Credit Card Debt…Next Financial Crisis?

Significant concern has developed over the increase of credit card debt and the accompanying increase in credit card charge-offs by banks. Moody’s Investors Service indicated that balances written off by credit card companies as unpaid rose to 6.8% in August, a 48% increase over a year ago.

The largest five credit card companies (Discover Financial Services, Bank of America, J.P. Morgan Chase, Capital One Financial Corporation and Citigroup) issue approximately 80% of all U.S. credit cards. If massive loan defaults begin to occur, these companies could be subject to significant losses due to write-offs.

Because of this concern, a proposal was presented on October 29, 2008, to the Office of the Comptroller of Currency (OCC) to allow credit card companies to test a new set of concessions for those who are close to bankruptcy and unable to qualify for the repayment plans presently available. The proposal was made by The Financial Services Roundtable, a lobbying organization with 100 members representing the largest financial services companies providing banking, insurance, and investment products, and the Consumer Federation of America, a consumer advocacy group whose membership consists of 300 consumer groups with more than 50 million individual members.

The new proposal asks permission from the OCC to do three things:

• Forgive up to 40% of the debt. For individuals who have serious debt issues and are close to filing bankruptcy, the proposal would allow credit card companies to forgive a portion of the debt up to a maximum of 40%. Currently, the credit card companies can negotiate reduced payments on outstanding balances, lower interest rates, and lower penalties, but no significant reduction in the principal amount owed.

•Extend payments over multiple years. The proposal would allow the remaining debt after the reduction of principal to be paid by the debt holder over multiple years. The credit card companies are currently only allowed to extend payments on reduced debt balances over three to six months, causing the debtor to make larger lump sum payments to pay back the remaining balance.


•Postponement of recognition of corporate write-offs and debtor taxable income. Currently, when any debt is forgiven, the credit card company must recognize immediately a corresponding expense in the year of the forgiveness. This reduces the credit card company’s earning for that year. At the same time, the amount of the debt forgiveness is reported to the IRS and the taxpayer is required to recognize the amount as taxable income in the year the debt is forgiven. This means the debtor must include the amount on their income tax return and pay income tax on the amount forgiven. Under the proposal, the recognition of the loss on the corporate books and the recognition of income by the debtor would be delayed until the reduced balance repayment plan is completed or the borrower defaults on the plan.

For example, let’s assume that an individual has a $10,000 credit card debt and that bankruptcy is eminent. The credit card company reduces the debt by the maximum amount of 40%, or $4,000, and works out a three-year payment plan for the remaining balance of $6,000 with the individual. The credit card company is not required to reflect their loss of $4,000 on their income statement until the payment plan is completed in three years or at whatever point the repayment plan is in default. Likewise, the individual does not have to reflect the $4,000 debt reduction as income until the 3-year payment plan is completed.

From the perspective of the credit card company, they feel that this proposal will give them an opportunity to recover some portion of the debt versus having the card holder declare bankruptcy and not pay any amount back. However, this is also a benefit for the credit card company since it postpones the recognition of the loss, thus making their balance sheet appear stronger than it should.

If this proposal is accepted, the credit counseling services will be involved in working with the eligible individuals to work out the debt reduction and repayment plan. Since there are a number of fraudulent debt management and counseling services contacting debt holders, it is important that debt holders ensure they are working with a credible and legitimate organization.

Summary

This proposed plan represents another form of “bail-out” for those holding significant debt and, to a lesser extent, the credit card companies. This will be a source of frustration for those individuals who continue to spend responsibly and who pay off their debts on time. Just one more sour pill to take to rectify the excessive consumer spending.

Elaine E. Bedel, CFP®, is president of Bedel Financial Consulting, Inc., a wealth management firm providing fee-only financial planning and investment management services. For more information, visit their website at www.BedelFinancial.com or email to ebedel@bedelfinanial.com.