Subprime Cards, Act II

  The subprime market has gone through a series of upheavals over the last two years. Just what does the new subprime cardholder look like and how will the changes affect collections?
  In the mid and late 1990s, card issuers turned to the subprime market in search of new revenue at a time when the industry was hitting the wall in the prime market.
  The subprime market is estimated at between 25 million and 50 million of America's 105 million households.
  Sure, subprime cardholders were a risky bunch. But they were desperate for credit and willing to pay hefty annual fees and annual percentage rates that sometimes exceeded 25%. And issuers thought they could keep bad debt at bay by using sophisticated software to select cardholders and manage their accounts.
  They were wrong.
  Over the past two years, a host of issuers have stumbled or failed in the subprime business, including some of the most technologically sophisticated and aggressive players-Metris Cos. Inc., Providian Financial Corp., NextCard Inc. and Capital One Financial Corp.
  NextCard is liquidating, Metris is trying to stay alive, and Providian survived only by downsizing by more than a third and going up-market.
  Only Capital One, which last year disclosed that 40% of its portfolio was subprime, escaped without long-term damage.
  "The big players clearly have left the market entirely," says Donald M. Berman, chairman and chief executive of CardWorks L.P., which manages subprime portfolios.
  Smaller subprime players, such as First Premier Bank, Cross Country Bank and First National Bank of Marin, also pulled back from the market-under restraints imposed by regulators. The result?
  "The market is a lot less saturated and a lot less competitive than what it's been over the last two years," Berman says.
  And the problems continue. In the past few months, regulators and ratings agencies have take action against a number of subprime issuers, including:
  * Bankrupt retailer Spiegel Inc.'s First Consumers National Bank. In late September, Moody's Investors Service downgraded two outstanding classes of securities backed by the receivables of the now-defunct Beaverton, Ore.-based FCNB, citing faster-than-anticipated deterioration in the credit quality of the underlying receivables. FCNB revoked cardholders' charging privileges in March.
  Moody's took the action because of the "precipitous drop off in the payment rate or collections that are used to pay down bondholders," says William Black, vice president and senior credit officer, structured finance.
  From March to April, the payment rate on FCNB securities fell from 14.18% of receivables to 6.21%, Black says, and the payment rate hasn't been above 5% since April.
  There also was a "rather noticeable increase in late-stage delinquencies that are likely to translate into an increase in losses as time goes by," Black says. The two issues, totaling $676 million in Class A notes, were downgraded to Ba1 from Baa3.
  Moody's originally placed the securities under review for possible downgrade in March 2002, and downgraded four classes of bonds in April.
  A month earlier, the Office of the Comptroller of the Currency ordered First Consumers to refund $1.65 million in annual fees charged to cardholders on or after Dec. 28, 2002. The OCC said the bank knew it would have to liquidate its credit card portfolio and it should have told its cardholders their credit cards would be terminated.
  Under the agreement with the OCC, FCNB also will refund $255,685 in overlimit fees charged to customers who exceeded their credit limit as a result of the annual fee charge.
  Also under a May 2002 consent order with the OCC, FCNB was ordered to sell, merge or liquidate. The bank was unable to find a buyer and began liquidation on June 19.
  * First Premier Bank. On Sept. 23, Sioux Falls, S.D.-based First Premier Bank, its affiliate Premier Bankcard, and parent company United National Corp. reached an agreement with the Federal Reserve Bank of Minneapolis to limit to 8% growth in First Premier's subprime Visa and MasterCard portfolio. First Premier has about $720 million in receivables.
  A Fed spokesperson wouldn't comment on the agreement.
  Under the pact, First Premier will not increase the size of its managed subprime card portfolio above the balance at Jan. 9, 2003, without prior written approval from the Minneapolis Fed. The Fed defined subprime as a loan to a borrower having a Fair Isaac Corp. (FICO) credit score of less than 600 that is not fully secured by a borrower's deposits at the bank.
  That limit will not be lifted until the bank submits a plan to manage growth, capital, reserves, funding and affiliate transactions. The bank also must limit new accounts and credit-line increases for each credit card portfolio segment.
  What's more, the agreement calls for the bank to submit to the Fed within 60 days a plan to sell or liquidate the subprime card portfolios in the event that the bank and United don't fulfill the provisions of the agreement.
  Miles K. Beacom, president and chief executive of Premier Bankcard, says the Fed drew up the agreement after a routine annual review of the bank's operations. "Like any organization in the subprime industry, we're under a lot of scrutiny," he says.
  However, the review didn't uncover any problems, Beacom says. "The Federal Reserve has not identified anything that is wrong with our current practices," he says. "They are simply asking us to make the extra effort to insure that our systems and procedures are rock solid."
  Beacom adds that Premier will hire a third-party accounting firm to review revenue recognition and reserve policies. It also is hiring an as-yet unidentified "worldwide expert" on credit card management information systems to conduct an audit of its current systems, he says.
  First Premier and its card affiliate already have taken steps to address items cited in the agreement, Beacom says. One area of concern was Premier Bankcard's reliance on federally insured deposits to fund receivables.
  Because Premier saw banking regulators focusing on other subprime issuers' use of insured deposits, it began to reduce its use of them as well, Beacom says. In 2001, insured deposits funded more than $250 million of receivables, he says, adding that "we were at $137 million at the end of last year and we ended August at $21 million."
  Premier also is in compliance with reserve and capitalization requirements, Beacom says. Under the agreement, First Premier and United National must maintain a total risk-based capital ratio of at least 12%, and enough reserves to cover 12 months of expected losses.
