Valuable insights from a Minyan

An excellent article that appeared on Minyanville yesterday covering a variety of topics. Particularly interesting was the insightful analysis of Target's credit card business. Really worth the read if you have the time.

This letter comes from Minyan Peter, writing to Todd in response to his column yesterday, "Petty Morning Quarterback", and is reprinted here with permission for the benefit of the Minyanville community.


Todd,

I am a new Minyan, but in my former life I helped build and ultimately ran a Wall Street asset-backed securities business, was treasurer of a top credit card company and treasurer of one of the largest banks in the Midwest.

In light of the past several weeks in the markets, and in the interest of sharing, here are some observations that I think may be helpful to you and the Minyanville community at large.

First, having been there at the beginning, the genesis of the asset-backed commercial conduits was regulatory capital arbitrage. Through the conduits’ convoluted structures, banks were able to "lend" huge amounts off-balance sheet and collect fees on no-capital-required lines of credit. No one - and I mean no one - ever expected these conduits to move from off-balance sheet back on-balance sheet and I don't think the market yet understands the earnings, capital and liquidity impact of this migration. If you figure you need anywhere from 6-8% capital per dollar of loans, then a move of $1.0 trln from off-balance sheet to on requires $60-80 bln in additional equity capital. I don't know about you, but I don't see this kind of free capital sitting around.

Second, I don't think people appreciate the significance of the change in Fed policy that took place on Friday involving the brokerage affiliates of several money center banks. In the asset-backed commercial paper market, maturing commercial paper is normally either rolled over or replaced by loans from standby liquidity banks when it can't be rolled over. With Friday’s change, it would appear that investors now have the ability to "put" unmatured commercial paper back to the bank affiliated brokers - who in turn will pass it along through the Discount window to the Fed.

In doing this, I believe the Fed has established a very dangerous precedent. If investors can now put unmatured CP to the banks (instead of waiting for the standby liquidity banks to fund at maturity), it may not be long before investors pressure the bank-affiliated brokers to accept MTNs and who knows what else further out the curve.

Third, the last consumer led recession was around 1990. Since then, the SEC has placed enormous pressure on the banks to minimize their loan loss reserves. The SEC hates earnings management and the loan loss provision has historically been a key way for banks to "save for a rainy day." I don't think the market yet appreciates the fact that banks are currently provisioned for the top of the market. (And, in fact, up until recently, most major banks reported net provision reductions over the last several quarters.) As credit continues to deteriorate, the earnings/capital hits will be enormous as provisions need to reflect higher and higher delinquency and loss rates. And, experience suggests, that when the banking regulators finally do begin to act (as they did in New England during the late 1980’s), the pendulum will push banks to over-reserve at what will ultimately be the bottom of the credit cycle.

Finally, no one is talking about it yet, but I think the market will soon begin to realize that the credit card lenders have in essence become the consumer lenders of last resort. As consumers have been shut out of the mortgage and home equity world, the last available credit is plastic. One statistic that I have found very troubling is the degree to which credit card balance growth is running ahead of retail sales growth - a key sign that the consumer is stretched. In normal times, you would expect aggregate credit card balance growth to run about in line with GDP and retail sales growth. This year it is running almost 2.5 times that. Clearly consumers are using their cards for far more than purchases. And my guess is that for many Americans their credit cards have become the latest, but potentially last, source of financing available.

Because of the oversized credit card balance growth, however, I think the market is missing what is really happening within card issuer portfolios – particularly loss and delinquency data. Today, no one seems to be very concerned about the increases in reported losses and delinquencies. However, when you start to normalize these statistics for the enormous balance growth we’ve seen, the increases in both are quite dramatic.

To put this all together, take Target’s (TGT) latest financial results and you can see the numbers for real. First, credit card balance growth was up 14% year-on-year - almost 1.5 times Target sales growth of 9.5%. Second, thanks to this balance growth, reported year-on-year delinquency ratios are up only a little bit (60+ days delinquencies of 3.5% versus 3.4% a year ago), but the dollars of delinquent accounts are up almost 18% - to $242 mln from $205 mln – and, as an aside, “late fees and other revenue” are up more than 36% year-on-year.

Digging even deeper, you come away with more unanswered questions. First, annualized net write-offs for the quarter were up 17% - 5.4% of loans versus 4.6% during the year ago quarter. But behind that, masked by 14% balance growth, there is a 32% increase in the dollars charged off. Further, and to me more troubling, Target dropped its loan loss allowance from 8.3% of loans at the end of July 2006 ($501 mln) to 7.4% at the end of July 2007 ($509 mln). Had Target kept its provision at 8.3% of loans, the incremental cost would have been over $64 mln or almost 40% of the pre-tax quarterly earnings of Target’s credit card business. Alternatively, had Target kept its provision at the same 1.8 times net charge-offs as last year (an 8.3% allowance on 4.6% in net write-offs), the required ending provision would have been over 9.7% of loans - at an incremental cost to the company of almost $144 mln – all but eliminating earnings from the credit card operation for the quarter. Put simply, when measured in dollars (rather than percentages of balances) Target’s nearly flat year-on-year loan loss allowance does not synch with the increase in loan balances, delinquencies, charge-offs, and late fees.

And while I have used Target as an example, I don’t think Target is alone. As we have seen already in other parts of the credit markets, many banks and finance companies are managing their businesses as if today’s increases in credit deterioration are merely a “blip”, rather than the beginning of a broader, potentially more serious, decline. From where I sit, it looks like it is only going to get worse, and “it’s already in the cards.”

-Minyan Peter