Wallet Watch

How defaults on credit cards could contribute to the credit crisis.  

Just like mortgages, lenders package our credit card debt into trusts, then sell this debt to investors on Wall Street. As credit card payments are sent to the bank, the bank ships them off to the trusts, where the investors receive their payments from them. This frees up the banks funds so they can make more credit card debt available.

But with more people defaulting on their credit card debt, observers are predicting that the quality of credit card securities will begin to deteriorate. This is what happened in the subprime mortgage market: people who didn’t understand their mortgages began to default on them, which ruined the quality of the securities that these mortgages were packaged into However, observers debate how badly credit card securities will deteriorate.

In a column in the New York Times last week, Joe Nocera says its only “frothy.” But his column shows a lack of evidence as to why increased defaults won’t rattle credit card securities. The “explosive” prediction comes from BusinessWeek, who declares that “The party was paid for with credit cards,” and “the hangover will be a whopper.” It cites weakened securitizations and anecdotes of Americans with debt problems. (Strangely, their article isn’t available online.) The more sensible approach of “bubbly” comes from the Center for American Progress report “House of Cards.”  This report uses Federal Reserve data to illustrate increasing reliance on credit cards, combined with increasing defaults. It only speculates on credit card debt contributing to the credit crisis.