Double Whammy: Bank Card Companies May Be Next

Aside from Visa (V) or Mastercard (MA), it doesn’t seem as if the credit card issuers have been getting the attention they deserve. With all of the panic and concern surrounding the brokers and builders, perhaps plates are too full to take on any more. Yet, I have been thinking about how easy credit policies made available for housing created a monstrous economic problem. Even so, it does seems plausible that companies issuing collateralized debt could eventually see a recovery if the underlying property can be liquidated for some portion of its worth. But, what happens as defaults rise on credit/bank card debt, which is only backed by the full faith and credit of the borrower?

During the past few months, investors have pummeled Discover Financial (DFS) and others lenders over fear of rising defaults and delinquencies. Here is an example of the recent news and behavior of credit companies caused by the subprime problems (2/12/08 Washington Post):

The subprime mortgage meltdown has spilled into the credit card industry in other ways. Banks have reported steep write-offs related to the mortgage mess, and their stock prices have plummeted.

“Credit cards historically have been a very profitable segment for the banking industry, so what they’re doing is trying to squeeze customers as much as they can, particularly for accounts they don’t see as profitable or as high risk,” said Curtis Arnold, founder of CardRatings.com, a consumer resource on credit cards.

Bank of America (BAC), for instance, notified some customers last month that their rates would increase as a result of a periodic review of their credit risk. Chase (JPM) last fall increased the rate paid by new customers of its Freedom card. Bank of America and Chase are also among some banks that have increased ATM fees for other banks’ customers to as much as $3. Capital One (COF) has changed its cash-advance fee for new customers from 19 percent to 23 percent.

Beyond the current economic crisis, there is an even more troubling issue confronting the industry with the pending legislation known as H.R. 5244: (MSNBC Consumerman)

‘The Credit Cardholders’ Bill of Rights Act of 2008, known as H.R. 5244, would protect cardholders from arbitrary interest rate increases and unfair fees. Maloney, who chairs the House Financial Institutions and Consumer Credit Subcommittee, is quick to point out that her bill does not have any price controls. It does not cap rates or fees.

Interestingly, it looks as though some analysts are continuing to recommend a BUY rating on COF and other names within the sector and are oblivious to the mountain of problems facing bank card companies, aka: The Double Whammy: (Yahoo/AP)

Amid difficulties with mortgages in the U.S. and unloading corporate debt, banks are competing more than ever for market share in their core business — deposits. A large source of profit, banks are introducing newer, higher-yielding accounts to attract more customers’ cash.

The grease that keeps the wheels turning for these companies is capital. In times when money is easily available, bank-card companies utilize their customer accounts to lend money to the credit card customers. As credit card balances rise, new capital is needed to meet the consumer demand.

In order to bring in fresh capital, brokers such as Lehman (LEH), JP Morgan and Goldman Sachs (GS) raise money through note, bond and stock offerings. What do banks do? Of course if they are publicly traded they have the ability to do the same as the brokers and other companies, yet a quieter and quicker maneuver is to bring in new deposits through higher yielding savings accounts. This also helps to bring up the reserve requirements for loans issued through credit card issues and direct loans.

The simple point shows that as customers continue to look for safer alternatives and margins are squeezed as delinquencies and defaults rise, banks that do a big business within the consumer credit card arena could be hit by both problems of limited capital available to loan and ceilings on the fees they can charge for those loans.

The problem for COF is not restricted to our country. Over the past several years, Capital One move aggressively into England and offered attractive terms in order to expand their reach into the credit card business. The New York Times recently explored this problem in the March 22 article entitled, Debt-Gorged British Start to Worry That the Party Is Ending:

…Economists say Britain’s relationship to debt is complex, but at its core is a phenomenon more akin to recent American history than European trends. As in the United States, a decade-long housing boom and strong economic growth bolstered consumer confidence, creating a perception of wealth almost unknown in countries like Germany and Italy.

…The average British adult has 2.8 credit or debit cards, more than any other country in Europe. A growing number are borrowing to pay for vacations, furniture, even plastic surgery. As a result, Britons are spending more than they earn, racking up a household debt-to-income ratio of 1.62 compared with 1.42 in the United States and 1.09 in Germany.

CNN/Fortune has picked-up on the potential problem back in October, 2007. It is becoming ever apparent that there is a trend that is developing on both sides of the Atlantic. The looming question being asked is; How similar are the problems of British consumers to those of their Americans counterparts. If England is really an advanced indicator, the pain will be unbearable in the next few months. The $915B bomb in consumers’ wallets:

If there is an international precedent the U.S. should be watching, it’s actually that of the U.K. British consumers are just as overstretched as Americans, but since the real estate market there rose faster and fell earlier, they’re about 18 months ahead in the credit cycle. Since the last quarter of 2005, credit card delinquencies and charge-off rates in Britain have risen as much as 50%, forcing banks to take huge write-offs.

