Charge-Offs Ready To Rise Again?

  Credit card issuers large and small saw charge-offs decline during the first half of 2006 compared with the same period in 2005, and 15 issuers studied by Cards&Payments sister publication Collections & Credit Risk all rated their credit quality as being high at the end of the second quarter.
  A combination of factors-consumers' existing debt loads, their increased reliance on credit cards to finance daily living, rising mortgage interest rates, and higher gasoline and home-heating prices-could translate into tougher times for credit card issuers and collection firms over the next 12 to 18 months.
  Government and bank economists, analysts, consultants and debt buyers all have chimed in on what might be happening with consumer credit card debt and how it will affect the debt-management industry. Their general consensus is that if a greater proportion of consumers become overleveraged, some will be obliged to cut corners, and credit card payments will suffer.
  Credit card charge-off rates of late have taken a roller-coaster ride. The Federal Reserve Board reported that the second-quarter charge-off rate of credit card accounts at commercial banks was 3.48%, up from 2.93% in the first quarter but down from 5.66% in the fourth quarter. The volume in the fourth quarter related to consumers' rush to file for bankruptcy protection before the new bankruptcy law went into effect last October, credit card issuers explain. The low first-quarter rate represents the lull after that storm.
  An examination of a dozen credit card issuers' quarterly reports found their combined charge-offs fell 17.5% in the first six months of 2006 compared with the first half of last year.
  "Charge-off rates are down a lot since the bankruptcy-reform law went into effect. It's probably fair to say that as that bubble passes, charge-off rates will increase," predicts Moshe Orenbuch, banking industry equities research analyst at Credit Suisse.
  Although credit quality this year is very high on a historic basis, in part because of bankruptcy reform, Orenbuch believes that when it starts to worsen, debt sales "will accelerate to offset the initial increase in [issuer] losses."
  Robert Deter, vice president of acquisitions at Hudson & Keyse, a debt buyer and collection firm in Painesville, Ohio, agrees. "Write-offs are down drastically," he says. "The bankruptcy rate is staying low, so write-offs remain low. It's clear issuers are benefiting from this situation now."
  But if they run into tough times, "they'll maneuver the debt into the strategy that will give them a quick cash influx," including charge-off sales, Deter says.
  For the time being, though, few banks will sell off card portfolios, contends Scott Anderson, vice president and senior economist for Wells Fargo & Co. He says credit quality remains strong and banks believe they will be able to recover much of the debt themselves. Factors in their favor include $70-a-barrel oil prices and stable job creation.
  Forecasting into next year, however, is a bit more difficult. Looking into 2007, "the unemployment picture is murky," comments Sameer Gokhale, banking industry analyst at Bear, Stearns & Co. There has been some relief in crude oil prices, but gas at the pump remains high. And recent futures prices indicate that consumers will pay more for heating oil this winter, he says.
  Consumer prices directly and indirectly affect how individuals manage their debts. The Fed reports the delinquency rate on commercial banks' credit cards reached 4.13% in the second quarter, up from 3.92% in the first quarter, 3.5% in the fourth quarter and 3.67% in the second quarter of 2005. The 2006 second-quarter rate was the highest since the same quarter of 2004, when delinquencies were at 4.15%.
  LENDING GROWTH
  Although the ongoing federal funds rate hikes halted in August with the funds rate at 5.25%, slowing home-price appreciation may make home-equity lending and cash-out refinancing less financially advantageous, which in turn could reinvigorate growth in other forms of consumer lending, such as credit cards, FDIC senior financial analyst Lynne Montgomery writes in the FDIC's Summer 2006 Outlook.
  "We are starting to see borrowers come under pressure" because of a series of "interest rate increases and federally regulated minimum monthly payments [on credit cards]," Wells Fargo's Anderson says.
  Although credit card borrowing can be more expensive, on top of other rising costs, "that has not deterred borrowing from credit cards, which are funding spending," says Anderson.
  Americans are on track to charge nearly $1.7 trillion in purchases this year with Visa, MasterCard, American Express and Discover cards.
  As some borrowers "begin to feel rate shock from the adjustable-rate mortgages" they used to squeak their way into the housing market, "we could see continued strong demand on credit cards," Anderson says.
  Gokhale of Bear, Stearns agrees. "In 2007, consumer credit in the aggregate is going to worsen, and it's going to get ugly for those with subprime loans. As interest rates rise and home-price appreciation slows, homeowners cannot extract equity any longer, so they move on to credit cards to continue spending."
  Will they or won't they sell? How much and when? These are the questions now occupying debt buyers and collection firms.
