Rebuilding the House of Cards
June, 2010 (Bloomberg Markets)-- After writing off a record $89 billion in 2009, U.S. credit card issuers are dumping risky customers and competing to sign up richer, more-stable payers.
William “Wild Bill” Janklow’s law office in Sioux Falls, South Dakota, is crowded with mementos from his 16 years as a Republican governor. On a low, wooden bookcase, near bottles of hot sauce custom labeled for his annual Buffalo Roundup, he keeps a 4-foot length of red ribbon festooned with Citibank credit cards.
Janklow is the politician who, in 1981, brought Citibank to South Dakota. When he cut that ribbon to welcome the New York- based bank, he blew the lid off the U.S. credit card business, Bloomberg Markets reports in its June Issue.
The law inviting Citibank to South Dakota threw out limits on how much interest the state’s banks could charge borrowers -- rules known as usury caps.
“Citi wanted the invitation, and they knew what we were doing with rates,” Janklow says. In a secret meeting at the governor’s residence with Walter Wriston, chief executive officer of Citicorp, the bank’s parent, Janklow agreed to drive through the legislation in a swap for 400 jobs.
“That was the deal,” Janklow says. “You have no idea, in a state of 750,000, how many 400 jobs is, all in one place.”
The business Janklow and Wriston set in motion with a handshake that evening transformed U.S. consumer lending. Once interest rates were allowed to rise as high as banks could push them, credit cards became a ticket to enormous profit. In the decade ended on Dec. 31, 2007, credit card issuers together earned more than $50 billion, mostly on the difference between their own cost of money and consumer rates of as much as 30 percent. So-called subprime lenders pitched rates as high as 80 percent. At JPMorgan Chase & Co., cards accounted for 20 percent of both revenue and profits in 2007.
“The credit card business has been a critical driver for these companies; it was the single most profitable product in the lending arena next to mortgages,” says Richard Bove, an analyst at Rochdale Securities in Lutz, Florida.
Then the harshest economic decline since the 1930s crushed the job market, and a record number of card holders stopped paying their bills. The three biggest card-issuing banks lost at least $7.3 billion on cards in 2009. Bank of America Corp., after earning $4.3 billion on cards in 2007 -- a third of its total profit -- swung to a $5.5 billion loss in 2009. JPMorgan Chase lost $2.2 billion last year on cards and, in mid-April, reported a $303 million loss for the first quarter.
“We have a business that is hemorrhaging money,” says Paul Galant, CEO of Citigroup Inc.’s card unit, where Citi- branded cards lost $75 million last year. The bank won’t disclose how much it lost on cards it issued under the names of retail stores.
At the same time, the card issuers’ bottom line is being hurt by a new federal law forcing them to be more transparent about fees and interest charges. U.S. credit card issuers wrote off a record total of $89 billion in card debt in 2009 after losing $56 billion in 2008, according to R.K. Hammer Investment Bankers, a Thousand Oaks, California-based adviser to card issuers.
U.S. credit card delinquencies and write-offs tend to track the national jobless rate. When unemployment jumped to 10.1 percent in October, card industry loan write-offs hit 10.4 percent, according to estimates from Moody’s Investors Service.
American Express Co., Capital One Financial Corp. and Discover Financial Services, which only in recent years became banks, fared better than Bank of America, Chase and Citigroup. They made money in 2009 after more-cautious lending during the boom years, which limited the rise in defaults. The sea of red ink began to recede in the first quarter for Charlotte, North Carolina-based Bank of America. It reported $952 million in profit from cards in the quarter after releasing reserves set aside in 2009 to cover future defaults.
Turning around their card units may be more important than ever to the banks in the wake of the U.S. Securities and Exchange Commission’s lawsuit accusing Goldman Sachs Group Inc. of fraud, says Michael Holland, who oversees more than $4 billion as chairman of Holland & Co. in New York. The case is focusing Washington’s lens on regulating the derivatives market, which could weigh on the big banks’ trading operations, he says.