It’s a sign of the times that, according to one survey last month, 6% of British homeowners have been using their credit cards to pay their mortgages. That’s suicidal, of course, given that credit card interest rates are more than double even the heftiest mortgage. Keep your fingers crossed that it’s not a trend that crosses the Atlantic.

So, that all leads to the main point of the discussion: Capital One Financial. Take a look at the business model for the biggest issuer of credit/bank cards in the U.S.:

The National Lending segment consists of three sub-segments: the U.S. Card sub-segment, which consists of domestic consumer credit and debit card activities; the Auto Finance sub-segment, which includes automobile and other motor vehicle financing activities, and the Global Financial Services sub-segment consisting of international lending activities, small business lending, installment loans, home loans, healthcare financing and other diversified activities.

At this stage of our economic cycle, any one of the three sectors would be enough to concern for an investor . This is not the time to be tinkering in an area that has seen a historic contraction without any real plan for recovery. Reports on revolving and non-revolving credit have not been encouraging either. It is perplexing how COF’s stock price has maintained a relatively decent level of support with all of the data and projections available; yet that is exactly why we are zeroing in on this particular company.

The chart above shows the massive increase in revolving credit over the past 18 months. This will only be good for the issuers of credit cards as long as payments stay current. If we see a further increase in late payments and defaults, all bets are off as this stock could nosedive towards the $20 price not seen since 1998. The last time we saw a share price significant slide was during 2002 when the economy was slowing at a rapid pace. The fact is that right now, there are too many headwinds to own this name.

Beyond that, there is one recent piece of news out that needs to be addressed and flushed-out. Odd as it seems, on February 1, 2008, COF’s press release explained of the company’s plan to raise the quarterly dividend from $0.027 to $0.375, payable Feb. 20, 2008 to stockholders of record on Feb. 11. In addition, they put a $2BILLION stock buyback plan into motion. Why? The only thing that can be made of this is an attempt to make it look as though the company is past their problems, and management is convinced they will be profitable over the long term. The ugly little truth is that this kind of maneuver allows the company to actually pay less for the dividend, in total, and increases EPS by taking shares off the market. It appears to be nothing more than a move to buy some more time hoping to see if this whole credit crisis will blow over. I am not buying that hype, or the stock!

It is abundantly clear that we are seeing a rise in delinquency rates across all credit genres. The only reason that there has been a lag for the bank card component is that consumers have realized that this is the only remaining source of funds as the equity in their homes have dried up and new home equity loans will be difficult or impossible to find. What used to be the order of payments: Mortgage-Auto-Credit Cards has now changed to Credit Cards-Auto-Mortgage. At first this may seem to be a ray of sunshine in an otherwise cloudy forecast. yet, once again, this is actually a more concerning trend as it shows that borrowers are keen to the current need to keep credit available until they exhaust their limits. None of this is very encouraging.

Throughout the country, credit counseling professionals concur. (USA Today 2/28/08)

Credit bureau analyses of consumer payment data show that financially squeezed borrowers have begun paying their credit card and car bills before their mortgages. That’s a striking reversal from the norm, one that reflects rising desperation. It suggests that some people essentially have given up trying to stay current with their mortgages and instead are focused on using credit cards to squeak by.

If the trend persists, many economists say, it could accelerate mortgage losses and further drag down the economy.

Adding further concern is the fact that COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%.

Needless to say, COF=SHORT for our portfolios. We have been recently begun building a position for clients. There just doesn’t seem to be any good reason to put money into an institution that relies on uncollaterlized consumer debt as its product/inventory. Adding the economic climate, consumer sentiment and the pending legislation does not seem to provide a recipe for success. Sure, anything is possible - but why go long into a position that appears to have so many potential traps?

Disclosure: Short COF

Comments

[User 167355]

The author is correct in his assessment of the long-term risks of uncollateralized credit. However, the short-term outlook is bullish. Historically, consumers have used government tax rebates to pay down debt. During the next two months, the Federal government will be issuing checks to millions of Americans. How will this affect credit card companies? It will provide them with a huge inflow of cash. Look for the credit card industry to profit significantly across the board during the next three months.

[Malkiel]

Credit card fees and interest rates need to be capped by government regulation because experience proves that consumers are generally not able to calculate the effect of exorbitant rates on accelerating their debt and payments, and it isn't in the interest of the market to disable consumers by rate gouging. Consumers should be shielded from gouging and lenders should be prevented from making lending terms that are usurious. It's part of the package of reforms that need to be made and the collapse of the current economy and the end of GOP rule will be the moment when these things happen. And all of us, including the whining free-market libertarians, will be better off for it...

