Over the Limit

Americans accustomed to cheap and easy money—and an economy geared to their free-spending ways—face a harsh new reality as banks raise rates and lower ceilings on credit cards

by Mara Der Hovanesian, Christopher Palmeri, Nanette Byrnes and Jessica Silver-Greenberg

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Max Miceli

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Life got more expensive for the Fitzgerald family when their daughter was born last year. So John, a bartender, and his wife, Adela Uchida, an anchor at a local TV station, sometimes used credit cards to charge household expenses such as groceries or the taxes on their two-bedroom home in Lansing, Mich. That's not an option anymore, they say, because their bank hiked the rate on one card from 17% to 25%, while another cut their credit limit from $13,000 to $2,000. Now it's cash only for the couple, who worry about how they would deal with a financial emergency. "The economy here is not good," says Fitzgerald. "If something happened to me or my wife, we would never pay off these balances."

The credit crisis that began rumbling through the mortgage market last summer is now spilling over to the nation's other great expanse of borrowing: credit cards. Banks have extended $740 billion to Americans like the Fitzgeralds, a 15% jump over the past five years. With the economy weakening, delinquencies are rising, particularly in states battered by the housing bust.

The casualties are piling up. Profits at Citigroup's (C) U.S. card division dropped 53% in the fourth quarter from the third. JPMorgan Chase (JPM) reported in the latest period a 40% year-over-year jump in credit-card costs, to $1.8 billion. At American Express (AXP) provisions for loan losses rose 70%, to $1.5 billion, a sign that even the well-heeled may be feeling the pinch. "Every day we obsess [over] how bad could it get," Richard D. Fairbank, CEO of one of the largest card issuers, Capital One (COF), told analysts on Jan. 23. He also conceded that the nearly $2 billion it has set aside for loan losses may not be enough. "The real answer is: Nobody knows."

Banks and other card issuers are lowering credit limits, hiking interest rates, and refusing to approve applications as part of a broad clampdown to prevent more losses. That leaves strapped consumers with few options. Homeowners can no longer turn their equity into cash to pay their bills. Tough bankruptcy laws passed in 2005 narrowed another avenue of escape. So some desperate borrowers are resorting to more perilous measures: raiding their retirement accounts and insurance plans and seeking loans from alternative credit sources such as payday lenders and pawnshops that extract a high price for the cash.

The roots of the problem can be traced to the mortgage mess. As housing values ballooned over the past decade, a warm feeling of financial security washed over borrowers, who jacked their cards up to the limit. After all, when they hit the ceiling, they could tap into their equity to pay down their balances. Between 2001 and 2006, borrowers cashed out some $1.2 trillion from their homes. As a result, the average debt-to-income ratio for middle-class Americans now stands at 141%, double what it was in 1983. "As home prices went up, consumers felt confident about purchasing all kinds of extravagant goods and services on their credit cards," says Ray Schimmel, a San Diego attorney who specializes in bankruptcy and mortgage defaults.

Now the trend has reversed. The drop in home prices has wiped out billions in equity, and since families can no longer use their abodes as ATMs, debt loads are mounting and borrowers are falling behind on payments. At the Consumer Credit Counseling Service of San Francisco, the average balance of those seeking help has jumped from $14,000 to $27,000 over the past year, with more people turning to plastic for everyday items. From here, "any kind of perturbation will cause families to go into financial shock," says Edward N. Wolff, an economics professor at New York University.

If that happens, it could set off a chain reaction, with consumer losses crippling lenders and infecting the markets that the banks depend on to finance credit-card lending. As with mortgages, banks bundle big chunks of so-called credit-card receivables, essentially consumers' outstanding loan balances. Then they issue bonds backed by the bundles, which are sold to big investors such as pensions and mutual funds.