“I look at cards as able to do well when other parts of the business aren’t,” says Holland, who owns shares of JPMorgan. Still, he thinks the days of immense profits in cards may be over. “The future may not be as good as the past,” Holland says.
As the economy revives, defaults will ease. Washington’s assault on the industry may not. In February, the Credit Card Accountability, Responsibility and Disclosure (CARD) Act wiped out many of the banks’ most lucrative billing practices, including their ability to raise rates on existing debt at any time.
Now, the banks have to give cardholders 45 days’ warning on any rate rise and can’t apply a new rate on existing debt. JPMorgan Chairman and CEO Jamie Dimon said during an earnings conference call in April that the changes will cost his bank up to $750 million in 2010. Banks overall may lose $50 billion in revenue during the next five years, including $11 billion in 2011, because of the legislation, says Robert Hammer, CEO of R.K. Hammer Investment Bankers.
Congress isn’t finished. A proposal for a U.S. consumer finance protection agency, which would police how banks deliver and service financial products, has passed in the House and was being discussed in the Senate as of mid-April.
Credit card customers, meanwhile, are still furious after years of rising rates, snowballing fees and less time in which to pay their bills. Citigroup’s Galant, who took over in April 2009, gets hundreds of e-mails a month.
‘Angry at Us’
“They are angry at us; they are angry at the system; they are angry at the government,” he says. “All they want to do is get back to a peaceful existence.”
The lenders are busy reinventing themselves and the risk models they used to justify passing out plastic to almost anyone who would take it. They had come to rely on computer-generated data to assess borrowers.
“We have shifted to more judgmental lending,” says Susan Faulkner, who took over Bank of America’s card operation in early March.
That means they’re putting human eyes on applications and judging borrowers on, for instance, the type of mortgage they hold. “Instead of starting with the product, we are starting with the customer,” Faulkner says.
The borrowers that card issuers want are richer and more- stable payers than the hordes they marketed to during the boom years. The least-creditworthy customers are being dumped.
Shrinking Credit Lines
The big six issuers have trimmed total credit available to their customers by about 25 percent partly by shrinking credit lines and not renewing expired cards, says Moshe Orenbuch, a bank analyst at Credit Suisse Group AG in New York.
The number of cards in circulation has declined to 576 million from 708 million in 2007, according to the Nilson Report, a Carpinteria, California-based industry newsletter. Customers bear some responsibility for the mess, Faulkner says.
“The business has to be right-sized,” she says. “There was too much credit extended; customers overextended themselves in the use of that credit.”
To hang on to their richest and most reliable payers -- and increase their fee revenue -- the banks are inventing new premium cards and adding to rewards programs. Those willing to pay $85 a year for a Chase Sapphire card, for instance, are guaranteed a live person will answer if they call. They also receive a yearly “dividend” of 7 percent of the reward points they have accumulated.
In November, Chase also offered a co-branded card with British Airways Plc that gave 100,000 miles to any customer who signed up and spent $2,000 in the first three months of membership. That’s more than enough points for a round-trip plane ticket from the U.S. to Europe. Chase has since scaled back the reward to 30,000 points.
They’re all chasing American Express, which has long catered to a wealthier group. The firm made $2.1 billion in 2009, helped by expense cuts and a default rate that was among the lowest in the big six. The company’s stock was the top performer in the Dow Jones Industrial Average in 2009, returning 118 percent.
Total spending per American Express card averaged $8,665 in 2009, compared with an average of $3,073 for cards issued by banks that partner with San Francisco-based Visa Inc. and Purchase, New York-based MasterCard Inc., according to the Nilson Report.
“Everyone is trying to be American Express,” Orenbuch says. Down the line, he says, the competition may mean better pricing for the most-creditworthy customers.
The razzle-dazzle isn’t working yet. U.S. cardholders, still stung by recession, have spent less on plastic. Revolving debt fell by $9.4 billion in February, according to the U.S. Federal Reserve, compared with the same month a year earlier. Overall, consumer credit fell in February for the 12th time in 13 months.