[jcrash]

Dunno - playing devils advocate...in general credit card rates are high, but banks have been desperate lately. Lifetime of transfer rates have been around 3.9% for the last few months. Miss a payment or two and I'm sure they stick you hard, but 3.9% is lower (even tax adjusted) than any fixed rate mortgage you will ever get.

[Roger G.]

Andrew Horowitz, should understand that VISA and MASTERCARD DO NOT make money giving credit. They make money on transactions fees only. People will not stop spending money on credit cards. They are both in a unique position, when it comes to making money. Transactions are going up and up only. Everyone has started buying gasoline and groceries on their credit cards. VISA & MASTERCARD WILL ONLY GO UP AND UP.

[Lisa]

But Roger, if people max out on credit card debt, they can't carry on using the cards and generating those transaction fees.

[Lisa]

One other thing, Roger: exhortations in block capitals sound rather desperate. I assume you own V and MA.
:-)

[rafa]

Las tarjetas de credito son como las fichas del casino... solo te das cuenta del valor que tuvieron cuando ya no las tienes o tienes que hacer el cheque a fin de mes.

[clitosil]

yeah, it sounds like that familiar mantra: "Property values NEVER go down." DOH!

[drmalaka]

Great article. Watching these banks go up is funnier than any episode of Friends I never watched.

This market is like CNBC, it is looking for any reason to go up. Home sales are higher than forcasted, buy the home builders. Who cares if the prices were down significantly and related to foreclosures.

COF is one of the worst banks with their agressive lending. It will not be long that the same people who can not pay for their houses will not be able to cover their monthly minimum at 25% interest. Plus they have tightened credit standards, so they have fewer new customers, which is how they make money.

This is a great run by the banks and home builders, if you own them this is a great time to sell, if you don't it is a great time to short. There are tons of people out there that have been drowning in these companies and will be getting out now that they have seen a nice bump up.

[User 167355]

Dr., if the banks are so overpriced as you are suggesting, then why do they have such low P/E ratios?

[User 167519]

I agree with Roger, V and MA have very little risk in their business models because: 1) they take no risk in the transaction - they only act as a processing clearinghouse to verify the transaction and available dollars; 2) they also get paid a transaction fee for debit (not just credit) transactions; and 3) this component of the market place has relatively high barriers to entry due to the significant cost to establishing a global network. I think the biggest risk to V and MA is the potential for merchants and consumers to start using a web-based transaction processing solution, but again, the establishment of a global processing network is a huge undertaking (and no, I don't own positions in either V or MA, though I'm considering a modest investment in V). I don't expect credit/debit card transaction volume to decline over the long run, but I'm no expert . . .

[boblicious]

OMG, if this plays out as the author suggests in his well thought out analysis, we are in for an even sharper downturn in the US economy than anyone has been led to expect. Most certainly by the FED, and since they are about out of ammunition we are in for some tough sledding. We're definitely not in Kansas any more TOTO. This could rival the 30's in terms of impact.

[AndrewHorowitz]

Hello and thanks for the comments and input. If you notice, I said that MA and V aside as I am well aware there is little or no credit risk. This article is squarely focusing on Capital One.

While there may be other companies mentioned, that is the ONLY one in focus.

I discussed on recent podcast as well: www.thedisciplinedinve.../



So, with that cleared up... does it make more sense?

Andrew

[djmemphis]

A couple of other things I learned researching this short. How about the fees that COF earned from securitizing its receivables? There is currently no market for these receivables leaving COF with a greater percentage of the rising volume of revolving consumer debt on its balance sheet. Great boost for earnings in the very short term. Further, COF has always had a penchant for issuing multiple credit cards to the same individuals. These are the same individuals that are paying off other credit cards, mortgages and fixed expenses with additional debt. CC debt will be the last to collapse because cc companies are the creditor of last resort. These factors leverage COF's exposure to rising delinquencies. Finally, the first credit cards consumers will allow to go delinquent will be those where they do not have a banking relationship (and thus access to their deposit account). The former Hibernia pales in comparison with Chase and Citi in this area.

Also, in response to one of the previous posts, the economic stimulus will not be a boon to COF as people using it to pay down cc debt will result in less interest income to COF.

I am short COF and about to get shorter. The last quarter at Discover was certainly not an outlier. Thanks for clearing up for me why this stock keeps going up. Dividend boost was free, buy back allows insiders to cash out, and who's left holding the bag? Not me.

[Forrest]

This article is no more than typical boiler-room talk to add support to the author's short position. You may be able make a couple of bucks in a daily short position, but don't look for the big drop to twenty any time soon.