  Certain issuers, such as JPMorgan Chase & Co., have not been selling as much delinquent credit card paper as they once did, "perhaps 10% of their overall volume," says Brian K. Williams, manager of portfolio acquisitions and sales at Crown Asset Management LLC, a receivables management firm in Duluth, Ga.
  Instead, many banks have outsourced the bulk of the work to contingency collection agencies and law firms. "Charge-off sales generate revenue when the credit card issuers need it. But banks have been performing quite well, and they don't need an immediate return," Williams says.
  EAGER TO SELL?
  But Gokhale of Bear, Stearns adds a wrinkle. Because of the premium prices that portfolios have been fetching, he surmises that credit card issuers may become more eager to sell delinquent accounts because "they can get top dollar and get rid of the paper.
  "Pricing increased 80 to 100 percent since the end of 2003," he notes. "Given how much prices have increased, it suggests that supply has not kept up with demand."
  Buyers paid 4 cents to 6 cents on the dollar for fresh debt a few years ago, and margins could be made on a one-year pricing model, says Dawn Willey, president of Bridgeforce, a Newark, Del.-based consultancy with major credit card issuer clients. Today, buyers are taking more risk because they are seeking returns within three years and yet are paying 12 cents to 15 cents on the dollar.
  "Prices are too high, so high, in fact, that large [debt buying] companies are pushing out their recovery curve," says Louise Epstein, president of Charge-off Clearinghouse in Austin, Texas.
  Encore Capital Group disclosed in August that it has revised its models to extend its collection curve from 54 months and 60 months to 72 months. Management explained this was done because "we continue to generate collections from many of our older vintages well beyond" four to five years, but Epstein says high portfolio prices force a broader horizon for profit generation.
  She says it is getting harder to buy portfolios from credit card issuers: "They are holding on to their debt longer, working the accounts harder and becoming increasingly efficient with their own collection practices."
  Issuers "have become more aware of the asset they created and are realizing the value before they sell" delinquent accounts, Epstein adds.
  For buyers of credit card charge-offs, "Demand is up and supply is down and degraded," Epstein claims, adding that today's average credit card portfolio is "worth less than the same product last year or the year before" in spite of increased prices. "Quality is on a straight-line downward trend," she says.
  However, the fourth quarter is the time to look for fresh charge-offs from credit card issuers seeking to beef up their books.
  Banks are keen to keep their contingency collectors on their toes, experts say. "The industry is getting really competitive. Some issuers look at collectors' performance as a horse race," says Willey of Bridgeforce. "If you are off your projections for only one month, the issuer can take 50% of that business and give it to another agency. There is less forgiveness" if the rate of recovery slides.
  Agencies are under price pressure, too. When seeking bids from three to four agencies of equal performance, an issuer will ask for the lowest contingency rate. The agency that wants to win will go 2% to 4% below the prevailing rate of 30%, Willey says.
  When Bank of America seeks to hire an outside collection agency, "We look at a variety of agencies, compare their current performance with their past performance, and compare them with their peers," spokeswoman Betty Riess says.
  Among the performance measures the bank tracks are file transmission accuracy, forecast accuracy, inventory controls, settlement rates, and maintenance and dispute reporting, says Riess.
  Many issuers have a four-pronged approach to recovering delinquent accounts: in-house collections, outsourced collections, credit counseling and litigation, says Hudson & Keyse's Deter. They "are looking for the greatest liquidation rate possible, and they require solid estimates as to what the return will be," he says. "They must be able to rely on forecast recovery rates."
  Deter agrees with Riess that another common measure is peer comparison. "Issuers will let agencies know how each ranks against the others. It's very competitive," he says.
  ADVANCED TOOLS
  Both debt sellers and buyers are employing more advanced tools to succeed in the marketplace. "Higher risk requires more analytics and specialized performance modeling; credit card issuers have been using analytics and modeling for years," Willey says.
  On the buy side, due diligence is becoming more sophisticated among debt brokers and buyers, and more of them also are using analytics and models, necessitated by higher prices and a lengthening time line for return on investment, observers say.
  Willey believes collection agencies, too, will use sophisticated analytics, modeling and alternative technologies, such as virtual collecting, to remain competitive.
  Issuers expect to have a solid 2006: Virtually all the companies Collections & Credit Risk researched forecast growth this year. Advanta Corp., for example, anticipates 45% to 50% growth in new accounts.
  As credit expands and borrowers keep stretching this resource, the elasticity of the market will be tested. Perhaps as soon as 2007, debt buyers and collectors will learn whether debt growth will remain as profitable.
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