Reduced Credit Limits: That's the Good News

In a great and uncharacteristic show of responsibility, banks and other financial companies are reducing credit limits. The NY Post misinterprets this as bad news. They note that lower credit limits reduce spending power, which is bad for growth.* But they neglect the larger issue at stake, leverage, which is greatly improved.

Credit-card companies, which have been slashing credit limits on millions of cardholders in an attempt to right their balance sheets, are also sucking up to $200 billion of much-needed spending power out of the economy, credit-industry professionals tell The Post.

That amounts to nearly 1.5 percent of gross domestic product, or GDP, enough to further stymie the already fragile economy.

You can tell right off the bat this writer has little understanding of the bank crisis. “Righting” their balance sheets is exactly what lenders should be doing. As over-leveraged as they are, they need to be reducing their assets. [Remember: a bank's assets are the loans it makes to borrowers.] When borrowers default, the value of bank assets declines. If equity is small relative to assets, then declining asset values will quickly expose banks to bankruptcy.

And credit card loans are particularly risky assets for banks. They are unsecured: there is no collateral behind them. With a mortgage or car loan, when borrowers default the bank can foreclose on the collateral—the home or car in question—and sell it to recover some of the money owed. With a defaulted credit card loan, the lender is often up a creek without a paddle.

The NY Post piece falls prey to a common misconception: that more borrowing/lending is unambiguously a good thing. The article quotes an S&P economist who concludes that the consumer economy is in danger because access to credit is being reduced. Ugh.

We can’t have our cake and eat it. We can’t reduce leverage and keep pumping credit into the economy.

Economic policy-making has literally descended to the absurd. On one hand, we want banks to repair their balance sheets, which means they have to reduce the amount they lend relative to their capital. On the other hand, we insist on pumping more credit into the economy in order to fuel more spending so that “growth” continues. Since banks are the economy’s financial intermediaries, they are the instruments through which credit is extended.

It’s an impossible position. Society insists that they lend more even though their survival requires them to lend less.

———-

*Is it not absurd that our economic equations treat spending other people’s money as “growth”?

Comments

[Eric in IL:]

I agree that they should be reducing lines. One takeaway I have from here is that rampant inflation will not come as soon as many expect. Therefore, I would not be bullish gold. We also should expect lower forward P/E on average. You are not going to get the growth you once had. And that might just be a good thing.

May 04 12:39 PM

[Harry Tuttle:]

The economy is in a no-win situation. Either we manage to reflate the consumption bubble and delay the pain or there is more pain to come. Most market pundits do not want to accept this fact which is why we get nonsensical statements like "much-needed [credit-card based] spending power."

May 04 01:36 PM

[Bylo-:]

I've heard it said before and said it myself..."You can't fix too much debt with more debt"!

May 04 02:10 PM

[willynill:]

I agree with the author and the other responders above.

May 04 03:41 PM

[silver-bug:]

While reducing credit limit may be good for the credit card companies, it is bad for the consumers who depend on credit cards. It is like getting the drug addict addicted to drugs and then cutting off the supply immediately.

And how is Obama going to make people spend more money to stimulate the economy when they have no jobs, no credit, and no house to live in?

Sure, it's one thing to forcibly give the credit addicts a lower limit, but what about the government? Does it have a credit limit? How much more can it spend without having the money? Where will the money come from? Who will the government tax? How much? The remaining workforce will have to pay the higher taxes down the road because the government can't tax people who have no income and no jobs. Say "Tax Squeeze!"

May 04 03:57 PM

[David Hasson:]

Well, as a consumer, my problem is largely that they cut credit lines without much warning at all. This can cripple the consumer - it's not always as simple as keeping people on welfare from buying 22's for their cars. The dejected consumer in many cases spirals into not spending any money at all until there is a surplus, which I would think could be hard on the economy. The 200 billion gets magnified quite a bit.

May 04 04:08 PM

[naidle:]

It can only cripple the consumer if they require such credit. I would argue the big problem is that the consumer believes that credit will always be available. Now that it's tightening (as there should be) there are problems.

Welcome to Stagflation :)


On May 04 04:08 PM David Hasson wrote:

> Well, as a consumer, my problem is largely that they cut credit lines
> without much warning at all. This can cripple the consumer - it's
> not always as simple as keeping people on welfare from buying 22's
> for their cars. The dejected consumer in many cases spirals into
> not spending any money at all until there is a surplus, which I would
> think could be hard on the economy. The 200 billion gets magnified
> quite a bit.

May 04 06:56 PM

[pimp:]

Here I was thinking that credit was part of the world of make believe.

May 04 07:31 PM

[Alan Young:]

I have no problem with banks becoming more prudent. The problem is that a responsible consumer who has a good credit score because they only use say 25% of their credit limit, is now suddenly at 50% of the new credit limit, and given a bad credit score. Not fair.

May 05 09:18 AM

[Carlos Lam:]

On May 04 04:08 PM David Hasson wrote:
> The dejected consumer in many cases spirals into
> not spending any money at all until there is a surplus, which I would
> think could be hard on the economy.

With household debt at 100% of GDP the consumer NEEDS to not spend "any more money at all until there is a surplus." Before we can get back to real growth, we need savings. Obviously, the consumer didn't save enough voluntarily, so now the consumer is "forced" to save by paying down debt. This may be "hard" on the consumption-based economy, but it is a prerequisite for placing us on a sounder footing. We need more savings to get more capital investment, which will in turn create more jobs. Trying to short-circuit this process with government spending and added liquidity can only cause dire unintended consequences.

May 05 10:59 AM

[Marcelo S:]

The credit card companies have been lowering limits to reduce exposure to a tumultuous market. This is understandable. What is simply unacceptable is that they have increased revenues by raising interest rates on the balances left. Using contracts that allow them to raise rates to default levels for just about any reasons they have become collection agencies rather than lenders. This country needs lenders to allow our economy to flow. Meanwhile he consumer hurt by the economy weakening also finds that they have no more credit and are paying more for the credit they had, funneling any savings the consumer may have into the hands of creditors.

May 06 11:21 AM