[WAKEUP]

Maxed-out credit cardholders will simply not pay this unsecured debt. There will be millions of these people doing this, in 2008, and beyond. Why will this happen? Because these same people will be using what money they have, to pay secured debt. Then, transaction fees will tank, and maxed-out receivables will have to be written off.

[Iceman]

Your analysis is shallow and dependent on too many surface issues - you ignore the role of the bank integration and actual portfolio underwriting. Dig a little deeper next time.

Hows your short position working out?

[kansas]

Add to the credit card impending disaster, the sub-prime auto and home mortgage business the fact that COF's recent conversion of their deposit systems was a disaster and that their employees have recently collected their annual boneses and hundreds of employees are resigning, I expect the stock to plummet and they will be begging for someone to acquire them. Also, the Hibernia bank employees will becoming to the end ot their contracts in the near future and they will be running out the door. In 2006, when COF acquired NFB, Dick Fairbank and "Johnny-slick&quo... Kanas made about $500 million in compensation and now "johnny-slick&quo... goes around bragging how he cashed in all of his COF stock. Did he do right by the NFB stockholders and employees or for himself?

[AndrewHorowitz]

Is it me? Or has anyone else noticed the venom and lack of constructive comments posted when someone suggests a short? Like clockwork, the name calling and stab-and-run gang posts comments with nothing to add. Come on.. boilerplate? Shallow? I would like to see your analysis.

Hello? I would wager that both Iceman and Forrest are one and the same.

And, shorts working out so far, thanks. (did anyone see the downgrade today?

www.thedisciplinedinve.../

[Wez]

Lol, the only reason I haven't bought any shares (I'm not short either) yet is because of the sheer number of rabid bulls in these forums. We need way more fear.

[canyonal]

can anyone shed light on the changes in bankruptcy law with regard to credit cards?

i thought that credit card debt could no longer be discarded in bankruptcy but will follow the borrower post bankruptcy.

if this is the case then what is the impact on prioritizing payments and subsequently credit card receivables?

[Iceman]

Andrew - short / long - it is an individuals decision - but to publish an analysis of a company that does not even mention its bank integration and how deposits impact its business model is, well, shallow.

[thesession]

Can one assume that if FICO was meaningless in predicting non-prime mortgage defaults, that same credit history is likely to be meaningless in predicting CC defaults as well? Thus subprime CC lenders may not have done a good job in portfolio underwriting. They do have better risk pricing but are unsecured and have revolving credit.

Financing of these portfolios is all time highs. I think you really have to watch the performance trends in the CC portfolios to call this one, most important being "excess spread".

They provide that data on their websites, so follow the trends.

[SubprimeBorrower]

Insider Trades: Cap One Chief Sells 21% of Stake in COF

Capital One Chairman and CEO Richard Fairbank continued his rapid sell off of company stock on Wednesday. Over the past eight weeks Fairbank has sold more than 21% of his shares for a total take of $26,283,955.39.

www.insidercow.com/his...

[Muzie]

Iceman: It's not as shallow as giving out an analysis which consists of blasting out a few words from the SEC filings without any further explanation. If you're not going to contribute one way or the other, please just don't post and move along.

[mysamba]

Subprime Borrower appears to be mistaken about insider trades by Cap One's CEO. The link provided shows that he exercised some options and then sold the acquired shares. In fact, his holdings have INCREASED by about 10% in number of shares over the last year.

[stacked up]

A fabulous article on COF, whose artificially high price should actually be more like $ 35 now, and going down, down, down..
What is holding the price up at $50 plus no less ? Why it must be the
"calm before the storm". Because, this "dog won't hunt"..COF has to be a loser..Unless, we all wake up from this extended nightmare economy, and find ourselves in la-la-land ...
Don't think so, as '08 has tons of pain in store ...Despite the rally days here and there, the market must fall and COF with it ...

[Yes, I'mshort]

Fact is, and this is somewhat directed at the poster asking about the low P/E's, is that a decline in earnings is already priced into these stocks. They should trade at single digit ratios, b/c their earnings stand to fall 50% + People still don't see that, while rising, deliquency statistics and charge offs are still near historic lows. Consumer charge-offs tend to DOUBLE from trough-to-peak, and we've only seen the beginning. Given that the only outsized growth these companies will experience would have to be obtained by subpar underwriting, they deserve multiples of approximately 12x - a fair market multiple. Assume that their profit margins have been unduly high for some time and will contract, and that charge offs will rise, lump in rising financing costs due to the shut down of the securitization markets and I'd say that COF and DFS are trading at multiples of what true, normalized earnings will be of approximately 18-20x. I'd say they have up to 40% to fall once analysts begin to revise estimates and the market begins to discount future earnings.