It was another tough week for credit cards.
Two issuers, NextCard and Providian Bank, on the same day indicated to their stockholders that they were up for sale, both companies independently retaining Goldman Sachs to explore the opportunities. Providian also retained Salomon Smith Barney.
Providian's announcement was not wholly unexpected, as just a week before the bank said it expects future losses and perhaps significant portfolio deterioration associated with its subprime loans (see ASR 10/29/01).
NextCard's situation may be more perplexing, analysts said. From a regulatory perspective, NextCard is significantly undercapitalized; however, that's primarily because the regulators told NextCard that its securitizations no longer qualify for low-level recourse treatment, which means NextCard must place its securitizations back on its books. In doing this, the company's risk-weighted assets increased nearly 35% to $2.1 billion. NextCard was told that what it had previously counted as "fraud losses" - booking them as expenses, and deducting them from the seller's interest must now be accounted for as credit losses, adding approximately 1.5% to the total charge-off rate.
With the fraud losses factored in, NextCard's charge-off rate is at 7.89%, compared to 4.92% at the end of the second quarter. The company expects delinquencies and charge-offs to stabilize going forward, as the portfolio seasons. So far, both Moody's Investors Service and Standard & Poor's have said there is no reason for immediate ratings action. Fitch did not rate the transactions.
Though NextCard's portfolio is performing well, with charge-offs in the mid-5% charge-off range (minus fraud losses), reclassifying fraud as credit losses requires NextCard to increase its loan loss reserves from the mid-$30 million range to just over $80 million, a source said.
As it stands, the reclassification, combined with the increased risk-weighted assets and an additional $5.6 million reserve account to recognize estimated uncollectible finance charges and fees, has lowered NextCard's tier-one capital ratio - a measure of capital adequacy - to 5.38%, compared to 17.35% at the end of the second quarter.
How they lost
It's unclear exactly why the regulators determined that Next-Card's securitizations would not qualify for low-level recourse, and how that decision is associated with the reclassification of the fraud losses, as NextCard stated in a release. Officials at the company declined to comment beyond what was publicly released.
However, an outside source familiar with the situation said that the regulators are, somehow, taking action on NextCard in a retrospective manner. In traditional credit card securitizations, fraud losses are deducted from the seller's interest, because they are not considered credit losses, which address a borrower's ability to pay. Fraud risk, on the other hand, addresses borrower (or card user) motivation to pay, which is why it is not typically considered part of the credit risk to be transferred in a securitization.
Since the fraud loss is now being reclassified as credit loss for NextCard, the loss will flow through the master trust, and be deducted from the buyer's interest, as per the rules governing credit losses. In a surprising move, the regulators are saying that, if the fraud loss is reclassified, it should be reclassified as credit loss retroactively as well. If this analysis is applied, than credit losses have been deducted from the seller's interest all along , and thus credit risk is not truly transferred in the securitization. This would mean that NextCard has been subsidizing the securitizations by deducting credit loss (previously fraud loss) from the seller's interest, the source said, even if that deduction was arguably inconsequential. If NextCard was subsidizing its securitization, it would not qualify as true-sale from a regulatory perspective.
During an investor conference call, Chief Executive Officer John V. Hashman argued that under the Generally Accepted Account Principles (GAAP), NextCard's securitizations still qualify as true-sale.
"We believe, and we have been supported by our accountants and legal counsel in this regard, that the categorization of fraud losses and changes in accounting procedures do not violate recourse treatment," said Hashman. "This categorization would have a negative impact on any credit card company to capitalize and fund its growth. We have formerly challenged the decision of our regulators, which we believe is not supported by regulatory precedence."
A source close to the regulators said that the appeals process with the Office of the Comptroller of the Currency has worked in the past, and noted one instance where a decision which had placed securitizations back onto a bank's books was reversed."What you're seeing is post-Superior Bank hysteria," the source said. "This is just the tip of the iceberg."
Being "significantly undercapitalized" restricts Next Bank, the NextCard bank holding company, from accepting brokered deposits, a fundamental source of funds for banks. NextCard also suspended or limited certain line management programs, secured card originations, repricing programs, and fee based product strategies, Hashman said. The company said it had increased its FICO threshold to 680 and above, in complying with regulators and bracing the weakening economic conditions, even though the company already targets the upper prime segment of the market.
Because NextCard is a 100% Internet origination platform, it is exposed to fraud unique to the Internet origination channel, the company said.
We're for sale now
Though most players agree that NextCard's problems are not credit problems, some more bearish analysts are concerned that the fraud issue raises uncertainty with the entire platform.
"Traditional credit card fraud is when someone steals a credit card and uses it," an analyst said. "This is identity theft. It's all new. It calls into question the integrity of the entire pool."
Still, conventional credit card wisdom assumes that fraud loss is front-loaded, because these accounts would be identified in the first month or so after origination, so as the pool seasons, the fraud dissipates. What's more, if NextCard is in fact slowing down origination with these new regulatory constraints, the fraud factor would decline significantly.
"If I could get my hands on NextCard triple-As right now, I'd be buying it up," said a banker following the developments. "It may be an opportune time to buy them cheap, if you believe, as I do, that portfolio will be picked up in a short time."
That banker added that, since the securitizations aren't considered true-sale anymore, NextCard, or whoever ends with the portfolio, could tweak it further if credit issues did arrive, not having to adhere to recourse guidelines.
The banker referenced a First Union credit card deal from a few years ago, where First Union actually discounted the receivables to add yield to the portfolio, losing true-sale status, but injecting excess spread into the trust.
Sources anticipate that NextCard will get picked up fairly soon, given its size (just $2 billion).
Speculations of potential suitors include Capital One, which recently purchased one of the only other 100% online origination concerns, PeoplesFirst.com.
"NextCard could end up with the First USA and Bank One companies," one source said. "They just bought Wachovia's portfolio this year. They're back on the acquisition path."