NextCard — Pressed by FDIC, OCC — Up for Sale

NextCard Inc., the credit card company that — up until Wednesday — had consistently been hailed as a pioneer and a success story, has fallen victim to the very strategy that drew it praise.

In a hastily arranged conference call Wednesday morning, NextCard said its Internet-based business had been abused by so many fraudsters that regulators stepped in, imposing requirements that NextCard says it cannot meet on its own. The four-year-old San Francisco monoline said it hired Goldman Sachs to sell it to “a larger, more established financial institution” that can put up the capital regulators want.

The news, which took industry observers by surprise, came the same day as a report that troubled monoline Providian Financial Corp. had also hired Goldman to find a buyer or financing.

The coincidences (NextCard was founded by and is run by former Providian executives) suggested that the industry is bracing for yet another round of corporate consolidation.

NextCard said it put itself on the block because the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. are requiring it to increase capital reserves to cover 12 months of projected credit card losses.

“We will require additional capital beyond our resources,” said John V. Hashman, NextCard’s chief executive officer. He said the regulators’ moves occurred during the course of “normal examination processes for banks. We have been in regular discussion with them as a national bank regulated by the OCC.”

The problems seem to stem from the high number of people who were able to use identity theft to open fraudulent accounts, and from the accounting practices NextCard used to document the accompanying losses. NextCard had categorized these losses as “fraud losses,” but the regulators said they should be referred to as chargeoffs.

In the second quarter, NextCard reported $11 million of operating losses that were primarily due to fraud, Mr. Hashman said in a telephone interview Wednesday. Beginning with its third-quarter results — which will be announced Thursday — such losses will go into the chargeoff column.

Using the old accounting system, NextCard reported a 4.92% chargeoff rate for the second quarter and a 3.99% rate in the first quarter. Under the new accounting, it will report a 7.98% third-quarter chargeoff rate.

Though that rate is not in itself unusual — NextCard is a prime and superprime lender, but subprime lenders like Metris Cos. routinely report chargeoff rates in the 10% range — it has forced regulators to take a different view of the company’s performance.

NextCard, which issues credit cards through its NextBank subsidiary, has been classified as “significantly undercapitalized” under federal banking regulations because its risk-based capital ratio has dropped below 6%.

Additional restrictions will hinder NextCard’s ability to open new accounts. Though it can continue to operate its existing secured card accounts, it can no longer originate secured accounts. Moreover, NextCard cannot open new accounts unless the customer has a Fair, Isaac & Co. credit score of 680 or above. (Fair, Isaac’s Web site www.myfico.com says a credit score of 670 is below the national average and 70% of consumers have higher scores. It did not give an assessment for the score of 680.)

Mr. Hashman said the company would appeal the changes and restrictions. “When you are a small company that does not have lots and lots of capital, you fall under some increased scrutiny,” he said. “You end up in a situation where people want you to keep additional reserves and take more conservative accounting practices than larger companies.”

Further, the regulators say NextCard’s securitization activities do not qualify for “low-level recourse treatment,” and Mr. Hashman said this determination will hinder the company’s ability to raise capital.

The effect of the regulators’ decision to disallow low-level recourse treatment on securitized assets was to increase the bank’s risk-weighted assets by about $537.5 million, to $2.1 billion at Sept. 30. NextCard has 45 days to file an acceptable capital restoration plan to the OCC. It is appealing this mandate, which it says is not supported by regulatory guidelines.

NextCard suspended its official guidance for the fourth quarter and for 2002. In an interview, Mr. Hashman said the company had been on track to break even in the fourth quarter but that the regulatory impositions threw everything into question.

During the conference call, NextCard’s chief financial officer, Bruce Rigione, said that, though the company has an adjusted book value of $185.9 million, this does not take into account the value of NextCard’s $2 billion portfolio of credit card loans, its brand, analytical tools, or marketing expertise.

NextCard’s stock, which closed at $5.35 a share on Tuesday, finished trading on Wednesday at 87 cents.

Robert Hammer, an investment banker who specializes in brokering credit card portfolio deals, said the market might have a hard time valuing NextCard’s receivables. “The true value of the business is not reflected in the plunge,” said Mr. Hammer, the chairman and chief executive officer of R.K. Hammer Investment Bankers in Thousand Oaks, Calif.

Because all its customers applied for their cards over the Internet, NextCard’s clientele cannot easily be compared to any other company’s, and the firm will be difficult to put a price on, Mr. Hammer said. Most card issuers “do not have expertise in the Internet and are not heavily into Internet-driven distribution networks, which would limit the audience of buyers,” he said. “But for those who are into the Internet in a big way, it might be worth more.”

Another question is whether bidders would want to buy the portfolio alone or along with the company and its intellectual property.

The plight of the company is yet another sign of the “fragile period we are in,” said Mr. Hammer, who added that just a few months ago Providian, which has a heavy Internet emphasis, might have been a likely buyer. Now it is faced with chargeoff-related troubles of its own and is also looking for a buyer.

NextCard was founded by Jeremy Lent, a former chief financial officer at Providian. Mr. Lent’s hand-picked successor, Mr. Hashman, is also a Providian alumnus, and he said he learned the cards business from Shailesh J. Mehta, the Providian chairman and chief executive officer who announced his resignation last month in the wake of his company’s troubles.

The implosions of Providian and NextCard suggest to some observers that other companies may be next. “This is the cockroach theory,” said Paul Jamieson, an Internet analyst who recently founded his own firm, FiSite Research, in Littleton, Mass. “There’s never just one cockroach — there’s always a family out there. There’s a general expectation that other issuers will surface with similar portfolio issues.”

Mr. Jamieson was formerly the director of the Internet banking team at Gomez Inc., the Waltham, Mass., Internet research firm that, earlier this year, had ranked NextCard the No. 1 Internet credit card company because of its advanced services, such as e-mailing its customers reminders that their payments were coming due.

“The hyper-competitive credit card market has led credit card issuers to become very aggressive in acquiring accounts that have a high degree of profitability during good times but come with substantial risk during economic down times,” Mr. Jamieson said. Providian and NextCard, he said, “are the first to show the downside of such a strategy.”

Furthermore, he said, “these public companies are under great pressure to meet investor numbers, so the pressure is to always grow the business and to acquire more accounts, to produce higher volumes and the resulting profitability from that. It makes it increasingly difficult for an issuer to turn off those strategies in spite of signs that the economy is weakening.”

David Hendler, a strategist at Credit Sights Inc., an investment securities research firm in New York, said NextCard’s fall pointed to the inherent difficulties of operating a direct bank. “It gets down to simple banking: Know your customer,” he said. “They didn’t know their customers.”

One of NextCard’s biggest innovations — the guarantee of an instant decision on credit applications submitted online — turned out to be a source of weakness, said Ken Kerr, a research director at GartnerGroup Inc. of Stamford, Conn. Some people who got instant approvals were also given instant lines of credit.

These features made it “ripe for any major fraudster to go get a NextCard and start using it,” Mr. Kerr said.

Mr. Hashman of NextCard said his company still has strong fundamentals, and he predicted it would sell for a good price. “The company has a lot of value it can add as a leader in the Internet. Nobody has been doing business as long as us. We have a rich data set, proprietary models, and great technology.”

Looking at the choice of trying to rebuild the company under the restrictions the OCC has set, he said: “We are in better position to align with a larger entity.”

David Breitkopf contributed to this story.