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Time to clarify ‘true lenders’

John Costa, Managing Director of Auriemma Finance, has published an article in American Banker’s BankThink section. The piece describes how recent court cases have created confusion over the powers of national banks, with some findings in conflict with longstanding precedent. In the piece, Costa argues that Congress needs to clarify and reiterate certain legal principles, such as “valid when made,” in order to reaffirm the national bank regulatory model.

You can read the full story here: Dear Congress: Time to clarify ‘true lenders’

For more information, contact John Costa at john.costa@auriemma.group or 212-323-7000.

 

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Four Things for FinTechs to Consider Before Filing a Bank Charter Application

(New York, NY):  All eyes are on FinTech following the announcements last month from the Office of the Comptroller of the Currency (OCC) and the U.S. Treasury Department supporting financial services innovation. The OCC’s decision to start taking applications for a new Special Purpose National Bank (SPNB) charter for FinTech companies is particularly intriguing. While the new OCC charter represents an opportunity for FinTechs to gain national bank powers, there is a long path ahead for any organization wishing to explore this option. Potential challenges include understanding the legal underpinnings of interest rate exportation, weighing the relative value of taking deposits, understanding the impact, if any, of the Bank Holding Company Act, and evaluating the advantages and disadvantages of a bank partner model.  For those FinTechs that elect to pursue a bank charter there is the prospect of a lengthy regulatory review process and the challenge of integrating a complex compliance framework into a technology platform.

While the OCC SPNB charter may be the newest way to facilitate FinTech lending, it isn’t the only option. Other choices include the “State Finance Company” model, in which companies must comply with the usury laws and regulations of each state in which they operate, the “Bank Partner” model, as well as the recent reemergence of the Industrial Loan Company (ILC).

Each FinTech now finds itself at a regulatory Rubicon: To either take control of its destiny by embracing one of the available bank charters, with all of the attendant compliance and regulatory challenges; or to remain a non-bank technology company, dependent on a bank partner or subject to multi-state laws.

Here are four of the most important factors for FinTechs to consider now:

  1. Determine the importance of interest rate exportation to your business.

All models with the exception of the State Finance Company model enable the exportation of interest rates, to some extent. FinTechs need to compare the strengths and weaknesses of the exportation rights available through the OCC SPNB model, the Bank Partner model, and the ILC charter model.

In recent years, there have been challenges to the legal framework that supports the Bank Partner model. The claims raised in recent lawsuits allege that when a non-bank entity purchases or funds a loan, the originating bank in fact is not the lender, but that rather, the non-bank entity is the “true” lender, notwithstanding that the bank did in fact underwrite and originate the loan in question. Courts are reaching conflicting conclusions in these cases: Some have identified the originating bank as the true lender while others have ruled that the non-bank is the true lender.

If rate exportation is important to a FinTech, thinking through the advantages of all models and charter options in detail will be paramount.

  1. Consider the need for deposit funding.

The FinTech models for lending, including “peer to peer” and “marketplace” lending, do not require deposit funding.  This type of pass-through model, which has the benefit of a much lower capital requirement, needs only a “warehouse” type of funding which can be supplied by other banks or capital market participants.  But some FinTechs have concluded that building a large portfolio of on-balance sheet loans in an aggregation facility may allow them to access even lower-cost securitization funding. For such FinTechs, deposit funding could be very advantageous.

FinTechs will need to decide if FDIC-insured deposit-taking ability is a critical need. The bank charter options vary – for example, the ILC model provides deposit taking, but the SPNB does not.

  1. Consider the requirements of equity investors – now and in the future.

In the US, there has been a longstanding concern over mixing commerce and banking. Under the Bank Holding Company Act (BHCA), a private equity firm that holds a controlling interest in a bank may be deemed a bank holding company, which may result in restrictions on other business investments. For a FinTech with private equity or venture capital investors, the BHCA restrictions may be a deal killer.

Having an ability to export interest rates or to take deposits may be hugely beneficial, but if it comes at the expense of raising equity capital it may be a non-starter. ILCs operate under an exception to the Bank Holding Company Act and have been established by some of the major US industrial businesses, such as General Motors, Ford, GE Capital and others.

Obviously, the Bank Partner model does not impose BHCA restrictions on investors in a FinTech business. With regard to the SPNB charter, the US Treasury Department has encouraged reconsideration of the definition of “control” under the BHCA.  If properly addressed, this could free some SPNB investors from the constraints of the BHCA.

