Downfall of Subprime Cards Spawns Opportunity

When Americans with poor credit histories find themselves in a jam, it's harder than it used to be to get a reasonably priced loan.

Prior to the financial crisis, such consumers would open their mailboxes and find a raft of credit card offers. These subprime cards were laden with fees, and some of them drew derision from consumer advocates. But for customers who had poor repayment histories, they often served as a cheaper source of credit than payday or car-title loans.

Today the subprime credit card market is a shadow of its former self. In the first quarter of this year, credit card issuers sent out just 22 million direct mailings for cards that carried fees and offered no rewards, down from nearly 300 million in the first quarter of 2007, according to data from Mintel Comperemedia. That data serves as a rough proxy for the marketing of subprime credit cards.

Raj Date, the former deputy director of the Consumer Financial Protection Bureau who is now an industry consultant, argues that part of the contraction is good, since some consumers were previously using cards with terms they didn't understand. "But part of it is bad," he says.

"There's a big jump in the pricing between a subprime credit card and a traditional payday loan."

The hole left by subprime card issuers helps explain why lots of nontraditional lenders now see an opportunity to serve Americans who don't have access to prime credit. Many of these firms, which include a number of technology-oriented startups, say they want to replace the much maligned payday loan with something better.

Some of the companies hope to use the massive amounts of data now available about individual consumers to make lending more efficient, and then pass the savings on to borrowers. Others are seeking to increase repayment rates, often by working closely with the consumer's employer or payroll provider.

In a four-part series over the next month, American Banker explores the opportunities and challenges associated with efforts to lower the cost to borrow for those with less-than-stellar track records. Today's article sets the scene with a look at how this market arrived to where it is today.

In the middle of last decade, subprime credit cards were a booming business, with big banks including HSBC and Washington Mutual competing against smaller, more specialized players. In 2005, when WaMu purchased the subprime card issuer Providian, the acquired company had more than 9 million card holders.

The line between prime cards and subprime ones has never been entirely clear, but a credit score of 660 often serves as a demarcation point.

The biggest banks previously offered credit to borrowers who fell below that line far more frequently than they do today. At Bank of America (BAC), the portion of the company's securitized card portfolio that involved loans to people with credit scores below 660 fell from 28% in 2007 to 15% five years later.

A recent analysis by the investment bank Jefferies concluded that since 2009, approximately $122 billion in credit availability to Americans with scores of below 660 has been removed from the market. That's roughly twice the estimated total annual loan production by pawn and payday lenders.

"Although credit contraction to this bottom rung of borrowers appears to be slowing," Jefferies analysts wrote, "we don't expect banks and card lenders to meaningfully re-engage with the customers for the foreseeable future."

By the first quarter of this year, specialized lenders Credit One, First Premier Bank, Continental Finance and Merrick Bank were the only companies using direct mail to market credit cards with fees and no rewards, according to Andrew Davidson, senior vice president at Mintel Comperemedia. Larger firms such as Capital One Financial (COF) were sitting on the sidelines.

The reasons for the subprime card industry's steep decline are complex, but most observers chalk it up to a combination of the fallout from the financial crisis and regulatory changes that ensued.

"Coming out of the financial crisis, you have a much lower tolerance for credit risk among credit card issuers than you had before," says Moshe Orenbuch, an industry analyst at Credit Suisse.

Regulatory pressure likely played a role, too. The 2009 federal law known as the CARD Act restricts the ability of issuers to charge certain fees, including late fees and over-limit fees. Importantly for some subprime issuers, the law also bars banks from charging fees that total more than 25% of the customer's credit line during the account's first year.

It is not clear how much payday lenders have benefited from the steep drop in subprime credit card use. At around $50 billion, payday loan volume in 2012 was largely unchanged from 2006, although industry-wide revenue was up by about 16%, according to a recent report by John Hecht, an industry analyst at Stephens Inc.

Some of the loan demand that was previously filled by subprime credit cards may have been replaced by informal personal loans or reduced consumer spending. And some consumers may be dipping into their retirement savings more frequently; a recent study found that penalized withdrawals from 401(k)s increased by 67% between 2004 and 2010.

Other consumers may be overdrawing their bank accounts more often, though industry-wide overdraft revenue remains well below its 2009 peak.

"Consumers use a whole swath of credit services interchangeably," argues Jamie Fulmer, senior vice president of public affairs at the payday lender Advance America.

Among the firms seeking to disrupt the payday lending model are a number of startups that cast themselves as do-gooders. The obstacles they face include the difficulty of building a large-scale business and the need to compete against companies that make no apologies for charging high interest rates to cash-strapped consumers. Still, these entrepreneurs project optimism, arguing that storefront payday lending is an inefficient, labor-intensive business.

"This is a market that is ripe for disruption," says Alexander Karlan, chief executive of FairLoan Financial, a San Francisco startup that's looking to reduce the cost of consumer credit. "I think there's now a once-in-a-lifetime opportunity to build a brand that people can trust."

For now, consumer advocates are taking a wait-and-see approach toward efforts to provide a better loan to Americans with shaky credit histories.

"I would love to see improvements in this arena," says Paul Leonard, director of the Center for Responsible Lending's California office. "I think we have to assess these companies based on what they actually do, and not on … early reports of what their intentions are."

Next: An examination of companies that are seeking to reduce consumer borrowing costs by creating a tighter link between the loan and the borrower's employer.