The credit card debt paydown miracle that took place during pandemic is ending

Ask a consumer expert what would happen with credit card loan balances during a recession and the answer wouldn’t be that balances decline sharply and Americans avoid a wave of card delinquencies.

But that’s what happened during the pandemic year. Helped by government stimulus and limited to spending on necessary goods rather than discretionary items, consumers bucked economic downturn history when it comes to credit card debt.

“It’s been an upside down credit environment,” said Stephen Biggar, who covers financial institutions at Argus Research. “If you told me the market was going to crash 40% and we would have 20% unemployment, you would have also said card delinquency rates would go through the roof, particularly for the lower-end consumer.”

The savings rate spiked to a level not seen since World War II, and that caused consumers to take the cash they had and pay down debt — and often the first kind of debt they paid down was cards, which have among the highest interest rates, averaging 16%. 

According to Experian, from Q3 2019 to Q3 2020, credit card balances fell 24%. Among active credit card holders right before the pandemic, 58% carried a balance month-to-month, an interest-rich pool for card issuers that is now down to a record low of 53%, according to the American Bankers Association.

“Lots of people made lots of progress paying down debt and we would not have thought that at the outset of the pandemic,” said Ted Rossman, senior industry analyst at CreditCards.com.

But even paying down significant debt, the average balance on a card is still above $5,000, and there are signs the pay-down surprise may be nearing a reversal.

“I think we are at the tail end of that,” Biggar said. “Once government stimulus ends, then we get a consumer mostly on their own holding their debt capabilities up.”

Government stimulus checks that came in multiple batches are slowing, though child tax credits to those at lower-income levels and unemployment tax refunds continue. Enhanced unemployment already has been ended in many states and will end in early September for the rest.

And, most importantly, consumers want to spend.

“There is a lot of money, a lot of savings and they are out spending it,” Rick Caruso, founder and CEO of real estate company Caruso & Co. which develops malls and resorts, recently told CNBC. “They’re shopping, dining, they are going to the movies and they are doing it consistently. $2 trillion of ‘forced savings’ is just starting to get unleashed.” 

For now, consumers still have leverage and the cautious financial habits formed during the pandemic remain in evidence.

Payment rates continue to be high given the trillions in cash and savings. Loan growth in the card industry is down double-digits in most consumer assets over the past year since, according to Kevin Barker, a Piper Sandler senior research analyst covering consumer finance companies, and savings rates are still double the run rate pre-pandemic.

The course of the highly contagious delta variant remains a wildcard in this picture as well with a recent estimate that as many as one million Americans are being infected daily. But there are some signs that the priority consumers have made of paying down debt during the pandemic is beginning to give way to a focus on spending again, including travel and entertainment, as stimulus is wound down. “There is a feeling now that perhaps we are staring to see a reversal, the early stages of it,” Rossman said.

A Creditcards.com survey found 44% of people saying they are willing to take on debt in the second half of 2021 for non-essential purchases, which are mostly out of the home activities such as dining.

The Federal Reserve’s G.19 report covering consumer credit for the month of May found that credit card balances went up 11% from April to May, the largest jump in five years, on an annualized basis. 

“Either old habits die hard or new habits take hold and consumers continue to say ‘let’s pay down even more debt,” Rossman said. “I want to say it’s the latter as a consumer advocate,” but he added that history doesn’t give him confidence.

The historical pattern that played out around the Great Recession a decade ago reinforces the theory that it takes a big crisis to bring credit card debt down, and that it won’t last. Credit card balances fell 20% from 2007-2014, but from 2014-2019, balances rose by 41%, according to NY Fed household credit data.

“The point is, the same thing will happen this time, but much more rapidly. It’s one area where consumers don’t want a V-shaped recovery,” Rossman said.

“The pump is primed,” JP Morgan Chase CEO Jamie Dimon said during the Wall Street bank’s recent earnings call. “The consumer, their house value is up, their stocks up, their incomes are up, their savings are up, their confidence up.”