  1. Weigh the risk represented by a Bank Partner.

The Bank Partner model has a long and successful track record, but a FinTech that relies upon a Bank Partner is always at risk of exogenous events impacting the Bank Partner and curtailing the FinTech business.  Some FinTechs may choose to address this by having more than one Bank Partner. Ultimately, a FinTech must decide how much control over its own destiny it requires.

How Auriemma Can Help

For FinTechs weighing the options, there are numerous considerations on the road ahead. Auriemma executives have experience working with regulators to successfully obtain necessary approvals with respect to various types of bank charters. Auriemma is actively exploring the nuances of these charter options to assist FinTechs in making the best possible strategic decisions.

In addition to identifying whether to pursue a charter and pinpointing the advantages and disadvantages of each model, FinTechs must also develop policies and procedures and operational infrastructure that align with their chosen direction and strategy. As a result of our decades long industry roundtable practice, we have extensive benchmarking data and “best in class” operational know how which can help new lenders.

About Auriemma Group

For more than 30 years, Auriemma’s mission has been to empower clients with authoritative data and actionable insights. Our team comprises recognized experts in four primary areas: operational effectiveness, consumer research, co-brand partnerships, and corporate finance. Our business intelligence and advisory services give clients access to the data, expertise and tools they need to navigate an increasingly complex environment and maximize their performance. Auriemma serves the consumer financial services ecosystem from our offices in New York City and London. For more information, call John Costa at (212) 323-7000.

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As CECL Adoption Nears, Implications for Credit Card Issuers Mount

(New York, NY):  As the time for Current Expected Credit Loss (CECL) implementation draws closer, most credit card issuers are working feverishly to develop workable models by the relevant deadline – 2019 for SEC filers, 2020 for non-SEC filers. CECL is intended to better capture the inherent credit loss exposure within a loan by measuring the total expected credit loss over the entire life of the loan, as opposed to other time frames, such as the next 12 months.

While the CECL standard applies to lending broadly and will not be overly burdensome for many types of loans, the new standard presents an unusual challenge for credit card issuers. The heart of the problem is the calculation of the “life” of a credit card loan. Since credit card accounts are revolving facilities, determining the life of a credit card receivable requires adoption of certain modeling positions. While the industry has not reached firm conclusions on modeling conventions for CECL, issuers have been discussing the implementation’s challenges at Auriemma’s Card Accounting Roundtable, where CECL has been a continual agenda item for the last two years.

Some of the major considerations currently under review by issuers include:

Allocation of payments. While the CARD Act stipulates certain rules for the allocation of payments, issuers are looking at other payment allocation methods for CECL. Under the CARD Act, principal payments are directed at the highest outstanding interest rate balances first (a credit card loan may have certain balances at higher rates than other balances – e.g., a 0% teaser rate for a purchase, but a 16% interest rate on other outstanding amounts). While this statutory principal allocation is intended to give the most benefit to the consumer, it can needlessly complicate the sizing of the credit loss reserve. An alternative payment allocation method called FIFO (First In, First Out) would allocate principal to the oldest balance first.

Portfolio segmentation. Any credit card portfolio is comprised of thousands (in some cases, millions) of individual accounts. Some of these cardholders will always pay the minimum amount due, some will pay the entire outstanding balance, and some will pay an amount between the minimum and the entire balance. (Using the average payment amount in a portfolio-wide calculation may give a distorted result: a portfolio with 50% minimum payers and 50% transactors will likely have more risk than a portfolio where everyone pays 50%.) While the correlation between payment amount and credit risk is not perfect, there is the general understanding that minimum payers are likely to produce a higher rate of loss than cardholders making more than a minimum payment.  Most issuers, therefore, will want to calculate a loss exposure on multiple segments.  Segmenting into the three categories mentioned (minimum, full, partial) would seem to be the most basic level of analysis and some card issuers will stratify their accounts into numerous payment cohorts (deciles).  Beyond payment amount segmentation, issuers are also considering segmenting by other characteristics: months on book (longevity of customer), credit score, origination channel, etc. The CECL for the entire portfolio would be the sum of each CECL value for each segment. Further complexity is created by combining variables – for example, payment amount and FICO score.

