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Prepare for a plastic meltdown
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First is the subprime mortgage crisis, then the auto-industry crisis. Now as we approach 2009, the unsecured debt crisis threatens a plastic meltdown next year.

The frailty of mortgage securities has been shocking, but at least the concept of secured lending made sense. After all what could be more secure than bricks and mortar and, with even modest inflation, the asset should be worth ever more than the debt as each year goes by, and not every Westerner has just taken out their mortgage.

However, as we know now, to achieve that ever-rising housing market meant bringing in more and more marginal buyers with more dubious creditworthiness.

This at the same time as existing borrowers, hungry for the best rates on secured loans, could not resist remortgaging/refinancing to get extra funds from increased home equity.

So when the downturn came as the most marginal borrowers defaulted, the house price falls left many other borrowers with no or negative equity and the whole game changed.

It is not surprising that auto-industries in the West have been brought pretty quickly into this. After all a new car is normally the second most expensive purchase after a house (except for those American families who pay for private tuition at top US schools - a story for another day) and credit is for sure involved.

Indeed selling cars is as much about credit as the car itself, with many incentives to shift stock off dealers' lots including cash back on purchase, low-interest loans, 36 month "affordable" leases and anything else that can stop the customer thinking about the huge sticker price.

Such is the role of finance in the Western used car markets that adverts for "bad credit or no credit? - No problem!" were commonplace and those seeking to get a credit score (credit record) were advised to start with an easy-to-get car loan reporting to a credit reference agency to facilitate other loans later.

Some new car deals were so good that a family could sign their life away on a $20,000 vehicle with no money down, and even cash back of $2,000 - $3,000 on purchase - so buying a car financed a holiday too. No wonder folks felt rich in the Western lands of opportunity.

So equally no wonder the freezing of credit for many loan agents, the new harder to qualify for credit requirements and the delay of replacement car purchases have come together to bring this industry to its knees.

But if these two horror stories are sending the world economy into a spin and threatening jobs in many countries, the world better buckle its belt for the storm yet to come. For 2009 will surely be the year of the plastic meltdown as unsecured credit problems, predominantly on credit cards, overwhelm many Western families, not to mention the banks behind the cards.

Unsecured credit is by its nature more risky - there's no asset backing the debt and it all rests on the borrowers' ability to repay from an income stream.

When such credit was taken out prior to the 1970s it was essentially bank loans repayable over a few years with some semblance of vetting and monitoring by more cautious bankers.

Since then the huge increase in credit cards, the competition between issuers (domestic and foreign) for a piece of the pie, the lack of real tracking of how much credit was available to borrowers, has made this kind of lending far too risky.

It has not deterred lenders as interest rates could reflect this risk and on revolving credit accounts, borrowers focused on the ability to service the debt each month, often oblivious to the true interest cost.

Such cards allowed Western consumers to live beyond their means, but how could this be reconciled with ability to repay? Assuming all borrowers don't operate on the "I have enough money to live the rest of my life like a wealthy man - providing I get hit by a bus by next Tuesday" philosophy, there must have been plans on how to cope with and eventually clear such debt.

For some perhaps not, for others the ability to churn cards, taking a new one with a year's zero interest and transferring past balances provided some temporary respite. But for most, the plan was always to refinance - to draw down that low interest home equity loan (or cash in shares that have made a nice profit) and clear the credit card mess.

Now that game doesn't fly for all the reasons above. Add the new caution that lenders have belatedly imposed and many avid plastic users are finding they cannot get any more cards, their credit limits are being cut, their interest rates are being raised and their access to cash withdrawals suspended.

Link that to no alternative cheaper financing and rising job losses and it is again no wonder that credit card issuers are seeing rapidly rising defaults and that credit card debt advisory services have become a growth industry.

It is almost certain that the world has only seen the tip of this iceberg so far and that 2009, with rising unemployment, lost overtime and bonuses, will see many more Western consumers struggling with this plastic debt mountain.

It is one thing to say in a recession "cut back to essentials" but what if past spending is still with the consumer as a current claim on diminished income? What if, as more and more governments are recognizing, economies enter a period of deflation with falling monetary incomes servicing a fixed monetary debt? What if there is no transmission mechanism between cuts in central bank interest rates and the rates lenders continue to charge on these debts?

The year 2009 could really see a financial meltdown of unprecedented proportions which would hugely damage the export prospects of developing nations, including China, which have not even participated in this credit indulgence. Fasten your seat belts for this turbulence ahead.

The author, Colin Speakman, is an economist and Director of China Programs at the American Institute for Foreign Study

(China Daily December 2, 2008)

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