issuers with the highest current credit card default rates are:

American Express (Remember when having an American Express Card was a status symbol?  Now those cardholders are one of the biggest deadbeats of all, with a 7.0% charge-off rate.)

Bank of America (7.86% charge-off rate)

Citigroup  (6.94% charge-off rate)

TARP funds are no doubt flowing to these institutions but I’m betting that charge-offs are growing faster than Paulson can print money.  If you own these or any other institution with a significant credit card business, consider moving your money elsewhere.  If you are a risk taker, shorting these stocks could be a big profit play for you in 2009 or 2010.

This brings us to the question of whether there are any card issuers who are expected to perform comparatively better than others during this difficult period.  The key factor here is likely to be having substantial bank deposits on hand to prop up the balance sheet.  In that regard, Capital One has been very aggressive in acquiring smaller banks to get access to their deposits.  In addition, Capitol One Online bank has a sweet deal with Costco, getting access to Costco customers in exchange for offering a .50% premium on depositis.   If you watch any television at all, you will know that Capitol One is still promoting the heck out of its credit card business so it must be feeling pretty good about its future in that department.

In summary, consider whether you want to (a) sell, hold or short stocks in financials with big exposure to credit card defaults; or (b) look for a relative winner in the financial services sector, e.g., Capitol One.

I chose (a) and took my losses on Citi and Bank of America.  Good luck with your decision.

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5 Responses to “Profiting from Credit Card Defaults”
  1. TMN says:

    That’s an interesting assessment given my own recent experience as a customer of two of the companies you mention.

    I hold both an American Express card and a Capitol One Visa (paid off in full every month, of course). The AmEx offers competitive interest rates, amazing bonus services such as extended warranty on anything you buy with the card, and cashback that averages 2.2% across my purchases this year.

    CapitolOne has been my backup card for a while, since it’s my oldest account. They’ve been desperately sending me “please call by to upgrade your account” letters for nearly a year. When I did finally relent, their representative was able to offer me 1% cashback on select purchases only, and 18% APR. I have a credit score above 770, and have been a customer of theirs (in good standing) for over 6 years, and the “upgrade” they were offering was just sad.

    Now, it’s true that sometimes better terms are a sign of desperation. But I can’t imagine that massive advertising campaigns coupled with extremely uncompetitive rates for those who apply is a great sign either. And you need to remember, American Express has a very different cost structure from VISA providers. Their cut off the top on merchant transactions is MUCH higher (half their income), and their high-end cards may provide significantly more interest income than even the best VISA customers (the “status symbol” effect).

    I’m not denying that AmEx is facing some hard times… everybody is. But from my observations, CapitolOne has been flailing around in desperation for quite a while now.

  2. GettingUp says:

    It is definitely interesting to note that AMEX has the highest default rates. Also, almost as surprising is Bank of America. Citigroup, I would expect, as I think that they do more sub-prime credit card lending, as well as private label cards.

    I am very surprised about who is NOT on the list… HSBC. They have a huge amount of private label card holdings, and have been using “advanced credit profiling” for years. This sometimes allows more sub-prime borrowers to get credit. Capitol One surprises me as well.

    I think that there are some very rough times ahead for credit card issuers.

  3. andy says:

    I would even consider shorting Capital one, particularly because it needs the extra capital. In the current climate, the best bet is to stay put or trade with ETF’s/funds.

  4. kitty says:

    I wonder how much of this is already factored into the market and the cost of these stocks. So shorting seems risky to me. Have you checked earnings (or loss) expectation for the quarter vs charge-offs? Disclosure: I own Citigroup stock – bought for $5.25 one day before the bottom. This was a gamble, so I only bought 150 shares – the amount I wouldn’t lose sleep over. Should’ve probably sold two days later…

    HSBC is interesting. Not only they have all the expected losses, but I believe they also lost a bunch of money with Madoff.

    “And you need to remember, American Express has a very different cost structure from VISA providers. Their cut off the top on merchant transactions is MUCH higher (half their income), and their high-end cards may provide significantly more interest income than even the best VISA customers (the “status symbol” effect).”

    Exactly. I believe bank’s share of merchant transaction fees is $0 – these fees go to Visa company and not to the banks. AmEx gets everything. They also have corporate card business as well as corporate travel business, although with slowing economy there’ll be less business travel. I don’t know how much profit corporate cards bring – they have to be paid in full by the due date or the holder’s manager gets a friendly reminder.

  5. Jen says:

    I apologize but all this seems extremely selfish and irresponsible in light of economic times. People are loosing their jobs, going broke having hard time feeding their families, and what I am reading here is how people can make money off other’s misery. This is exactly the attitude that got is into this mess, as a nation…not just a few group of people who have stock in banks. Shall we say to all those people-Let all thos in debt eat cake! And then we can toss them our scraps. It just seems very wrong to me.

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