The current lack of industry standards or modeling conventions has created great uncertainty among card issuers. This lack of consensus makes issuer comparisons fraught with complexity. While the original impetus behind CECL may have been a desire to create additional loan loss reserves, the lack of standards may result in widely divergent loss assessments for portfolios of comparable credit quality.

In addition to CECL modeling challenges, there are other concerns for issuers, such as governance and oversight.  Should responsibility for CECL rest with credit risk, accounting, both or elsewhere?  Generally, capital issues are managed at the enterprise level for large, multi-line banks.  For these banks, CECL governance may be distant from the individual lines of business, increasing the likelihood that the modeling does not reflect the idiosyncrasies of the credit card business.

CECL will also have an impact on credit card portfolio M&A. In many instances, portfolio purchasers will have limited historical loss information for an acquired portfolio. Since the CECL model is based on historical loss experience, an acquirer will need to look for similar quality assets to derive a loss proxy.  This additional ambiguity may result in a wider range of market prices for a given credit card portfolio.

Since increases in the loan loss allowance reduce operating income, the CECL adoption may have the unintended consequence of reducing lending capacity.  Moreover, for an issuer with a growing credit card business, the CECL adoption is not a “step change” function but will be continuous.

Finally, issuers are preparing for a period of “parallel testing” where the loan loss reserve is calculated under CECL and under the previous methodology.  But this begs the question: why a parallel run?  It suggests that comparing the outcome of the CECL levels to levels under the prior methodology may lead to further mischief.  If a card issuer calculates a lower level of loan loss allowance under CECL, will regulators require the pre-CECL methodology? A loan loss “ratchet” might be in the offing, just as the Collins Amendment became a “floor” under the new Basel III regulatory capital rules.

These are just some of the considerations that credit card issuers are weighing in the CECL implementation planning.  Auriemma is involved in these matters in multiple ways including, notably, its Card Accounting Roundtable, writing comment letters to FASB, as well as bespoke consulting work.

About Auriemma Group

For more than 30 years, Auriemma’s mission has been to empower clients with authoritative data and actionable insights. Our team comprises recognized experts in four primary areas: operational effectiveness, consumer research, co-brand partnerships, and corporate finance. Our business intelligence and advisory services give clients access to the data, expertise and tools they need to navigate an increasingly complex environment and maximize their performance. Auriemma serves the consumer financial services ecosystem from our offices in New York City and London. For more information, call John Costa at (212) 323-7000.

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The Challenge of CECL for Credit Card Issuers

For many years, the credit card industry calculated the loan loss allowance (the ALLL) as an estimate of losses projected over the next ten to twelve months.  This long-standing practice is now about to be overturned. While card issuers have not disclosed the likely impact of the new approach, a doubling of the loss allowance would not be far-fetched. This change in methodology will only magnify the recent acceleration in credit losses.  It is imperative for card issuers to start communicating with the investment community about this change now, before the financial impact is felt.  Without a proper understanding of the accounting rule change, investors will conclude an increase in the loan loss allowance is a signal that credit quality is deteriorating, which may or may not be the case.

Why did the accounting profession feel compelled to change a long-standing practice? Back in 2008, when the world was trying to come to grips with the global financial crisis, the Financial Accounting Standards Board (FASB) embarked on a project to improve the estimation of a lender’s credit exposure.  The theory was that by moving from an incurred loss model to one which captured the expected credit loss associated with a loan exposure over its complete term, banks and other lenders would be better prepared to endure a future credit crisis.  FASB conducted a long evaluation and comment period which ended in June 2016.  The result, Accounting Standards Update (ASU 2016-13) Financial Instruments – Credit Losses (topic 326), is not yet adopted.  The new standard has far reaching implications and FASB has provided a long lead time for implementation (essentially 2019 or 2020 depending on the classification of the reporting entity).

One of the core concepts of the new ASU was the “Current Expected Credit Loss” standard – or CECL.  CECL requires that the lender estimate the expected credit loss over the life of the loan exposure.  While this is challenging for any lender, it is easier for amortizing term loans than for revolving loans.  In particular, for credit card issuers, determining the “expected life” of a credit card receivable (loan) is inherently complex.  What is the life of a credit card loan? One month, one year, ten years?  Since credit cards give the borrower a payment option (minimum, partial or full), determining the life of a loan exposure is challenging.  Quite obviously, CECL could result in a much higher loss allowance if the life of the average credit card loan were deemed to be longer than one year.

