The new credit card law, enacted in the depths of a recession, cracks down on issuers' longstanding practices, but could also indirectly benefit the companies in an economic recovery.
Ever since momentum for sweeping restrictions on price increases began to build late last year, issuers have been increasing cardholders' rates and shifting accounts from fixed to floating rates on a massive scale. They took these actions as a preemptive strike — come February, many of their old strategies, like raising rates on existing accounts in all but the narrowest circumstances, will be restricted.
The defensive moves could put card industry profits on a springboard when credit losses subside, some analysts say.
"You may have a phenomenon where in good times, the card issuers overearn … and in bad times underearn" because of restrictions on their ability to increase prices, said Sanjay Sakhrani, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc.
"They've basically repriced their assets higher to compensate themselves for the reduced flexibility they have in bad times," he said. "However, if we're going into a period of good times, you wouldn't necessarily need that flexibility."
Scott Valentin, an analyst with Friedman, Billings, Ramsey & Co. Inc., said that the credit card industry could be headed toward a strong recovery. "The industry has become more pro-cyclical because of the" legislation, he said. With the pricing restrictions that are due to take effect, lenders "price a rate where over the cycle the account is profitable. So, when losses are very low, the margins should be very high."
Historically, issuers' net interest margins would shrink when credit expenses fell, Sakhrani said. Gains in employment made it easier for people to pay their bills, but pricing on credit cards had trouble keeping up with rising interest rates as the economy strengthened.
Cynthia Ullrich, a senior director for U.S. consumer asset-backed securities ratings at Fitch Inc., said that in the past, a lag in price increases on fixed-rate accounts has been evident in pressured spreads when rates rise rapidly. "Usually, it's when there's a rate adjustment that's pretty large," like a couple of 50 basis point increases in the prime rate over a few months, she said.
But this time around, some analysts contend, credit card pricing will have an easier time keeping up because of the move to floating rates. So margin compression is less likely to offset the decline in chargeoffs that usually accompanies an economic recovery.
"At minimum," Sakhrani said, issuers will be "match-funded."
And margins could even expand at some issuers, he said, as assets reprice faster than some liabilities once rates rise.
Discover Financial Services, for example, has built up a stockpile of long-term certificates of deposit in reaction to the capital markets dislocations during the crisis. Their weighted average maturity at Aug. 31 was 26 months. By contrast, asset-backed securities, a large source of funding in the industry, are generally tied to the one-month London interbank offered rate.
Others do not think a supercharged recovery in credit card profits is likely.
Michael Taiano, an analyst at Sandler O'Neill & Partners LP, agreed that the move to variable rates has made issuers more "asset sensitive." (Discover, for example, has estimated that all else being equal, an immediate 100 basis point increase across the interest rate curve Aug. 31 would have resulted in a $108 million increase in pretax income in the subsequent year, compared with a $38 million decrease in the year after Nov. 30, 2008.)
But, Taiano said, unlike other loan categories, credit card pricing has not fallen along with benchmark rates during the downturn, and he doubts issuers would push through more increases "in lockstep" with Federal Reserve Board tightening.
"You're talking about some really high rates for borrowers," he said. "That's a little bit of a dangerous game" that could overburden consumers and push them into default, or prompt them to curb borrowing.
Taiano also noted that in the past, when issuers could raise rates retroactively, "fixed rate" in the card universe was not a literal term.
Of course, there are many other pieces to the funding picture for credit card lenders — the government is just now withdrawing from support programs, for one thing. In any event, rising rates could be a distant prospect. Barclays Capital Inc. has projected that the Fed will only modestly increase its rate target next year, beginning in September.
Taiano said an important near-term boost to margins is likely to come from the recognition of interest income that issuers had been losing when they were charging off accounts more rapidly. Capital One Financial Corp. has already said that fewer reversals of finance charges than it had expected boosted profit margins last quarter. But while the company does not expect revenue as a percentage of receivables to decline much from its current level, it has not forecast a further increase either.
"I don't see much in the way of the trends out there, either at Capital One or in the industry … over the next couple of years, to see margins increase," Richard Fairbank, Capital One's chief executive, said at a presentation this month.