Asked by analysts where loan growth and payment rates are headed, Wells Fargo chief financial officer Mike Santomassimo said activity “has really picked up” but it hasn’t translated into bigger loan volumes given the payment rates. “Payment rates are still really high, and I think they’ll come down and normalize eventually.”

Card issuers make money on card transactions, but loans are the bigger part of the equation. And because interest rates on credit cards are so high relative to other loans, it plays a big role in the key bank metric of net interest margin.

Credit card businesses have net interest margin as high as 10% versus the average bank debt at 3%, though defaults are historically significantly higher than other loans. And unlike other forms of debt, the average rate charged to customer stays at 16% even when underlying rates come down.

“Diversified banks face pressure on mortgages and other interest rate products but you are not going to find a 13% interest rate credit card,” Biggar said.

In fact, in recent years the margin on cards has been “creeping up,” according to Rossman, with a prime rate at 3%. 

At Bank of America, the number of cards outstanding hasn’t changed notably, but there is roughly $20 billion less in balances. “People didn’t get any different,” Bank of America CEO Brian Moynihan told analysts after its earnings. “They just have more cash. And so they paid off their credit cards, which is a completely responsible thing for them to do.”

“When they can get out and spend more money, which is starting to happen, I think you’ll see them use these lines, short-term purchases,” Moynihan told analysts. “Yes, the pay rate’s up, but I don’t think it’s a fundamental difference of behavior. It’s just the opportunity to use the cards for activity has been limited coming into this quarter when you finally saw things open. So we’ll see where it goes, but the good news is it’s going in different direction.”

Banks need the consumer to be strong, and in fact, the silver lining of the debt pay down phenomenon during the pandemic was the stronger credit profile of banks, with the surprisingly low level of card charge-offs and excess reserves on the balance sheet.

“The pandemic played out well for card companies,” Barker said. “The losses they anticipated didn’t materialize and credit performance is a primary driver for these stocks.”

“Card businesses are in a sweet spot,” Biggar added. “Some of these estimates will be moving up dramatically when these guys beat a quarter by $7.71 versus $4.61, like Capital One did. Its almost a $3 beat.”

From a valuation perspective, and given the reserve levels, the card-focused financial stocks are trading at peak price to book value.

“High payment rates are continuing to contribute to strikingly strong credit results,” Richard Fairbank, CEO of Capital One Financial, which similar to rival Discover Financial has a much more concentrated business in cards than the more diversified Wall Street banks, told analysts. “We actually are always happy when our customers are paying at high levels, and it’s indicative of a healthy consumer, and those high payment rates correlate with the really strong credit results that we continue to see.”

For Capital One, domestic card purchase volume for the second quarter was up 48% from the second quarter of 2020, but the card charge-off rate for the quarter was 2.28%, a 225-basis-point improvement year over year.

For the banks, the current level of financial responsibility is not necessarily the most profitable. And the banks are betting that the consumer cash cushion won’t last forever, and people will take on more debt to spend.

“That is the most likely next phase of the credit cycle,” Barker said. “We are seeing spending up 20% in some categories. Right now, the default is to go with the historical pattern and the consumer goes back to way it was.”

A bigger behavioral shift in the way people treat debt or how they spend money can’t be ruled out, Barker said, but he added, “They want to spend and travel a certain way and they will do it because that’s the way they operated for a long time.”

The monthly numbers show an easing in payment rates, but Capital One’s Fairbank stopped short of saying it’s a trend.

“It would be a natural thing that payment rates would ease a little bit here and that also credit metrics would move toward normalizing a little bit. I would say we’ve seen the earliest of indications of that still running at really quite a breathtaking level,” Fairbank said. He told analysts that while the timing of the trend remains speculative, the direction is clear: “There’s really only one way for the credit to go from here.”

