Credit card charge-offs, reported by the Federal Reserve, hit the lowest level since 2Q1985. That is a record set almost forty years ago. Then, Ronald Reagan was in office, Paul Volcker was Chairman of the Fed, the ‘49ers won the Superbowl, and the Kansas City Royals won the World Series. The Dow Jones average closed at 3,388, the Prime Rate was 9.5%, and the inflation rate was 3.56%.
Aside from the politics, much changed since then. The LA Dodgers might win the series, Kansas City Chiefs are the Superbowl favorites, the Dow Jones is at 35,453, the Prime Rate is 3.5%, and inflation is 5.4%.
But credit losses are the topic du jour.
First, a few moments on why charge-off is a critical business metric.
Credit Card Charge-offs: When an Asset becomes a Bad Debt
When consumers transact, the item goes through an authorization process to ensure the account has a sufficient credit line available. There is adequate credit available in most instances, and the transaction settles with the merchant and consumer accounts. The consumer account receives a transaction that aggregates with all the consumer’s other purchase activity.
The customer account becomes a bank asset. On an open account, the institution has the right to anticipate interchange income when you transact and interest and fees based on how you maintain the account. In addition, the model expects that you will pay at least a minimum due payment every month, and if you fail to pay, the aging process begins.
After six delinquent months, the bank must reclassify the account as a non-asset. The issuer anticipates the loss and place funds into a reserve account in advance of the process. Once the bill becomes 180 days delinquent, the charge-off event occurs. When this happens, the account is no longer an asset, and the account balance is charged off as an operating expense.
The sweet spot for credit card charge-off is between 3% and 4%. At the worst level, credit card issuers experienced rates >10% during the Great Recession, and credit card issuer did not produce profits. The good news today is that the rate is the lowest experienced since 2Q1985. However, not all the metrics align.
Industry Outlook
Charge-offs look great, but they are not the only metric. The bigger picture relies on revenue items such as interest. Portfolios levels are down, which reduces that revenue line. Also, since payment trends changed during the COVID crisis, interchange is on the downswing.
Our recent viewpoint, 2021 Mid-Year Credit Card Checkup, talks about the drivers in deeper detail, but today, know that loss rates are better than ever.
Just keep a good eye on the economy because the winds can quickly shift.
Overview provided by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group