After receiving numerous comment letters from industry participants, the FASB created the Transition Resource Group for Credit Losses (the TRG) so that FASB and the industry could develop practical conventions for implementation of the proposed new standard.

The TRG worked on the knotty problem of the “life of loan” for credit cards.  One of the key areas of focus became the application of principal payments.  Beyond the borrower’s right to vary the payment amount, there was also the question of the allocation of principal payments received by the issuer.  Prior to the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the CARD Act), issuers used various payment allocation methods to prioritize the distribution of principal payments.  CARD Act, among many other changes, required issuers to apply principal payments to the outstanding balance with the highest interest rate first, until the high rate balance was reduced to zero or the principal payment was fully utilized.  Applying principal this way was clearly designed to benefit consumers by having the highest rate balances amortize faster than lower or teaser rate balances.

When card issuers began to consider how to implement CECL for their business, they faced a quandary: allocating principal payments according to the CARD Act could make the estimation of the life of loan even more complicated. Should an issuer assume that the life of a current card loan outstanding can vary with subsequent purchase activity, even if the issuer is not legally obligated to fund future activity?

In June 2017, the FASB reviewed a paper (and examples) prepared by the TRG to propose one of two possible solutions to the credit card payment allocation problem.    The first suggestion, “view A,” was a first in, first out (FIFO) allocation where the oldest balance received the principal payments until it was completely paid (or charged off).  This had the virtue of simplicity and consistency.  The second suggestion, “view B,” was more complicated but attempted to closely follow the CARD Act allocation.  While this may have the theoretical advantage of more accurately reflecting the life of a loan, the complexity of this approach was obvious.

The FASB concluded that while it could see no reason to prohibit either approach, it did see View A as more practical.  The staff also recognized that View A was more consistent with the intent of CECL that the loan loss estimate was for the balance at a point in time.  Moreover, since credit card lines are unilaterally revocable by the issuer, including future purchases would essentially change this from a “life of loan” calculation to a “life of loans” calculation.  At a meeting of the TRG on October 4, 2017, the Board agreed to provide further guidance on the acceptability of both views in a future new guidance Update 2016-13.

The credit card industry has enjoyed years of record profitability and near historic lows in both interest expense and credit loss expense.  Now, as credit losses have begun climbing, the move to CECL will have a compounding effect on the loan loss allowance.  In addition to the advance warning and education that issuers should be starting, perhaps there will be other actions that issuers can take post-adoption.  For example, should issuers calculate the allowance using the old methodology as a “non-GAAP” additional metric to be included in the MD&A section of financial statements?  For some long-time industry analysts, this would have the benefit of allowing easier comparisons to prior reporting periods.  Perhaps after one or two years of reporting under the new standard the old calculation can be dropped but including it for at least a transition period would no doubt be helpful.

There has been much media attention paid to the rising loss rates for card issuers, but there has been little discussion about the coming impact of CECL on card issuer profitability.  The credit card business will remain the most profitable lending area for US banks, but expect the future levels of profitability to “reset” at a lower level. The onus is on the card issuers to help investors understand that, at least in this case, the change in profitability may be more a function of convention than credit.

 

About Auriemma Group

Auriemma is a boutique management consulting firm with specialized focus on the Payments and Lending space.  We deliver actionable solutions and insights that add value to our clients’ business activities across a broad set of industry topics and disciplines.  Founded in 1984, Auriemma has grown from a one-man shop to a nearly 50-person firm with offices in New York and London.  For more information, contact John Costa at (212) 323-7000.

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Bolstering Credit Card Profitability Despite Challenging Economic Indicators

(New York, NY): It’s been quite a while since the U.S. credit card industry has had to worry about profitability.  Nearly a decade of close-to-zero funding cost and below-trend losses were the perfect mix for very healthy margins, even after increasing both consumer rewards and co-brand partner compensation.  But lately, new data is emerging that suggests the good times may be waning.

From 2012 to 2016, US credit card issuers experienced a gradual erosion of profitability.  Net income as a percentage of average assets fell from a high of 6.6% to 2.7%, according to the FDIC.  In this context, the results of the 2017 stress tests, in which credit card assets represented the largest potential credit risk for the large bank holding companies, seems more understandable.