The cyclical pattern implies that people who have jobs take on more debt, and then might lose a job and have more trouble paying back, and credit loss rates return closer to normal.

“I don’t think it goes back to 2019 consumer loss levels, the consumer is in pretty good shape,” Biggar said. “But at the lower levels there is always churn. Every day it is harder to make ends meet and inflation is a huge topic, from car prices to home prices to food prices and gas prices. Everywhere you look it’s problematic for lower income levels. The default rates moves back up.”

One major pandemic change is likely to be permanent, and is going to serve as a tailwind for the card business. Card spending accelerated during the pandemic relative to cash and checks, and though that was a secular trend already in place, like many pandemic shifts linked to technology and digital, it accelerated. That was beneficial for many companies in the payments space, from PayPal and Square to Visa and Mastercard and the card issuers.

“Aside from the cyclical aspect of credit losses, we’re just seeing enormous opportunity in cards. Lots of teenagers never carry cash any more,” Biggar said.

Card marketing and competition is getting more aggressive, and CEOs like Capital One’s Fairbank are preparing for it.

“We see competition heating up all around us, especially in rewards. … you see it in the marketing and the media activity. We see it in direct mail numbers. We see it in the rewards offerings and the heating up of some of that. The competition is intense right now …. but it’s not yet irrational,” Fairbank said.

Analysts say there is a big opportunity in the card space and the big banks, while having made major gains in trading and investment banking and other businesses in the past year — while being more cautious on cards given expectations of defaults — now see the growth and the higher net interest margin from cards at a time when the charge off rates are historically low, and are unlikely to double or triple in a good economy, which translates into an opportunity.

“The big banks may not be as aggressive as card companies like Capitol One or Discover, but JP Morgan won’t fall asleep at the switch with its credit card business either. Wells Fargo is coming out with more offers. It’s a big pie and I think there is lots of room for growth,” Biggar said.

“We’re clearly seeing more competition, being aggressive going after accounts right now, because if you are a card lender you are looking at a consumer who has a high savings rates, income is higher and is a better credit counterparty more likely to pay you back,” Barker said. “And they are being more aggressive because the industry is awash in capital looking for a way to be spent and for the best way to grow. “

With the bets being placed by both card companies and consumers at a time when a lot of the data is atypical and after an unprecedented year, there are risks on both sides.

How the consumer spending normalizes in the years ahead is an unknown, as is the strength of the economy and direction in rates, which can trip up both the banking sector and consumers.

If rates rise too quickly the consumer could quickly be back in a tough spot, but banks have a vested interest in making sure consumers are doing well because they need those loans to be paid back.

“The longer this persists, the more competition will likely be to extrapolate these trends to inform their decision making,” Fairbank told analysts. “And this can embolden them to make more aggressive offers, market more intensely and a particular one I worry about, loosening underwriting standards. And in this particular environment, the benign rearview mirror could encourage lenders to reach for growth. And it could be exacerbated by credit modeling that relies on consumer credit data that, frankly, may be very unique to the downturn and not as good for predicting where credit performance is going to be over time.”

That’s a potential problem for banks, and their shareholders, but also for the consumer.

The real sweet spot, and the most profitable for the card issuers, is if consumers carry debt month-to-month as they pay the banks back. All the outstanding balances are not good for the banks if they have to write them off, or if consumers continue to pay balances in full every month, but if consumers are making minimum payments it provides banks the interest month after month that is the most profitable way for them to get paid back.

“The longer you take, the more money they make. If people are spending freely and running up debt, even if it’s not the wisest thing for consumers, it’s probably the most likely,” Rossman said. “From a consumer perspective, the message is to keep that momentum going. If you paid down debt from $6,200 to $5,300, bring it lower still; resist the temptation to put a fancy vacation on a credit card. It’s no fun to pay 16%.”

It’s a hard message to make stick. “I would like to see the newfound frugality last, but we’ve seen this in the past,” Rossman said.