Charge-Offs Are On The Rise: Is The Worst Yet To Come?

  American consumers filed 801,840 bankruptcy petitions in 2007, a 40% increase from the 573,203 cases filed in 2006, according to the American Bankruptcy Institute. Filings had plummeted shortly after a new bankruptcy law went into effect in October 2005.
  Market observers say the rebound in bankruptcy filings was the biggest factor in last year’s significant increase in credit card charge-offs. And with bankruptcy filings expected to continue to rise this year, other factors that could affect charge-offs in 2008 include growth in Americans’ total debt burden, a falling housing market, and rising unemployment and consumer prices–especially for fuel. Moreover, bankers and analysts remain unsure how badly the subprime mortgage crisis might bleed into the credit card market.
  Net charge-offs of credit card loans at all institutions insured by the Federal Deposit Insurance Corp. through the first nine months of 2007 totaled roughly $11.5 billion, up $1.54 billion, or 15.5%, from $9.95 billion during the first nine months of 2006 (see chart on page 42). The recovery rate on charged-off card loans fell to 16.4% over that time compared with 19.4% in the same nine-month period in 2006.
  Among the 15 credit card issuers Cards & Payments sister publication Collections & Credit Risk studied–including such leaders as Bank of America Corp., JPMorgan Chase & Co., Citigroup and American Express Co.–only Discover Financial Services LLC reported a slight decline (1.2%) in charge-offs through the first nine months of 2007 compared with the same period in 2006. The group’s combined charge-offs increased 22.1% year over year.
  Though charge-offs were up, the credit card delinquency rate fell in the third quarter of 2007, the third consecutive quarter the rate had fallen, the American Bankers Association reported in January in its Consumer Credit Delinquency Bulletin.
  U.S. consumers made late payments on 4.18% of all credit card accounts during the quarter. During the same period in 2006, late payments were made on 4.57% of credit card accounts.
  The delinquency rate on credit cards, defined as payments 30 days or more late, generally rose in 2006 but fell during each of the first three quarters of last year, ABA data show. Last year’s third-quarter delinquency rate is the lowest the ABA has measured since the third quarter of 2003, when the delinquency rate fell to 4.09%. The highest delinquency rate the ABA measured in recent history was during the second quarter of 2005, when delinquencies rose to 4.81% of card accounts.
  â€œConsumers facing mortgage resets may be under financial pressure, but they still want to keep up with other payments,” James Chessen, chief economist for the ABA, said in a statement.
  However, based on CCR’s research, which was aided by ratings services, industry consultants and debt buyers, credit card delinquencies and charge-offs should rise again in 2008. This could lead to more business for asset liquidators and collection firms.
  Moody’s Investors Service forecasts U.S. credit card charge-off rates will increase throughout 2008 “due mainly to an expectation that bankruptcy filings will continue to rise to a level at or near levels achieved prior to the October 2005 change in bankruptcy law,” according to a November research report.
  Housing Market Ripples
  Despite Discover being the only issuer among the 15 CCR studied with fewer charge-offs, Goldman Sachs analysts downgraded Discover to “sell” on Nov. 19, citing the effects of falling real-estate values.
  â€œHouse prices have much further to fall,” Goldman Sachs said. “We estimate the U.S. median house price to be 13% to 14% above levels implied by current and forecast economic conditions. Such a fall should impact consumer spending as well as consumer credit trends.”
  The analysts felt Discover was underestimating its projected 2008 charge-off rate by as much as 75 basis points: “We forecast charge-off rates of 5% and 5.6% in 2008 and 2009, respectively,” they said.
  Total consumer credit outstanding in the third quarter of 2007, at $2.48 trillion, increased nearly 5.1% from $2.36 trillion in the same three months of 2006. Revolving credit–primarily credit card borrowing–totaled $920.1 billion, for a seasonally adjusted growth rate of 7.6% year over year.
  â€œWhen the economy is sucking wind, and you have regulatory issues and the collapse of the subprime mortgage market, it makes it more difficult to get people to pay what they owe. We see that happening,” says Gary Wood, president of debt buyer Collins Financial Services of Austin, Texas.
  In the recent past, mortgage refinancing was a major source of consumer debt payments, Wood says. “That has pretty much dried up. The principal source of wealth is the money in their home. If it’s no longer available, their ability to tap into nonincome funds is greatly reduced,” he says.
  As adjustable-rate mortgages move to higher interest rates, “it puts an additional squeeze on people,” says Wood. “The decision they have to make is: Which bills do I pay this month? A lot will choose to pay their mortgage to hang on to the house. So other debts–credit cards, auto loans–will suffer,” he predicts.
  Lou DiPalma, managing partner of Garnet Capital Advisors LLC, based in Harrison, N.Y., puts the subprime mortgage crisis at the top of the list of factors that will continue to affect card payments, delinquencies and charge-offs.