“The banks are feeling the squeeze,” says Elizabeth Warren, who chairs the Congressional Oversight Panel of the government’s Troubled Asset Relief Program and has written four books about debt and the American middle class. Warren, who turns 61 in June, was first to map out the idea for the consumer agency, which President Barack Obama supports.
“Everyone has more credit cards than they want,” Warren says, sitting in the cafeteria of the Russell Senate Office Building on Capitol Hill before heading to a meeting at the White House. “There is no more growth.”
Shifting demographics, abetted by the financial crisis, will limit demand for consumer credit for years to come, says David Robertson, publisher of the Nilson Report. The business gathered steam as the post-World War II baby boom generation hit their peak spending years, he says. The next generation is smaller and, coming off the market crash, more cautious.
“There was a fantastic opportunity for the industry to grow with the baby boomers,” Robertson says. “Now you simply don’t have as many people entering their prime years.”
Gordon Smith, who joined JPMorgan’s Chase Bank as CEO of card services in 2007, has a different view. As the U.S. population grows, so will the card business, he says. Long-term behavioral changes, such as Internet shopping and the decline of checks and cash, are spurring the credit- and debit-card business.
“My guess is that the piece of plastic will be in place for a very long time,” Smith says.
JPMorgan Chase, the biggest U.S. card issuer with 145 million accounts and $163 billion in outstanding loans, more than doubled its direct mail offers in the last three months of 2009 from the previous quarter, according to Mintel Comperemedia, a Chicago-based firm that tracks such offers.
“We intend to go after all the best customers of all of our competitors,” Smith says.
The challenge is to sort out the good risks from the bad.
“There is a segment of people who will have a lot less credit available,” Smith says.
Chase has revved up models that compare customers’ total debt level with their income. The bank will likely end up offering credit to about 15 percent fewer customers, Smith says.
To Warren, who is also a Harvard Law School professor, pulling credit from the riskiest borrowers may be necessary. Many low-income cardholders, she says, were drawn in by “tricks and traps,” such as time-limited low rates.
“Millions of American families can’t pay off their credit card bills right now,” says Warren, who estimates that they’re spending $100 billion a year on fees and interest-rate payments. “Are their economic lives better off because they are spending the hundred billion? I don’t think so.”
Warren says most people, regardless of income, should still have some access to consumer credit. She is pushing for lower rates and fees and simpler, more transparent marketing of terms.
“If the business model is to offer credit to every man, woman, child and dog in America in unlimited amounts, it just doesn’t work,” she says. “If it’s to offer a cheaper credit product to people who become more likely to pay, then that is sustainable.”
Bank of America’s Faulkner, who oversees $677 billion in deposits as well as a $150 billion card portfolio, says she has paid attention to surveys showing that customers want more clarity. In September, the bank slapped the decades-old brand name BankAmericard on a basic card, which has one rate (prime plus 14 percent) and one flat fee for late payments ($39). On its Web site, the bank cites its single-page disclosure form as a “key feature.”
“This was answering an unmet need,” Faulkner says.
20 Million Cards
Given the size of her franchise, Faulkner has a long climb ahead before she returns to a time when credit cards were Bank of America’s most reliable profit center. In 2006, CEO Ken Lewis paid $35 billion for MBNA Corp. and its 20 million card customers.
Until the first quarter, Bank of America’s card business had posted six straight quarterly losses, with many of its delinquent borrowers in parts of the country such as California, Florida and Nevada that were hardest hit by the collapse in housing prices.
At Citigroup, Galant is rethinking how revolving, unsecured lending relates to its customers’ other banking products. Among Citigroup’s ideas: the Forward card, which allows customers to earn a 0.25 percentage-point drop in their annual percentage rate, or APR, for three months of paying on time.
“Everybody now is saying, ‘We are going to pick the clients that we think are really safe bets,’” Galant says. “But what about the other 90 percent of people?”