While a net return on assets (ROA) of close to 3% is still a healthy profit margin by banking standards, the downward trend is unmistakable. (It’s particularly noteworthy that this erosion was concurrent with historically low interest rates.) And there are new risks to profitability: data from Auriemma’s Industry Roundtables indicate that the top 11 U.S. card issuers’ average quarterly loss rate increased 13.4% between the fourth quarter of 2016 and the first quarter of 2017, signaling that the increasing credit loss trend has not yet abated.

While these trends are gathering force, it’s important to note that the credit card industry has seen difficult times before and has always been able to adjust and rebound.  Here is a potential roadmap for this situation.

The first step for all players, regardless of size, is to conduct a deep-dive portfolio review. By identifying which segments are most vulnerable to deterioration, an issuer can more closely tailor possible solutions.  Ideally, the segmentation should be more than just a FICO or risk segmentation and would include profitability metrics as well. While the CARD Act has essentially eliminated the ability to re-price for credit migration, calculating profitability for each FICO band (or other risk metric) is still a critical step in evaluating the portfolio.  This analysis can be optimized with segmentation by either origination vintage or by origination campaign. Of particular importance: vintage analysis for any change-in-terms (CIT) portfolio actions. Establishing the link between underwriting changes and credit outcomes is critical to an honest assessment.

After the portfolio review, there are many possible paths to follow. Here are a few strategies for issuers to consider.

Take no action. If the portfolio review suggests that the credit trend is anomalous or is likely to revert to a better level, then taking no action and continuing to monitor the portfolio may be the best course. One month does not a trend make.

Be the counter-puncher – and aim for growth. Being aggressive when others play a conservative hand is a time-honored, but high-risk way to grow. (Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.”) Some issuers will see the market deterioration as an opportunity to gain market share as more conservative issuers pull back. This approach is not for the faint of heart, and the challenges it presents are obvious.  But for a highly capitalized, sophisticated, credit-savvy issuer this can be a tremendous opportunity.

Change underwriting standards. For an issuer that has seen some portfolio deterioration but is not expecting a default tsunami, reducing credit exposure on newly originated accounts with tightened underwriting may be all that is needed. In addition to modifying credit selection and market solicitation criteria, issuers will also want to revisit line assignments (both for the existing portfolio as well as for the new accounts), collection entrance parameters, servicing and collection strategies among other operating levers.

Conduct a portfolio segment sale. One possible outcome of the portfolio analysis, depending on the issuer’s outlook, may be to sell a segment of the portfolio which effectively transfers a disproportionate share of the total portfolio credit risk. While this type of pruning is not always possible, the current market appetite for consumer credit risk makes this a feasible strategy. (A recent example is Barclaycard US’ reported sale of $1.6 billion worth of subprime credit card receivables to the Credit Shop this year.)

These are just a few of the possible avenues to explore in the current environment.  Auriemma has a deep institutional memory about prior challenges and the creative ways in which successful issuers responded.

Ultimately, the strategy selected may be less important than the quality of the portfolio review; a strategy premised on a superficial analysis may be more dependent upon luck than execution. If, after a thorough portfolio review, an institution concludes that no change is needed, that may be a viable choice made with eyes wide open.  Heading into a challenging credit environment, however, it’s safe to say that inertia without analysis is hardly a wise choice.

About Auriemma Group

Auriemma is a boutique management consulting firm with specialized focus on the Payments and Lending space.  We deliver actionable solutions and insights that add value to our clients’ business activities across a broad set of industry topics and disciplines.  For more information, contact John Costa at 212-323-7000.

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Auriemma Analysis: Insight Into the OCC’s Proposed Fintech Charter

(New York, NY):  Last month, the Office of the Comptroller of the Currency published its proposal to debut a national bank charter specifically for fintech companies and invited public comment on potential implications of the measure.  Auriemma responded to the OCC’s request with a comment letter assessing the proposal’s possible effects on non-bank lenders, payment companies as well as traditional banks.

The core of the OCC proposal is offering a national banking charter to a segment of fintech companies, such as payments technology and marketplace lenders, that provides recipients with the ability to forgo deposits (and skip the FDIC insurance process), while still having the advantages of a national bank charter. For fintech companies with consumer lending businesses, this is especially useful in simplifying pricing, as a national bank charter would allow such companies to select one domicile for determination of rates and regulations and to “export” them to consumers in other geographical areas.

Currently, non-bank lenders are often in contractual relationships with “originating” banks as a way to indirectly achieve national bank advantages, such as avoiding the “state-by-state” regulatory compliance model historically used by non-bank finance companies. The new charter would eliminate the need for an originating bank and allow the OCC to more directly regulate these activities.

