Credit Card Business Model Tested in Current Downturn

As defaults ratchet up and expectations for future growth are pared, major credit card issuers are finding it more difficult to navigate the all-important institutional investment well for operational cash.

Discover Financial Services, facing the need for additional funding while revenues are declining and credit card chargeoffs are growing, received only a lukewarm response from the equity market as a public offering last week of its common shares had to be priced at a 12 percent discount to the market. Though the price has recovered some thanks to a positive comment Monday from Goldman Sachs analyst Richard Ramsden, who put the stock on his "Conviction Buy List," most indications are that Discover and other credit card firms will continue to struggle with investors the rest of the year.

“Right now there is a great deal of risk aversion when it comes to credit cards,” said Dan North, chief economist at Euler Hermes ACI, a trade credit insurance firm. “The credit panic started last fall. There is a recognition that delinquencies will continue to go up.”

As a result, people started using their credit cards less, meaning less interchange income from transactions. But even as the savings rate has risen nationally, there are still a large number of consumers who got too far into debt and are not able to keep up with their card payments. Many have lost jobs, as evidenced by the nation’s rising unemployment rate.

The credit card firms have also become defensive, cutting credit lines, raising fees and changing interest rates from fixed to variable, both in response to the need for more revenue now and to prepare for the restrictions from the “Credit Cardholders Bill of Rights,” which goes into effect next year.

Anyone providing funding for the card firms (e.g., equity buyers) is looking at these issues as well as the creditworthiness of the cardholders. According to North, Discover cardholders have weaker credit ratings, on a whole, than holders of MasterCards, Visas and American Express cards, though those companies are battling the same financial challenges.

All of those factors have also made it difficult for a new competitor in the market, Revolution Money, a payment platform complete with credit card and money transfer service designed to compete with major card companies Visa, MasterCard, Discover and American Express.

Revolution LLC, headed by AOL founder Steve Case, had hoped to compete mainly by offering better security through a chip-based card and lower interchange fees to merchants ("Revolution Card Could Shake Up Visa, MasterCard," Sept. 27, 2007). But the company is having trouble finding traction in the current economy.

“Their funding model is being challenged; there’s been a general shift from credit to debit,” said Tower Group analyst Brian Riley, adding that the current economic situation means the Revolution Money card is no longer as compelling as it was when it launched in 2007. However, when the economy picks up, there will be room for new niche players like Revolution, according to Riley.

A group of niche players that are gaining more traction now, according to a Scripps Howard News Service report, is peer-to-peer lending (P2P), which completely bypasses traditional financial institutions. P2P lending services bundle pledges from individual investors and offer small loans to other individuals at attractive rates, a model that could evolve into direct competition for credit cards.

According to research from Celent, the growth of P2P lending over the second half of this decade has been dramatic. In 2005, there was $118 million in outstanding P2P loans in the U.S., in 2007, the figure stood at $647 million. By the end of next year, Celent projects the total to reach more than $5 billion.