US issuers are already feeling the
effects of the subprime fallout and ensuing credit crunch (see US
banks post disappointing results) and now Morgan Stanley has added
to concerns that the crisis could spread into the wider credit
market, saying a consumer credit recession was likely.

In a client note, Morgan Stanley analyst Betsy Graseck said the
effects of tightening in credit markets on US large-cap banks would
be greater than anticipated and would spread into auto and card
loans. Graseck revised ratings for some of the US’s largest card
issuers, notably Citi, Wachovia, Bank of America (BofA) and Wells
Fargo; both Citi and BofA received downgrades.

In the client note, Graseck indicated: “We believe the liquidity
squeeze that started in July will drive up losses in consumer loan
portfolios over the next four quarters beyond our prior forecasts.
Our downgrade reflects our view that the coming consumer credit
recession we see will trump capital market healing, which had been
the basis of our ‘attractive’ call.

“The three primary drivers are tightening standards, significantly
higher subprime delinquencies and lower home prices. We now expect
a consumer credit recession in 2008 with losses above peak-of-cycle
in mortgage and at peak-of-cycle in cards, auto and other consumer

Effect on Citi and Bank of America

For Citi, Graseck predicted $1.1 billion in collateralised debt
obligation (CDO) write-downs in the final quarter of 2007, with
another $1 billion slated for the first quarter in 2008. There were
concerns about subprime consumer exposure, structured investment
vehicle exposure and thin capital levels.

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According to Morgan Stanley, Citi has the largest subprime exposure
of the banks analysed, at 13 percent of loans and 5 percent of
earnings assets. Those concerns were borne out when Citigroup
revealed CDO writedowns of between $8 and $11 billion, forcing
Chuck Prince, the beleaguered chairman and chief executive, to
resign on 3 November.

BofA was downgraded by Morgan Stanley to “equal weight” from
“overweight” because of exposure to deteriorating consumer credit
in its credit card portfolio. Graseck said there would be lower
than expected growth in credit card account acquisitions and higher
than expected investment spend in key businesses of retail banking
and credit cards. But Morgan Stanley added that BofA’s improving
share in the mortgage market and cost savings in the card group
were potential positives.

Looking to the wider bank sector, Morgan Stanley said it was
concerned that banks are reducing their capital allocated to
consumers, exacerbating the credit squeeze. With $77 billion of
subprime debt to be refinanced in the fourth quarter, it expects
the delinquency rate to rise sharply, coupled with declining house

Graseck’s report also had a few caveats. It said Federal Reserve
interest rate cuts might lessen the impact, but would be hampered
by the higher spread in the inter-bank lending rate. Any reduction
in interest rates would be unlikely to kick in for another two

Morgan Stanley’s report comes two months after global credit
ratings agency Moody’s warned that US consumers were defaulting on
credit card payments at a significantly higher rate in the first
half of 2007 compared with the year-ago period (see
CI 386

All eyes will now be on next month’s third-quarter credit card
delinquency figures, which will be released by the American Banking

Francesco Burelli, principal consultant and head of card services
for Europe at global strategy company Capco, told CI that the
outlook was weakening for the cards industry. He said there were a
number of reasons behind the continued threat of the credit crunch
extending into the consumer credit markets. Lenders were not being
fully accountable for risk through CDOs and interest rates were
likely to remain high, in addition to changing consumer attitudes
towards credit and increased lending to finance lifestyle.

Burelli said: “Competing for market share is a difficult business.
It’s much easier to chase additional customers in less
credit-worthy markets. But, all of a sudden there’s a problem with
liquidity, inter-bank lending becomes more difficult and interest
rates rise, adding to the overall cost of lending. Credit becomes
more expensive and when you put these things together with clinical
borrowers taking on more and more debt, you have an avalanche
effect – and at some stage the avalanche is going to become too

Burelli added that profitability could be further squeezed by
regulatory pressures, for example on interchange costs.