Sunday, November 9, 2008

US Credit Card Crisis

The Latest sensation in the US economy is the Credit Card Crisis. Wondering what do Credit Cards have to do with a economic crisis? Think again....

All of us use credit cards. It is one of the easiest way of purchasing things even when we dont have enough cash. You swipe your card and then make the payment after a few days or weeks.

Banks in the US as usual went on a rampant selling of Credit cards to everyone. Anyone who is in a job can get a credit card. People were offered hefty credit limits, lower finance charges and attractive gifts for owning their bank credit card. Now wouldn't we be lured by such great offers? Naturally we would be. And that's what happened to the millions of American citizens.

Before getting into the details of what has caused this crisis, lets first understand how a credit card issuing bank makes money.

Assuming you go to a shop and buy something for Rs. 10000/- on 16th September 2008. The shopkeeper would get only Rs. 9800/- from the bank. This Rs. 200/- is the upfront profit the bank makes out of your purchase. This amount may vary from bank to bank. It may range from 1% to 3% of the purchase amount.

Then once the bill is generated on 15th Oct 2008 the bank would send you the statement. And as per the statement, your minimum amount due is Rs. 500/-. Since you are running short of cash you just make a payment of Rs. 500/- before the 5th Nov 2008.

Now the bank would charge you a 3% rate of interest on Rs. 10000/- from the date of purchase which would work out to nearly Rs. 500/- and if you happen to purchase something else for Rs. 5000/- this month they would charge interest on this amount as well. So the next statement on 15th Nov 2008 would have an outstanding of Rs. 15150/-

This interest is compounded at 3% every month which would work out to a whopping 40% per annum. Say if you purchase for Rs. 10000/- and keep repaying only the minimum amount you would have paid Rs. 4000/- in the first year as interest and definitely a major portion of your purchase amount would still be outstanding. Apart from this they would charge us a late payment fee of Rs. 300/- every time you miss paying on due date.

The worst is withdrawing cash from your credit card. You would be charged interest from the day you withdrew cash. Plus you would be charged Rs. 250/- for withdrawing cash. If say today morning you withdrew Rs. 10000/- from your credit card and repay it today evening you would be paying them Rs. 10400/-

Moreover high value credit cards come with annual fees of a few thousand rupees for just possessing cards.

Isn't this a lucrative business? You get 2% of the purchase upfront as profit and then you charge the customers exorbitant interest rates.

What went wrong?

Banks issued cards to everyone, even to sub prime customers. (You are thinking "I guessed that..." Kudos to you. Good job) With the ongoing credit crisis in the states not everyone has enough cash to meet their monthly mortgage commitments. With jobs being cut down by many companies, everyone who has credit card debt is repaying only the minimum amount due or not repaying at all.

In case of mortgage loans, at least the banks can take possession of the property. In case of credit cards what can the bank do? All they can do is file a legal petition against the customer. If the customer declares bankruptcy? The money is LOST...

How big is the damage?

Financial experts expect losses/write downs of approximately $75 billion. Yeah you read it right. Seventy Five Billion US Dollars. That's nearly 11% of the bailout package offered by the US federal reserve.

Whats Next?

Some or all of the below things would happen.

1. Banks would increase their annual fee and interest rates.
2. The Credit Limits may be cut
3. New card applications may not be approved
4. Existing customers with a bad repayment record would be asked to close their accounts and surrender their cards
5. Even very credit worth customers may be asked to prove their credit worthiness

If the current economic crisis worsens and we see further job cuts, the credit card crisis may worsen too...

How are the Banks planning to handle this?

Do not worry as of now. The government is not going to take the Tax payers money and propose another bailout package. As per the current laws Lenders are not supposed to suggest repayment plans to the borrowers for credit card debt. The banks are trying to negotiate with the law makers to allow them to negotiate with delinquent customers and propose a repayment plan that would ensure that the customers are charged only nominal interest rates and even though the repayment period is going to be long they would at least get their money back.

The initial plan may reach a few thousand citizens who may opt for the settlement with the card issuing companies. They would be paying their debt as EMI instead of one bulk payment.

This way both the card issuer and the card holder benefit.

In cases where the card holders are extremely delinquent banks may opt to write off the bad debt.

Is there anything good about this?

Definitely Yes. For both people and banks. Banks have been on a lending spree because of the availability of cheap credit. Now they know that they could get hit in a awful lot of ways. Hence they would restrict lending only to creditworthy customers. Due to lack of easy credit people would spend only what they can afford and this would avoid any such crisis in the future.

Let us hope for the best.

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