A Different Kind of Credit-Card Company

The Service Employees International Union has frequently blasted credit-card issuers over the years for abusive lending practices. When the SEIU started searching for a firm to create a branded card for its 2 million members, union leaders demanded fewer fees and less onerous penalties. "We wanted a card that was more consumer-friendly," says Jeremy Smith, a deputy director at the SEIU. "[Most] card companies wouldn't consider our proposal."

Hal Erskine, the founder and president of PartnersFirst, did. In April his Wilmington (Del.) financial firm introduced an SEIU credit card that met the union's tough standards. The card, which has an average interest rate of 16%, doesn't levy annual fees or impose late-payment charges. And PartnersFirst won't hike rates or change terms without the SEIU's permission.

PartnersFirst is a different kind of credit-card company. Started in 2007 with funding from Western Alliance Bancorp (WAL), the fledgling firm has three key tenets: keep rates steady, eliminate fees, and rigorously evaluate the risk of potential customers. PartnersFirst mainly makes money from the interest it charges borrowers, whereas most credit-card companies also rake in huge fees. "I realized that there was an opportunity to give cardholders a square deal and still make a profit," says Erskine, 49, who says he was fired in 2007 from MBNA in the wake of its merger with Bank of America (BAC).

Before the financial crisis hit, a tiny upstart like PartnersFirst wouldn't have been much of a competitive threat. Long-entrenched behemoths Bank of America, Citigroup (C), and JPMorgan Chase (JPM) dominated the industry, with a combined 60% market share. Capital One Financial (COF) now spends $1.2 billion a year on marketing, compared with around $5 million for PartnersFirst. And PartnersFirst hasn't turned a profit in its first two years.

But the landscape is changing. The stalwarts are struggling as defaults rise amid the recession. Then there's the Credit Card Accountability, Responsibility & Disclosure Act of 2009, new federal rules that address everything from billing practices to fee structures—and threaten the industry's earnings. In light of the new law, which takes effect next year, "credit-card companies have to fundamentally change their business model," says Gene J. Truono Jr., a managing director at BDO Consulting and former chief compliance officer at American Express (AXP). The upshot: Some credit-card issuers may have to act more like PartnersFirst.

RAW DEALS?Erskine used to be part of the credit-card Establishment. After picking up his MBA from Wharton School in 1992, he joined MBNA as vice-president of strategic planning. There he pioneered affinity relationships, the deals in which credit-card companies fork over millions of dollars to universities, nonprofits, sports teams, and other institutions for access to their members' valuable data. The cards often are emblazoned with the mascot or logo of the organization.

Credit-card companies have made billions on affinity cards over the years—but regulators and lawmakers worry that consumers get raw deals. Critics say colleges put their financial interests ahead of those of their students, encouraging them to rack up high-cost debt. "Affinity cards started simply as a product that alumni associations could offer members, but alumni boards realized they could bargain for more cash up front," says Lewis Mandell, a professor at the University of Washington's Foster School of Business.

Many schools and alumni associations have defended the agreements, saying the cards are geared to alumni rather than students. But one deal with the University of Michigan that Erskine cemented for MBNA in 2003 suggests otherwise. Under the terms of the contract, MBNA pays the alumni association more for signing up current students than former ones: $6 for each student, vs. $5 for alumni. The association maintains that it helps current students far more than the credit-card program hurts them. "We invested over $800,000 in student programs and scholarships," says Jerry Sigler, the association's chief financial officer. "No logical person would conclude that the best interests of students would be ignored in order to facilitate this program." BofA declined to comment.

Erskine—who signed a confidentiality agreement with his former employer and can't talk much about his tenure at MBNA—recalls that few schools tried to negotiate for better card terms or less intrusive contracts. "Some of the schools got paid up front and turned their heads and held their noses" at the situation, he says. It's not clear whether he ever voiced his concerns to top management. But one former colleague recalls Erskine was uneasy about the industry for years. "He was really uncomfortable with some of the practices that pushed the envelope," says John E. Karzak, a former MBNA executive who worked with Erskine from 1992 to 1998 and is currently chief marketing officer for lender Affinity Financial. "He was essentially an honest guy and thought we could be doing better."

Now Erskine is trying to shake up the status quo. Last year, he pitched the alumni association at Western Kentucky University on his company's new credit card. He asked the 33-member board how many of them carried the school's branded credit card offered by JPMorgan Chase, which featured high late fees and over-the-limit penalties. After an awkward silence, only two raised their hand. Says Erskine: "I didn't blame them because the card was crap." Western Kentucky signed up with PartnersFirst in December. Says a JPMorgan spokeswoman: "Chase is a responsible, careful lender. We constantly evaluate the risks and costs of funding credit-card loans."

Erskine's operation has all the hallmarks of a scrappy upstart. And his team is a rag-tag group of credit-card vets and industry castoffs. "All of us have a little ax to grind," says Erskine. The firm's modest space, a step up from the garage where Erskine first hashed out the idea, seems more dot-com shabby than financial-services chic. The supply closet overflows with yellow balls, a favorite giveaway at pitch meetings. The only art is a framed jersey of hockey player Mario Lemieux.

PartnersFirst's business model is markedly different from that of most card issuers. The firm doesn't impose any fees on its cards. And it doesn't raise interest rates on any of its cards unless borrowers miss two payments. If consumers remain current for six months, the rates drop.

Partners also have a say in the terms of the credit agreements. The Western Kentucky alumni association, like the SEIU, must sign off on any changes in rates or fees. About 500 Western Kentucky alumni have signed up for the card since December. "We felt there had to be a better card out there," says Donald Smith, executive director of the alumni association. "So far, [our alumni] are thrilled with the card."

THE NEW STANDARDWithout fee revenue, PartnersFirst must pay careful attention to lending practices. Unlike many rivals, PartnersFirst doesn't rely solely on computer-generated scores like FICO, those ubiquitous three-digit measures of a consumer's creditworthiness. Rather, analysts review each application by hand, looking at factors such as work stability, job tenure, and payment history. Then every Thursday, Erskine convenes the entire staff to make the final credit decisions over pizza and snacks. "It can certainly get lively," says Harry Tower, PartnersFirst's director of partnership development.

Some of their decisions seem unconventional. Earlier this year the firm wouldn't extend credit to a real estate agent in Florida who made $2 million a year. PartnersFirst figured the borrower's pay would get slashed in the real estate downturn.

Such lending practices could soon become the industry standard. Under the new rules, credit-card companies can't jack up interest rates on a whim. That means they must prudently assess a customer's risk from the outset—or face huge losses when borrowers run into trouble. Most industry experts figure the big companies also will come up with new fees and impose higher rates up front.

As the big players adjust their models, PartnersFirst will be tested. The company, launched during the worst downturn since the Great Depression, is bleeding cash as it continues to invest in the business. But there are signs of improvement. PartnersFirst, which has affinity deals with 60 organizations and nearly 140,000 cardholders, lost $1 million in the first six months of the year. That's compared with a loss of more than $3 million in the same period of 2008. Analysts are cautiously optimistic. Says Sanjay Sakhrani, of research firm Keefe, Bruyette and Woods: "Issuers offering a better product will fare better in this environment."

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkCredit HackersFinance-savvy consumers are gaming the credit-card system in legal ways, according to a recent article in Wired. In one approach, "credit hackers" apply for several cards simultaneously, which lenders typically can't detect. The upshot is that they can "garner dozens of credit cards" and "can take advantage of special offers to get relatively small amounts of free money, or obtain sizable cash loans with zero interest."To read the full article, go to http://bx.businessweek.com/credit-card-industry/reference/

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