Fintech firms would be primarily regulated by the OCC, but this proposal makes clear that all other relevant regulators would still be involved (e.g., a public company would still be regulated by the SEC also).  If a fintech bank elected to be an FDIC depository, for example, the FDIC would also be a key regulator. (Among the most unique features of the charter is that the FDIC insurance is not a requirement, but rather an election.)

Should the proposal move forward, it could also signal a flow of new equity capital moving into the banking sector. (Many institutional equity investors had been sidelined by the current interplay of the Bank Holding Company Act and the FDIC insurance requirement.) This would mark a return of the same investors who flocked to the non-bank fintech companies to participate in consumer credit without these regulatory impediments.

Still up in the air: the appropriate level of regulatory capital that would be needed by a fintech bank. While a non-FDIC insured institution presents no risk to the FDIC guaranty fund, it may still present systemic/contagion risks. Similarly, a non-FDIC insured institution would not fall under the Community Reinvestment Act, but the OCC will still expect fintech companies to address financial “inclusion.” It remains to be seen how this could be addressed outside of the CRA framework.

Since the OCC published its proposal, political opposition has emerged.  Some state Attorneys General and Senators Sherrod Brown (D-Ohio) and Jeff Merkley (D-Ore) are questioning the new charter, saying it is a way to avoid state usury and compliance laws.  Although the OCC did not expect this to become a partisan issue, it now appears likely to become one.

Ultimately, we view this proposal as the OCC offering fintech companies national bank preemption in exchange for direct supervision.  While fintech companies have always had the option of becoming a bank, the new charter makes this more acceptable to institutional equity investors while simultaneously safeguarding the insured deposit base.  Clearly, the OCC is open to revisiting some traditional bank regulatory matters from a new vantage point.

 About Auriemma Group

Auriemma is a boutique management consulting firm with specialized focus on the Payments and Lending space. We deliver actionable solutions and insights that add value to our clients’ business activities across a broad set of industry topics and disciplines. For more information, contact John Costa at (212) 323-7000.

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Why Big Banks Would Do Well to Spin Off Credit Cards

John Costa, Managing Director of Auriemma Finance, has published an article in American Banker’s BankThink section. The piece focuses on large banks downsizing through a sale or spinoff of their credit card business.

You can read the full story here: Why Big Banks Would Do Well to Spin Off Credit Cards

For more information, contact John Costa at john.costa@auriemma.group or 212-323-7000.

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Will The Fed Raise Interest Rates?

Ever since former Federal Reserve Chairman Ben Bernanke took extraordinary measures to resuscitate the economy, the capital markets have been awaiting a return to “normalcy.” It’s been a long wait.

As the markets anticipate the September FOMC meeting, everyone is wondering whether Janet Yellen will continue the current Fed Funds interest rate stance or catalyze a long- awaited interest rate increase cycle.  Either move would be controversial.

Financial luminaries such as former Treasury Secretary Larry Summers and New York Fed President William Dudley have strongly urged the Fed to hold off on increasing rates, at least for the September meeting if not for the remainder of 2015, fearing that a rate increase may cause an economic contraction.  Yet the strengthening US economy, as well as some other global factors, may argue for commencing the long delayed rate increase.

With its historic mandate, the Fed must balance the twin objectives of “full employment” as well as “price stability.”  Since the end of the last recession, the Fed has been continually seeking to stimulate economic growth while keeping to its goal of a 2% inflation rate.  With inflation well below its target, and only limited signs of pressure on wage growth, the Fed certainly has had plenty of leeway to continue its historic monetary accommodation.

In addition to the tepid economic expansion in the US, the Fed board members are also weighing the impact of other external events in their rate deliberations.  The recent devaluation of the Chinese currency, as well as the massive correction in the Chinese stock market, may further support a delay in the increase of the Fed Funds rate.  While the US economy may not have to worry about a “contagion” effect from China (equity volatility notwithstanding), a slowing Chinese economy further reduces the demand for global energy.  With oil already trading at much lower levels, a significant further reduction in demand will cause even further price softening.  This reduces inflationary pressure, giving the Fed additional latitude to forbear a rate increase.

