Credit Card Crunch

I stumbled upon Yahoo portal story from BusinessWeek this morning that I've been expecting: credit card companies are beginning to cut credit limits and getting rid of some customers altogether. This has a couple interesting consequences. Overall, however, I'm not sure it's such a bad thing.

The article leads with:

After years of getting Americans hooked on credit, card companies are slashing limits and weaning themselves off all but the safest customers.

There are a couple things that explain this. Loss and delinquency levels that credit card companies are seeing have skyrocketed:

U.S. credit-card default rates reached record highs in May, near or even above 10% for Bank of America, American Express, Citigroup, and Capital One, according to Reuters.

Card companies are trying to mitigate that risk by forcing people to spend less. Even someone with a strong credit history might be in trouble if unemployed for a year or more.

But way down in the 17th and second to last paragraph, when probably only about 5% of people are still reading:

The banks might be tightening available credit in reaction to new federal legislation, taking effect in the middle of next year, that will restrict how credit-card companies raise rates.

I don't think there's any "might" about it. In addition to mitigating recessionary risk, the game has changed. Starting this year and into next year, banks will face new constraints imposed by Congress and the Federal Reserve. Credit card companies can't use the same tools they have in the past to maintain profitability. That means they need to reduce some their exposure.

Is this bad? If consumers have less available credit, they can't consume as much. And in order to get us out of the recession, there are those who advocate everyone should consume, consume and consume some more. I think that's crazy. The recession will run its course, but once we come out of it, to have mounds of credit card debt seems insane. I've long been an advocate for people spending only what they can afford. In most cases, a lower credit limit will still allow consumers to use credit, just more responsibly.

This affects credit scores. One metric of a credit score is the ratio of debt to total credit available. In other words, the lower a portion of debt you have to the total amount of debt you could have, the better. If the denominator in that equation -- your overall credit limit -- decreases, then your FICO score will decrease too. That means when a credit card company cuts your credit line, it is responsible for your FICO score taking a hit. The article has an expert comment on this:

"This is blindsiding people," said Evan Hendricks, author of Credit Scores & Credit Reports (Atlas Books). "For a significant portion of people having their credit scores go down, it had nothing to do with what they did. This is the system making credit scores go down. This is a new thing in history."

I have always been frustrated with many aspects of how credit scores work. Consumers should have more power over their credit scores, but right now that power lies almost exclusively with debt issuers and the credit agencies. This is one aspect of consumer credit that Congress' recent credit card legislation entirely neglected.

But in this case, I'm not sure the outcome is such a bad thing. I'd suggest that credit scores were probably overinflated, as people had credit limits that were entirely too high. Credit card companies are determining exactly that in light of recent events. That's why they're lowing credit limits. If someone has a large portion of an excessive credit limit utilized, his credit score should have reflected that to begin with.