Is Economy Facing Widening Credit Squeeze?

Kristin Schantz, a 26-year-old manager for a human-resources company in Kenosha, Wis., got some unpleasant news in the mail last week. In a form letter, Capital One told her the interest rate on her credit card was about to almost double—she’d been bumped up from a fixed 8.9 percent rate to a "variable rate that equals the prime rate plus 6.9 percent"—or about 15.8 percent. Schantz, who says she’s “never late with payments,” is irate. The letter blamed rising interest rates across the economy for the decision.

Schantz isn’t the only American who has lately received Capital One’s letter. Blogs are teeming with postings from people complaining about sudden rate increases by the company. In a statement to NEWSWEEK, the McLean, Va.-based Capital One acknowledged that it had raised rates for “some” customers, citing “business and economic factors (a core one being rising interest rates)” and changes in the lending market.

For now, consumers can dump Capital One and move their balances to other credit cards with better rates—as Schantz has done. But because Capital One is the largest independent issuer of credit cards, its move may signal that similar rate increases are on the way from other credit-card providers. “It could definitely be a harbinger of things to come,” says Aaron Smith, a senior economist at Moody’s Economy.com. “They may have assumed more risk than other companies—but I would be very surprised if it was an isolated move.”

That raises an important question: is Cap One’s rate increase the start of a widening credit squeeze? If so, it would be a direct result of the home-mortgage crunch, currently roiling financial markets worldwide. “We’re not in the same world as we were five or six months ago,” says Keith Leggett, senior economist at the American Bankers Association. “There is a growing risk aversion among market participants.”

As home prices across the United States have stagnated or fallen and consumers have tapped out the equity in their homes, banks have gotten more cautious about lending and have tightened their standards for new mortgages and home-equity loans. As a result, more Americans are shifting debt onto credit cards. This week, the Federal Reserve said non-real estate consumer-credit usage rose at about twice the rate than economists had predicted for June. And revolving credit usage (which includes credit-card debt) was up by 8.7 percent at an annual rate for the month. That boost helped bring total consumer credit, both revolving and not revolving (like auto loans), to a record $2.459 trillion.

Meanwhile, continued concerns about a credit crunch in the stock markets may be putting pressure on credit-card companies to tighten standards and raise rates. (Wall Street fell sharply again on Thursday after a French bank said it was freezing three funds that invested in U.S. subprime mortgages because it was unable to properly value their assets.) The market “has changed the psychology of the situation,” says Smith. “Now they’re saying, ‘Oh my gosh, we’re going to get into the same trouble these mortgage companies are getting into, we’d better tighten standards too’.” He predicts that evidence of tightening—and a resulting increase in consumer interest rates—could show up as soon as next week, when the Federal Reserve releases its quarterly survey of loan officers.

A credit-card squeeze carries real risks for the U.S. economy overall. “The shift from home-equity borrowing to credit cards is quite costly,” says Smith. Not only are mortgage interest rates about half that of credit-card interest rates, but the interest paid on credit cards isn’t tax-deductible. Smith believes that already-strapped households with little or no savings to rely on will be faced with increased financial obligations that will eventually lead to slower growth in consumer spending. And with consumer spending accounting for about 72 percent of gross domestic product, any slowdown could have a big impact.

Americans are so tapped out financially that they may not be able to stop using plastic no matter how high rates get, says Christian Weller, an economist and senior fellow at the Center for American Progess. “I think credit-card usage could still go up even if rates go up,” says Weller. “The credit market right now is like a balloon that’s being squeezed on the mortgage side and expanding on the credit cards side,” he says.

Weller says he’s concerned that credit-card debt has risen dramatically over the past few months, even as growth in consumer spending has slowed. This, he says, is a sign that credit-card borrowing is being used to close a widening household budget gap—that cards are being used to fund housing, transportation and medical care. “I believe what we’re seeing is that consumers are borrowing out of necessity—we’re not talking about a flat-screen TV or iPods here.”

For customers who need access to credit but get knocked out of the prime credit-card market due to tightening standards, the only alternative to meet their expenses may be the subprime credit- card market, says Ellen Cannon, assistant managing editor at the financial research group Bankrate.com. And that could put them even deeper into trouble, she says. “What happens with the subprimes is that they’ll give you a $200 credit limit and then they charge you $59 initiation fee and an annual fee of $45. So by signing up, you can be $150 in the hole and your interest rate is 32 percent. It’s highway robbery.”

How long will it take Americans to dig themselves out of their credit hole? Years. “Debt will increase and consumption will weaken in the next year,” says Smith. “But there will come a point when people will either have maxed out their credit or they’ll see their credit rating starting to suffer, and that’s when many of them will decide to get their household balance sheets back in order—probably by sometime in early 2009.” Smith warns, however, that reversing a borrowing trend is “a slow process.” And that’s something anyone who’s ever tried to pay down a big credit-card bill knows firsthand.

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