The recent struggles of the Internet retailing community seem to suggest that the credit card acquiring industry could be facing a genuine credit quality problem.

The press has been full of reports of a less-than-stellar Christmas season for retailers, and although Internet retailers have generated higher growth rates than their offline counterparts, the virtual world has not met expectations either.

The National Retail Federation confidently estimated that December retail sales would grow by 6% over last year. However, eToys recently announced that net sales for the quarter that ended Dec. 31 were $131 million, down from the $210 million to $240 million it had estimated Oct. 30.

This slowing of sales growth is occurring precisely at a time when the economy is showing signs of slower growth in general and tighter credit. Earnings warning season included a number of the nation’s largest banks announcing higher problem loans and lower earnings. The Nasdaq, off 39%, turned in its worst performance since the early 1970s, led by a near-collapse in Internet valuations, and capital for private Internet companies has become harder to come by. Economists have begun contemplating the possibility of a recession, and already Internet merchants including and eToys have announced major restructuring or are shutting down.

The key question is whether a wave of Internet merchant business failures will result in credit losses for acquirers.

Merchant credit exposure for acquirers, in the physical or virtual world, results mostly from chargeback exposure. A chargeback is a consumer dispute that, under certain circumstances, may be charged to a merchant. If the merchant is no longer in business to honor the chargeback, the acquirer effectively must make good on it, generating a loss.

Internet merchants are particularly vulnerable to chargebacks, and estimates of their average chargeback rates range from 80 basis points of transaction volume (according to Visa U.S.A.) to 15% (according to GartnerGroup). In First Annapolis’ experience, many Internet merchant portfolios generate chargebacks as a percent of transactions upward of 100 basis points.

Also, when a merchant goes out of business, its chargeback rates tend to spike for a variety of reasons:

• First, the purchases that consumers routinely returned when the merchant was in business often turn into chargebacks if the merchant is no longer in business to process the return.

• Second, things tend to go wrong in clusters for merchants going out of business, as the conditions generating chargebacks (such as defective merchandise) are more prevalent at troubled companies.

• Finally, there is a correlation between merchants with credit problems and merchant fraud. Often it is the merchant experiencing liquidity problems that commits or colludes in a fraud.

First Annapolis recently completed an analysis sizing the exposure for the acquiring industry of potential Internet merchant failures.

Focusing only on companies losing money, we examined public Internet-only merchants and private Internet merchants (with which we were familiar) and estimated the potential loss exposure at $80 to $100 million. At current burn rates these companies could survive a few months to a few years without further capital infusions.

Internet merchants affiliated with larger physical-world merchants represented an additional $120 to $130 million, although the credit exposure for those merchants is related more to the creditworthiness of the parent company than to the financial performance or access to capital of the Internet retail unit.

These figures do not include the sizable number of private Internet merchants about which we have no reliable information to judge their earnings or likely chargeback profile. They also do not include the hundreds of thousands of small Internet merchants that, in a general recession, may generate significant aggregate losses for acquirers even if no individual merchant accounts for a significant loss.

It is common for acquirers to require collateral of one form or another from Internet merchants, so not all of these chargebacks would result in net losses. But the acquiring industry does not have this significant a level of collateral.

Only in an extreme scenario would a large proportion of this chargeback exposure manifest itself as losses. However, our analysis shows that these exposures represent some 25% to 35% of industry earnings, and the majority of the risk resides at fewer than 150 merchants at probably no more than six or eight individual acquirers.

Of course, acquirers are not defenseless bystanders in all this. Many acquirers have “watch list” processes in which they gather periodic financial information to monitor the creditworthiness of certain high-risk accounts. From our perspective, it is timely for acquirers to review these processes and their collateral positions. (It is axiomatic that the time to increase collateral is not when a merchant already is exhibiting signs of illiquidity — and precisely when requiring more collateral itself could precipitate a cash crisis.)

We should add that the advice of a good bankruptcy attorney is probably prudent.

Acquirers can also take a number of tactical steps to reduce aggregate risk on a portfolio level, ranging from steering sales into lower-risk accounts, on the margin, all the way to selling static pools of higher-risk merchant accounts to an acquirer specializing in high-risk merchants.

Finally, acquirers can devise operational strategies to handle a potential spike in chargeback volume in their back offices to avoid losses generated by missing regulatory time limits on chargebacks simply because of volume and capacity.

In short, the long-anticipated shakeout for Internet merchants has arrived, by all appearances, and may be accompanied by one of the weakest economies in recent experience. If the breaks go the wrong way, acquirers’ risk-management strategies and financial performance could be severely tested.

The authors work at First Annapolis Consulting, a payment systems consulting and merger and acquisitions advisory firm in Baltimore. Mr. Grill is a senior consultant responsible for its Internet payments practice, Mr. Prangley an analyst specializing in e-commerce, and Mr. Abbey a principal responsible for the firm's acquiring and commercial card practices.

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