Citibank passed out $80 billion in new credit to borrowers in 2009, including $21 billion in the fourth quarter, spokesman Samuel Wang says. The company is 27 percent owned by the U.S. government.
In Sioux Falls, Citigroup has grown to more than 3,000 employees in 28 departments from those 400 employees promised to Janklow in the 1980s. They occupy a 76-acre (31-hectare) campus near the airport, in three broad, low buildings, which include a day-care center and kindergarten. About 1,200 people work in the 24-hour customer service unit, where most sit in grayfabric cubicles wearing headsets and taking calls from people who are having trouble with their credit cards.
Citi has enhanced efforts that let borrowers delay payments or reduce their interest rates, Wang says. The bank offers incentives and a consolidation program to help reduce card balances. About 490,000 people signed up for such help in the fourth quarter of 2009, compared with about 357,000 a year earlier, Wang says.
‘Hell of a Problem’
Three decades ago, Wriston had urgent business to conduct when he flew to South Dakota. Wriston, who ran Citicorp from 1970 to 1984, was struggling in the aftermath of the high inflation and interest rates of the time. In February 1980, the fed funds rate was 13.35 percent; New York law, meantime, had a statutory cap on consumer lending of 10.5 percent. Citi was losing money on every credit card loan it handed out -- even before factoring in accounting expenses and credit losses.
“Citibank had a hell of a problem,” Janklow says, reminiscing during a three-hour dinner on a March evening at Foleys Steakhouse in Sioux Falls.
Wriston had learned that South Dakota’s bankers were already pushing to jettison the state’s usury caps and that the legislature was in session and might be able to move fast, he says. When the law that some still call the “Citibank bill” passed, “I became a celebrity in credit card circles in America,” Janklow says, with a laugh.
Delaware Joins In
A year after South Dakota lifted its rate caps, Delaware also relaxed its usury rules. JPMorgan and Bank of America’s card businesses are both based in the Middle Atlantic state. Federal law allows banks to lend according to the rules of the state in which they are based.
Once South Dakota and Delaware knocked the lid off interest charges, the U.S. credit card business exploded. A big player in the 1990s was Capital One, which began as the credit card arm of Richmond, Virginia-based Signet Bank.
Capital One developed computer programs designed to assess customers’ shifting risk profiles. The statistical modeling allowed for a much broader range of rate offerings in which stable customers would get lower rates and riskier borrowers could be charged more.
With data suggesting that handing out more credit was a safe bet, card issuers bumped up limits, passed out second and third cards to existing customers and marketed to a broader group.
As the years passed, banks were lulled into thinking they could manage any economic downturn, Nilson Report’s Robertson says. They didn’t bargain for a sudden, severe economic plunge.
“The industry believed that they had enough experience to manage unsecured credit to higher risk consumers,” Robertson says. “But no one anticipated the depth of the recession and the impact it would have on jobs. The unemployment rate is the smoking gun.”
Still, bank adviser Hammer says, the card business isn’t going anywhere.
“The customer got lost in the days of easy money,” he says. “Now they just have to be much smarter about how they do all of this.”
Janklow, the man who brought those jobs to Sioux Falls, was re-elected governor of South Dakota in 1982 with 72 percent of the vote. He served again from 1995 to 2003 and was elected to the U.S. House of Representatives. Then, his career was marred by tragedy.
In August 2003, while driving a Cadillac near his home, he struck and killed a motorcyclist. He was found to have been speeding and to have gone through a stop sign; he was sentenced to 100 days in jail. He left public life and is now practicing law.
Janklow is sympathetic to the woes of the industry that helped make his career, he says. Yet he understands the public anger at the high rates and fees. He still uses an AT&T-branded credit card he got in the 1980s because he was guaranteed no annual fee for life.
“There is an old saying in capitalism: ‘What you abuse, you lose,’” Janklow says.
The question now is whether the executives running the credit card industry have gotten the message.
#<535521.224522.214.171.124.17993.25># -0- May/20/2010 20:12 GMT