  â€œClearly, there is a slice of America that was getting credit that was underpriced,” DiPalma says. “A lot of the run-up in prices for charged-off credit cards was because borrowers paid with mortgage refinancing. More people owned homes, [but] that 3% or 5% increase in home ownership [over the past few years] was all subprime,” he says.
  And that will affect recoveries and have a domino effect on prices and issuers’ willingness to sell, says DiPalma. “Banks have taken huge write-downs and will have continual losses–maybe recovering in 2009 and 2010,” he says.
  A growing amount of defaulted card accounts, not to mention troubles within other loan categories, was expected to compel card issuers to sell a great deal of charged-off paper during the fourth quarter of 2007. Confirmation that actually occurred was not available at press time.
  â€œIt’s an open secret that credit issuers are ready to sell. Write-offs have been painful,” says Mark Russell, a director at Kaulkin Ginsberg, a Rockville, Md.-based consultancy to the accounts receivable management industry.
  Market observers who spoke with CCR hesitated to make solid predictions about portfolio supply in the New Year, saying what happened in the 2007 fourth quarter will have a direct bearing on what issuers do in 2008.
  â€œPrime issuers with performing portfolios will sell them for a couple different reasons,” says Tim Kolk, managing partner at card-industry consultants Brookwood Capital of Petersborough, N.H. “Some sell a portion of a portfolio. They’ll find accounts that are not strategic to them. The pricing out there is really pretty attractive [for performing debt]. Here are premiums as good as we’ve ever seen, as long as the credit quality is average or better than average.”
  Other creditors will decide they no longer want to be issuers because of what it takes to compete in that space and because the risk is too great, Kolk says. So they will sell off their entire portfolio. “The market for those is incredibly strong, [and] there are spectacular premiums on that kind of product,” he says.
  The warnings on risk have been occurring in different parts of a bank’s assets, Kolk continues. “If mortgages get worse, it can’t bode well for card portfolios, but issuers are making attractive returns and profits on cards,” he says.
  There is pressure on card managers to keep risk low in spite of the moribund economy but also to continue to do more card lending, says Kolk. “I don’t know how that tension will resolve itself,” he says.
  Dave Ludwig, president of National Loan Exchange Inc., an Edwardsville, Ill.-based debt broker, says card issuers predict a 15% to 20% increase in charge-off rates through the second quarter of 2008 compared with the first half of 2007. “We are anticipating a 30% increase in sales volume from issuers as compared to the first six months of 2007,” he says.
  Pricing Predictions
  Kolk believes it is a seller’s market for performing portfolios, and issuers have not yet brought down their asking prices.
  â€œThere is so much concern about the overall economy and the bleeding of the housing credit crisis into what have traditionally been even riskier loans–credit cards–that buyers of card debt are paying a real premium for proven low-loss portfolios,” Kolk says. “Buying proven assets may be expensive, but the outcome is more predictable.”
  Collins Financial’s Wood notes that banks have taken a pounding on their losses in the subprime market, and the revenue they could generate by selling debt could help stem the flow.
  Ludwig predicts demand will continue to chase supply for the near future, but at lower prices. Pricing for primary issued credit cards with good supporting documentation already has fallen 10% to 15% since the fourth quarter of 2006, he says.
  Garnet Capital’s DiPalma agrees that card-portfolio prices have dropped 11% or 12% in the past year and will continue to slide. “The supply-demand balance is becoming more normalized,” he says. “It had been a market of more buyers than sellers. I think we will have a more balanced market, which means prices will come down,” but not substantially.
  Kaulkin Ginsberg’s Russell believes prices will remain stable at the fresh charge-off level, which will keep some buyers sidelined and push still others aside. “The number of buyers in the pool that will be able to compete for fresh paper will go down slightly,” he says.
  Going into 2008, the market is harder to gauge “because we have to see the results of the fourth-quarter sell-off,” says Russell. “If things happen the way they’re expected to, selling activity could increase from 2007. This fits with the expected increase in delinquencies and charge-offs and agency placements.”
  If issuers get concerned that the credit crunch and subprime fallout will hurt internal collection efforts, they may end up selling more, he says.
  Aktiv Kapital, an Oslo, Norway-based debt buyer and collector, recently told investors that, while developments in the subprime lending sector have reduced available funds for financial services as a whole, this “may result in more conservative prices for nonperforming consumer loans.”
  Aktiv’s board of directors issued a statement saying the subprime debacle and other trends create a window of opportunity.
  â€œThe pipeline for future purchases is significant, and we continue to see a positive trend among financial institutions to either outsource or divest the collection of nonperforming loans. New and existing vendors are bringing material portfolios up for sale,” the statement notes.
  If the supply of card paper does increase enough and prices fall, buyers that are securely backed by their own lines of credit will seize the day.
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