In the current environment, the cards seem to be stacked against a Fed rate increase. An increase would likely harm U.S. exports, due to an appreciation of the dollar against most world currencies.  And while any Fed Rate increase would be modest and gradual, the increasing rate cycle would reallocate capital from the US equities markets to the risk-free fixed income markets.  Both trends would weaken economic expansion, and increase the odds of a recession.

The Fed isn’t facing a red-hot U.S. economy. Inflation is below target. The U.S. economy is performing better than its counterparts in China and the Eurozone. So why bother with a rate increase at all?  The U.S. stock market volatility last week offers a clue.  In some cases, a delay (or a “relent” in the current vernacular) of an expected rate increase can trigger an overreaction by the market. Panicked investors would be asking, what does the Fed see that we don’t see?  Things must be worse than we thought!

The case for and against a rate increase will be argued right up until the September FOMC meeting.  Intervening events, such as a new round of volatility or, conversely, significant gains in employment and wage growth, make this a real cliffhanger.  Moreover, the Fed hasn’t forgotten the market gyrations that ensued when the gradual elimination of Quantitative Easing was first discussed (remember the “taper tantrum”?). To avoid a similar market reaction they will be reluctant to back away from their signaled rate increase.

Our view is that the Fed will not increase rates in September, but will characterize the decision as a short delay with an October increase all but certain.  This allows the Fed to take the safer route of delaying a rate increase, betting that a bout of inflation is not in the offing, while maintaining its credibility.  In times of volatility the markets appreciates the Fed’s discretion.

–John Costa, Managing Director, Auriemma Finance

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Auriemma Expects Credit Card Portfolio Values to Trend Lower Over the Next Several Years

(New York, NY):  Auriemma Group, a nationally recognized credit card valuation agent, has identified several factors which it believes will cause credit card valuations to decline.  The drivers of this anticipated reduction in market value are both changes in card business models as well as regulatory and accounting rule changes.  While Auriemma remains bullish on the credit card business over the short – intermediate timeframe, we expect to see the value reductions appearing in earnest by 2017.

Of the threats to the business model for traditional card issuers, Auriemma is focused on the following:

  • The inevitable increase in delinquency and bad debt expense as the business reverts to the long term mean for consumer credit performance
  • The gradual erosion in underwriting discipline which we are anticipating based upon the entrance of new issuers into the subprime arena
  • The change in “lifetime” value of a customer brought about in part by the change in perception about use of credit cards versus debit cards among millennials
  • The proliferation of alternative payment channels which will exert pressure on traditional card income as newer players enter the market and demand revenue participation.

Several of these are long term trends which we have been watching/anticipating and see signs of acceleration.  With regard to the impending regulatory and accounting changes and the anticipated change in market value, Auriemma is focused on the following:

  • FASB’s new methodology for loan loss allocation which we believe will have an exaggerated impact on credit card issuers versus other consumer lenders
  • The changes in both the composition of common equity tier 1 (CET1) capital and in the specific new capital treatment of purchased credit card relationships (PCCR) intangible assets.

Both the anticipated changes to the loan loss reserving methodology and to the new capital treatment for PCCR will result in very significant pressure on regulatory capital for the industry and will likely slow down future portfolio consolidation.  Auriemma’s expectation that market values will decline does not mean the card industry will become unprofitable; rather, the increase in the amount of capital necessary will result in a significantly lower return on equity.

There are multiple strategies that an issuer may pursue to position itself for these challenges.  Such strategies can allow for both aggressive and defensive postures.  Similarly, investors in credit card equities need to understand how their portfolio companies will address these issues.  Auriemma is prepared to assist our clients both in developing strategies and implementing plans to align their goals with the changing environment.

 About Auriemma Consulting Group

 Auriemma is a boutique management consulting firm with specialized focus on the Payments and Lending space. We deliver actionable solutions and insights that add value to our clients’ business activities across a broad set of industry topics and disciplines. Auriemma has been providing credit card portfolio valuations for over two decades and is a nationally recognized valuation agent. For more information, please contact John Costa at (212) 323-7000.

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Basel III Makes Credit Card Portfolios a Buyer’s and Seller’s Market

John Costa, Managing Director of Auriemma Finance, has published an article in American Banker’s BankThink section. The piece focuses on how Basel III rules have magnified the importance of regulatory capital in the decision-making process to buy or to sell a credit card portfolio.

You can read the full story here: Basel III Makes Credit Card Portfolios a Buyer’s and Seller’s Market

For more information, contact John Costa at john.costa@auriemma.group or 212-323-7000.

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