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As clouds last year began forming over the U.S. economy, many credit card issuers seemed slow to recognize how the growing subprime mortgage storm and real-estate collapse could rain on their card portfolios.
Issuers are now paying for that lack of foresight by battening down the hatches to survive one of the worst economic downturns in recent history that followed a long period of relative industry prosperity.
Changing conditions abruptly came to light earlier this year, when credit card issuers announced sharp declines in fourth-quarter income and higher charge-offs caused by spillover from the mortgage mess and beefed up reserves for future losses. If unemployment rises and the economy continues to weaken, issuer performance could get even worse later this year, analysts say.
"We may not be in a recession yet, but I don't know when we will hit bottom. And it's far too soon to predict a recovery for the credit card sector," says Howard Shapiro, an analyst with Fox-Pitt Kelton Cochran Caronia Waller, a New York-based investment banking firm.
In response to the changing conditions, issuers are scrambling to adjust their credit card underwriting criteria and to retool their risk models. They hope to find a balance between minimizing further losses from customers whose savings and home equity lines of credit are tapped out and securing growth opportunities in a fiercely competitive industry.
The pressure on issuers is compounded by the fact that Congress is mulling new legislation this year that could force new guidelines for credit card fees and set limits on interchange rates for the first time (see News story on page 8). Merchant acquirers pay interchange and pass the cost on to their retailer clients as part of the discount rate.
"Over the last decade we have had a boom economy, and many issuers were successful in spite of themselves," says Edmund Tribue, global practice leader of MasterCard Advisors' Global Credit Risk Practice. "Now issuers are going to have to take a hard look at the strategies, tools and approaches that worked before, realizing they may not be effective in this new environment. In order to survive, issuers will have to make significant changes in their methodologies and even their corporate cultures."
In hindsight, what is clear is that many lenders failed to prepare for the inevitable bursting of the real-estate bubble, and credit card issuers generally believed they would be sheltered from the fallout.
The misplaced industry optimism continued late into the third quarter of last year, when Richard Fairbank, chairman and CEO of Capital One Financial Corp., in September told analysts at the Bank of America Securities Conference that Cap One's credit card business "doesn't seem to be taking a hit from the problems in the mortgage industry."
In fact, Fairbank said, 70% of Cap One consumers that were 90-plus days delinquent on their mortgages were current on their credit card payments, marking an unusual reversal of traditional consumer behavior.
Lax Policies
According to analysts, while banks counted on continued home-price appreciation and abundant credit, they grew lax in their mortgage-lending policies by refinancing mortgages and extending home equity loans to subprime borrowers with shaky household finances. This was especially true in Sunbelt states in the southern U.S. where home prices soared highest and in Michigan, which is suffering from a local economic slump.
Although loans to the riskiest, subprime sector of the home-lending market represented only about 14% of all mortgages, according to Tribue, the subprime losses began to affect overall credit quality when home values began to sink in 2006 and 2007.
As home values declined throughout last year, home-equity lending dried up, and consumers suddenly lost access to the home price-fueled pipeline of cash that propped up household finances over the past few years.
"There was a sea change in consumer behavior last fall, when people began to walk away from home-equity loans and mortgages on homes whose values had fallen, while keeping up with their credit card payments for daily living expenses," says Shapiro. "But that was a temporary respite because the real-estate crash has stressed consumers overall, and cards are not immune."
The pain began in January, when American Express Co. reported that fourth-quarter income for its Card Services unit in 2007 declined 98.5%, to $7 million from $473 million for the same period a year earlier. Citigroup Inc.'s U.S. Card Division reported a 60% decline in fourth-quarter net income, while Bank of America Corp.'s Card Services unit's net income declined 50% and Capital One's net income dropped 42% compared with the fourth quarter of 2006.
JPMorgan Chase & Co.'s Card Services unit fared relatively well, with just a 15.3% drop in fourth-quarter net income.
Across the board, delinquencies and charge-offs are rising
Geography plays a big role in the current round of delinquencies and charge-offs. For example, BofA's rate of credit card delinquencies of 30 days or more in California, Florida, Arizona and Nevada increased more than five times the pace of the overall card portfolio in the fourth quarter versus the third quarter, and those four states represent more than 25% of BofA's total card portfolio, Joe L. Price, BofA's chief financial officer, told analysts in January.
"Charge-off levels will definitely continue to rise this year, but the question is, how far they will go?" asks R.K. Hammer, president of the credit card advisory firm R.K. Investment Bankers in Thousand Oaks, Calif. "For some issuers, charge-offs may rise by 75 basis points this year. But for those that were late to make changes in risk-decisioning models, charge-offs could rise as much as 150 basis points."
Card issuers are taking various actions to cope with the credit crunch.
