Bank and Fed credit card vortex is tough
Do Americans finally understand this by paying off their credit cards in record amounts? So far $ 25 billion a year in lost interest income for banks!
By Wolf Richter for WOLF STREET.
There has been a lot of fuss in the banks and at the Fed over Americans daring to pay off their credit cards – practically stimulus abuse, so to speak. In the five quarters since the fourth quarter of 2019, Americans have paid off $ 157 billion in credit card balances. “One of the most puzzling changes in debt balances,” called the New York Fed. Credit cards are extremely profitable for banks. The Fed cracked down on interest rates with all its might, but credit card interest remained surprisingly high.
According to the most recent data from the Federal Reserve, banks were charging an average of 15.9% interest on credit card balances that were actually valued as interest. That’s a drop of 1.2 percentage points from the May 2019 record (17.1%), but well above historical levels (red squares in the graph below).
In comparison, the average yield on BB-rated corporate bonds, the upper end of the junk-bond range (my cheat sheet for corporate credit ratings) fell to a record low of 3.2% in February, according to ICE BofA BB US. High Yield Index, and has barely increased since (black line). When it comes to making money with consumers in debt and strapped for options, there is nothing like it out there:
Based on the average interest rate charged on credit card balances of 15.9%, that $ 157 billion repayment of credit card balances that consumers have somehow engineered is $ 25 billion a year. year in lost interest income for banks!
This is why banks are trying so hard to convince consumers to borrow again on their credit cards. And that’s why the New York Fed, which is owned by financial institutions in its district, finds this reimbursement so “confusing.” We’re talking about $ 25 billion in banking income per year.
The bank collects a fee from the merchant every time a consumer purchases something with a credit card. The bank also collects interest from consumers who carry balances on their credit cards and do not pay them off every month. It is this second part of the equation that we are talking about here.
The interest rate can be over 30% for consumers who cannot pay off their credit cards. If they had enough cash to pay off their credit cards at that rate, they would. But they are stuck. Consumers who pay off their credit cards each month are often offered lower interest rates, but they don’t need to borrow on their credit card. Banks also offer teaser rates of 0%, then after a set period – once the consumer has charged the credit card and can no longer pay it off and is therefore blocked – the teaser rate drops to 29.9% .
Call it the credit card whirlwind.
In the world of debt, “spreads” measure investor appetite for credit risk. Spread can be measured as the difference in yield between a category of corporate bonds, such as investment grade bonds rated A (relatively low default risk) and Treasury securities of equivalent maturity (close risk of default). zero because the Fed can print the government out of trouble).
These spreads between high risk and low risk debt have narrowed and are currently close to historically low levels. The exception is interest on credit cards.
For example, the spread between the yields on unwanted bonds rated BB (high risk corporate debt) and interest on credit cards (high risk consumer debt) has widened, and in the last decade has doubled, from a difference of around 6 percentage points on average in 2010/2011 to more than 12 percentage points currently.
The average yield on BB-rated bonds fell from around 7% in 2010 to an average of 3.3% in early 2021. The average credit card interest rate on balances with assessed interest increased over the same period of about 14% on average to 16%. Hence the widening of the spread:
Credit cards have been carefully shielded from the Fed’s crackdown on interest rates. This profit center is just too important for the banks.
Using a credit card for 2% cash back or earning frequent flyer miles or whatever is a smart thing to do, as long as you don’t have to pay interest on the balance.
But paying those credit cards and not having to pay usurious interest rates is a much smarter thing to do. Maybe Americans are finally smart about the credit card bustle – hence the $ 157 billion paydown.
Interest on credit cards will always be higher than mortgage interest because credit card debt is unsecured debt while mortgages are secured debt. Thus, for banks, credit cards carry greater risk and interest must compensate for this risk. But not the kind of interest that banks charge for credit cards.
The credit card bustle has this element: When a bank charges 25% interest on a credit card, the high interest charges increase the risk of default because the borrower is unlikely to be able to pay the interest. Charging 4% interest would significantly reduce the risk of default. But that wouldn’t be part of the credit card hustle and bustle.
The irony is that the Fed has been pushing to suppress corporate debt yields. It is aggressively cracking down on mortgage rates, including buying mortgage-backed securities. He lowered the interest rates that all types of borrowers have to pay. The Fed has moved heaven and earth to wipe out the income streams of savers and bond investors.
But at the same time, the Fed is flogging its weapons to get Americans to borrow more on their credit cards and pay that usurious interest. And instead of exerting pressure to lower the interest rates banks charge on credit cards, the Fed gets angry when consumers begin to respond to the credit card turmoil by paying off the amounts they pay off. they must. But for now, the Fed assumes it’s only temporary.
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