  * Metris Companies. Minnetonka, Minn.-based Metris in late September sold about $550 million in brokered and retail jumbo certificates of deposits in its Direct Merchants Credit Card Bank. The OCC ordered the financially troubled subprime issuer to sell the deposits to eliminate risk to the Federal Deposit Insurance Corp. As a result of the sale, Metris will take a third-quarter 2003 pre-tax charge of $30 million.
  A day earlier, Metris had announced it was cutting its workforce by 65 positions, including 25% of the company's senior management team.
  Despite the unsettled conditions in the subprime environment, there remains a small group of issuers willing to take a chance on the market.
  "I don't think the subprime market is going to go away anytime soon," says Black of Moody's. "For those who can do it right, it still remains profitable."
  Indeed, if bad debt can be reined in, issuers still can expect to earn a handsome return in the subprime market, observers say.
  CardWorks's Berman estimates the pre-tax return on assets of a well-run subprime portfolio is somewhere between 3% and 5%. That's a "little less profitable" than in the past because of higher capital requirements and other regulatory constraints designed to slow subprime market growth, he says.
  "From our view, (the subprime business) is much more profitable than the prime business," Berman says.
  The average pre-tax ROA in the bank card industry stood at 3.15% in 2002 ("Issuers Shed Some Profitability," May).
  With fewer competitors in the market, there is less pressure on issuers to dig deeper into the pool of subprime consumers. CardWorks now markets cards to consumers with FICO scores above 600, whereas two years ago it sought out consumers with scores "in the 580 range," Berman says.
  A FICO score of 600 or below is typically considered subprime.
  Providian, a high-flying subprime issuer until 2001when rising chargeoffs hammered its earnings, also is targeting consumers in what one observer calls "the high end of non-prime." Providian Chairman and Chief Executive Joseph Saunders prefers to call it the "middle market."
  In a conference call reviewing Providian's second-quarter earnings, Saunders said the bank booked about 500,000 accounts with average FICO scores of 680. At the same time, it reduced by $1 billion accounts with FICO scores below 600, the "riskiest portion of our portfolio," Saunders said. That's almost a 46% decrease over the past 18 months, he added.
  Culling the Risky
  Providian culled the high-risk, high-chargeoff accounts by "aggressively" raising prices on riskier accounts, capping credit lines, and closing accounts, Chief Financial Officer Tony Vuoto said at an investor's conference sponsored by Morgan Stanley in late September.
  But shooting for consumers with higher FICO scores isn't enough for some subprime players. Many in the industry feel that a FICO score in the 640 area "is a good litmus test" for selecting cardholders, but other factors also must be considered, says Jon Hoffmann, managing director of collections for Atlanta-based subprime card marketer CompuCredit Corp.
  CompuCredit, which has cardholders below the 640 mark, makes its decisions based not only FICO scores but also on past behavior and proprietary scores.
  "Our niche has primarily been what we consider the underserved market," Hoffmann says. "They weren't people that were necessarily bad. They just didn't have a lot of banking history and people weren't marketing to them."
  Over the past year, CompuCredit has grown its portfolio primarily by buying receivables from other subprime issuers, Hoffmann says.
  "CompuCredit made a conscious decision to really ramp down (from originating accounts)," he says. "We just didn't think it was rational to compete with some of the offers that other players were putting out there."
  Operating a profitable subprime portfolio calls for more than just selecting the "right" cardholder, Hoffmann says. An issuer also needs an experienced collections operation that can keep bad debt under control. Several of CompuCredit's top executives have collections-agency experience.
  "We feel very comfortable that we've got a good core competency in collections as well as risk and analytics, and we're doing a good job of finding the right people and applying the right treatments to them and making money off the account," Hoffmann says.
  CompuCredit also operates Jefferson Capital, a buyer of charged-off debt. During the second quarter, the one-year-old Jefferson acquired defaulted accounts with a face value of $302 million at a cost of $9.2 million-an average of just over 3 cents on the dollar.
  "We felt there were some attractive returns" in the bad-debt-buying market, Hoffmann says.
  Because subprime cardholders pose a greater risk, many issuers are beefing up and modifying their collections efforts.
  "A number of (issuers) have gotten more careful about evaluating their risk and they've also gotten more attuned to managing their collection processes better," says Bernhard Nann, vice president of collections and recovery solutions in the Golden, Colo., office of Fair Isaac. Fair Isaac acquired Nann's collection software firm, Narex Inc., in July for $10 million in cash.
  A Different Mode
  Key to a successful subprime collection program is "getting to the customer and getting him to change his payment habits early," Berman says. "If you don't have him in a different mode by 90 days (past due) your degree of success is almost zero."
  Many issuers already are "being more aggressive in terms of placing their subprime consumers with outside collection agencies earlier in the process," Nann says.
  CompuCredit has refined some of its collections strategies, but as with prime cardholders, "at the end of the day, it's all about trying to convince people to pay you," Hoffmann says.
  Many of the risk-management and collections scoring models used in the prime and super-prime markets don't work well in the subprime market. That's because subprime cardholders often have little or no credit histories.
  "Data used in (traditional) behavioral models is not quite as powerful as we would like," Nann says. "We'd like to go and expand the universe of data that can be looked at to produce better predictions. That's particularly important in the subprime area."
  Such data would include rent and utility payments, "those kinds of things-data that's not typically captured by the traditional Big Three credit bureaus," Nann says.
  For now, the surviving issuers are picking their way cautiously through the subprime neighborhood. They're hoping that with the right risk-management and collections strategies, they'll make it safely to the other side.