Discussing fourth-quarter earnings with analysts in January, Gary Crittenden, Citibank chief financial officer, said the issuer was tightening underwriting standards, evaluating open lines of credit, and keeping a close eye on the relationships between consumers' mortgage positions and their credit card balances. Crittenden also indicated Citi would curtail marketing of balance-transfer offers.
Other issuers also are shifting new-customer acquisition strategies.
Standards Tightened
BofA tightened underwriting standards this year and put new pricing in place on cards with higher-risk profiles. But the issuer would not reduce a consumer's credit lines if he or she was "behaving" and making payments across the entire spectrum of their debt, Price told analysts.
Gordon Smith, CEO of Chase Card Services, told analysts in late February that the issuer responded quickly to warning signs and tightened lending requirements beginning early last year.
"We used historical data. ... We saw what was happening in the home-price appreciation data, and we forced up the cut-off levels. ... We also went through, looked at customer [credit] lines, and decided where lines should be increased or decreased," Smith said.
But the notion that any issuer saw the credit card downturn coming early last year seems ludicrous to Kenneth Chenault, American Express Chairman and CEO. At a February meeting with analysts, he observed that "some lenders say they saw the current environment coming ... but, you know, I don't seem to remember them saying anything at the time."
According to Chenault, the first signs of trouble for AmEx appeared late last year, when card-spending growth, which hovered at about 13% through November, suddenly dropped to 10% in December.
"We've been through slowing economies before, but none of us can recall such a dramatic drop in growth over such a short time frame, except during the event-driven decline of 9/11," Chenault said.
So far, the highest uptick in AmEx credit and charge card delinquency rates has been among cardholders who had acquired a mortgage over the last four years, while renters and those with mortgages acquired before 2003 were more stable, Chenault said. First-time home buyers are not in the highest-risk group; it is home buyers that recently acquired or refinanced a home, he said.
Chenault said AmEx took action by reducing credit lines available to higher-risk customers and by adjusting credit-risk models, especially in markets with the greatest home-price declines.
AmEx also is stepping up forbearance options for cardholders, offering them the chance to make smaller payments and waiving delinquency fees, Chenault said, adding that since last summer AmEx increased its collection-staff levels by 16%.
Dodging Risk
Brian Riley, senior analyst at TowerGroup, the consulting arm of MasterCard Worldwide, says the key to surviving the economic crunch is dodging risk while pushing growth in a tough environment.
"Leaving generous credit lines open to consumers during an environment like this is a risky strategy," Riley says, suggesting that issuers reduce credit limits among high-risk customer groups. Cardholders who revolve balances for everyday living expenses also should be classified as higher-risk, and credit lines should be curtailed for these groups, while people revolving balances on durable goods are a safer bet, he says.
According to Riley, two of the riskiest customer groups at the moment are those who make only the minimum payments due each month and "mass affluent" consumers with incomes between $50,000 and $100,000. "These are people most likely to be impacted by subprime loans. They have been living on their home equity, running up their credit and having a comfortable life. But they don't have anything to fall back on," Riley says.
Ezra Becker, principal consultant in financial services at TransUnion, a Chicago-based credit bureau, advises issuers to factor local economic and real-estate conditions into risk models used to evaluate new customers, and avoid overreacting. "Issuers should use more caution when extending credit, but remember there is danger in tightening underwriting criteria so much that you stunt healthy portfolio growth," he says.
Analysts say it is impossible to forecast how card issuers will fare beyond the first quarter because the economy is in flux. "Unemployment is the big question mark for the credit card industry," says Fox-Pitt's Shapiro. "If it declines sharply this year, the credit card sector will be in much bigger trouble, and a recovery will be further away."
Federal Reserve Chairman Ben Bernanke in March cut interest rates and signaled there may be further cuts, which might stimulate the economy but have little effect on credit card pricing because most issuers set their rates above the prime rate.
Issuers could catch a small break from a government economic-stimulus package that will result in 130 million households receiving checks of up to $600 for individuals and $1,200 for married couples beginning in May. Forty-two percent of consumers would use such a tax rebate to pay down debt, according to a TransUnion survey conducted earlier this year.
Robert Lime, a partner with First Annapolis Consulting, a Linthicum, Md.-based consultancy, points out that despite its current difficulties, the credit card industry is better positioned to survive an economic downturn than some other lending sectors.
"Unlike mortgages and auto loans, the credit card is one of the only consumer-lending vehicles that allows for repricing and changing risk strategies," Lime says. "Issuers have a lot of flexibility here, and although the road ahead may be rough from a profitability point of view, it's survivable."
No one can forecast when the storm clouds will begin to lift. But analysts agree that when delinquencies and charge-offs begin to decrease, issuers that made the right moves during the crunch can look for signs of recovery. CP