Smooth Sailing

  Low funding costs and improving credit quality made 2003 the bank card industry's most profitable year in recent memory. Will the earnings waters remain tranquil in 2004?
  Bank card issuers learned their lessons in 2003.
  In 2002, high chargeoffs prevented them from translating some of the lowest funding costs in 40 years into more earnings.
  But in 2003, issuers were able to convert further drops in funding costs as well as moderating losses into the biggest increase in profitability since CCM began tracking the industry's earnings in 1992. CCM estimates U.S. Visa and MasterCard issuers collectively earned $14.2 billion, up 32%, and posted a 2.53% after-tax return on assets last year, up from 1.99% in 2002.
  Profits rose even while net interest income remained steady as issuers passed along lower funding costs to their cardholders and improving credit quality led to reduced penalty revenues. Those factors reduced yields on average receivables by 78 basis points. Expenses, however, fell more even though chargeoffs, at nearly 6% of receivables, are still high by historical standards.
  "That's one reason banks are happy to continue these loss rates," says David Wyss, chief economist at securities rating agency Standard & Poor's Corp. "Where else can you get 17% on your money?"
  Adds Paul Grill, a principal at Linthicum, Md.-based First Annapolis Consulting Inc.: "A lot of (the improvement) was getting losses under control."
  Interchange, card issuers' biggest source of non-interest revenue, continued to grow largely in step with charge volume. Propelled by a modestly improving economy and new acceptance markets, Visa and MasterCard issuers garnered $945.7 billion in credit card purchase volume last year, up 7% from $880.9 billion in 2002.
  Banks Prosper
  The card industry's profit increase comes against a background of continuing prosperous times for the banking industry in general. According to the Federal Deposit Insurance Corp., federally insured financial institutions earned a record $120.6 billion last year, surpassing the previous record of $105.1 billion set only the year before. Some 36 banks with a heavy concentration of credit card loans posted a stunning 4.04% after-tax ROA in 2003, up from 3.61% in 2002, the FDIC reports.
  How long will the good times roll? After a series of decreases in 2001 and 2002, the Federal Reserve lowered its key short-term rate, the federal funds rate, only once last year, to 1%. It had been 6.5% at the start of 2001. Now Fed watchers believe increases are inevitable, particularly as some indicators start to show signs of higher inflation.
  Many securitized credit card funding sources are based on London Interbank Offered Rate (LIBOR) indexes, which roughly parallel the fed funds rate. Issuers will quickly pass on funding cost increases to preserve their net interest margins, but higher annual percentage rates could cause credit cards to lose market share to less-expensive loan types. Revolving credit's growth rates have trailed those of nonrevolving credit for the past three years, according to the Fed.
  "The better credit-quality customers will choose to pay off more," says Katie O'Flanagan, an associate at Westbury, N.Y.-based Auriemma Consulting Group who tracks card finances.
  Bankruptcies set a record last year, but the easing in chargeoff rates seems likely to continue as issuers clean up after the recession that officially ended more than two years ago. Under regulatory pressure, issuers have purged hundreds of thousands of subprime cardholders from their portfolios. That scenario has the potential to change quickly, however, because an uptick in APRs "could cause a greater proportion of consumers who are saturated in debt just to tip," O'Flanagan says.
  But the Fed hasn't said exactly when rates will rise, so for now the party is still on.
  Here is how CCM derived its earnings estimates for 2003. Data came from government agencies, Visa and MasterCard, and interviews with financial analysts and other industry sources. Figures include some minor restatements for 2002 based on updated data. Revenues first:
  * Average receivables grew 4%, in line with revolving credit growth figures reported by the Federal Reserve.
  * Interest income assumes an average APR on revolving balances of 14%, down from 14.8% in 2002, and that 83% of balances revolved in both years.
  * Interchange income applies a 1.7% blended interchange rate to the nearly $1 trillion in credit card purchase volume, the same rate as in 2002.
  * After years of growth, penalty-fee revenues fell 5% as credit quality improved. CCM assumes 7.5% of active accounts were delinquent each month in 2003, down from 8% in 2002, and that 93% of the late accounts were assessed a late fee. The average late fee for 2003 is estimated at $32, up from $31 in 2002 as some issuers pushed fees as high as $39 for higher overdue balances. Overlimit and other penalty fees are assumed to be 25% of late-fee revenue, down from 30% in 2002.
  * Cash-advance income assumes 35% of cash volume in both years was balance transfers not subject to fees. The rest was assessed 3%.
  * Annual-fee revenues assume that 13% of accounts have a fee, down from 15% in 2002. The average annual fee on open accounts, according to Chicago-based Synovate's Inside Track, was $44.30 in 2003 versus $43.73 in 2002.
  * Enhancement revenues from credit insurance and other marketing programs are estimated to have increased proportionately with charge volume.
  Expenses:
  * Cost of funds fell to 2.7% of average receivables from 3.5% in 2002.
  * Net chargeoffs declined 65 basis points to 5.9%.
  * Operations and marketing costs fell 20 basis points as issuers cut direct-mail solicitation volume ("Behind 2003's Direct-Mail Numbers," April), and processors reported continuing price pressure from issuer clients.
  * Fraud is estimated at 7 basis points of charge volume for both years.