COF, SYF, ADS: Consumer Credit Effects of Economy, Seasoning, and Underwriting

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Howard Mason

April 10, 2016

COF, SYF, ADS: Consumer Credit Effects of Economy, Seasoning, and Underwriting

  • We distinguish between key drivers of consumer credit performance – economic effects, portfolio seasoning, and underwriting standards – given mixed signals from credit card issuers: SYF is guiding to a stable loss ratio of 4.3-4.5% while COF and ADS are guiding to loss ratios up ~100bps by 2017 (to the low 4’s in the case of COF and 5.5% in the case of ADS).
  • Notwithstanding the volatility in financial and energy markets, there is no evidence that the economic health of US consumers has deteriorated and we do not expect any evidence of consumer credit deterioration in the first-quarter reports. COF insisted as recently as March that “we are not seeing any signs of any kind of credit deterioration” and SYF supported this with the remark that “early stage delinquencies have never been better in our business”.
  • Differences in credit guidance must therefore be due to either seasoning or underwriting effects. Rising loss ratios at COF are due to portfolio seasoning “independent of anything having to do with the economy [or…] consumer health” and, in our view, of underwriting effects. Seasoning effects occur because credit losses tend to rise on a new vintage of loans to a peak after 2-3 years before declining (once those unwilling, rather than simply unable, to pay have been winnowed out).
  • Seasoning effects are meaningful at COF because of an increase in the growth of the domestic card loan portfolio, accounting for ~three-quarters of total credit provisions, from zero in 2014H1 to over 12% in 2015H2. Beyond a step-up in growth in 2015Q2 (see Chart), SYF has maintained more stable growth rates and so is less subject to seasoning effects.

Chart: Loan Growth for COF Domestic Card (Green) vs. SYF (Grey)

Source: Company Reports, SSR Estimates)

  • Loss ratios at ADS are lifted by changes in underwriting and particularly a mix-shift to dual cards (carrying the Visa or MasterCard acceptance brand). ADS has maintained a relatively stable rate of loan growth (~10% from legacy portfolios and ~10% from the initial ramp of new retailer-client signings) so that loss ratio variation is less affected by seasoning than at COF. However, unlike SYF which has stable delinquency rates, ADS attributes rising delinquency rates to a “normalization” of consumer credit; the suggestion is that, after a period of abnormally strong performance, consumer credit quality is reverting towards a long-run average. There is no support for this thesis from other industry players, and we believe rising delinquencies at ADS reflect underwriting effects rather than a normalization of ambient credit conditions.
  • Specifically, to support growth, ADS has indicated it will increase the mix of dual-card balances in the portfolio to 30% from the current 15% and that 25% of current originations are on dual-cards. Dual cards carry higher open-to-buys than private-label cards (nearer $2,000 on average than a few hundred dollars) and, unlike private-label cards, can and are used by stressed consumers to stock up on non-discretionary items, such as food and gas, immediately before permanent non-payment or bankruptcy-filing.
  • The net loss ratios reported by ADS are also affected by recovery rates which are tending to decline as the portfolio of charged-off loans from the recession years is worked-through (and given that the firm has acquired recently acquired some portfolios from which the charged-off loans have been stripped); recoveries amounted to ~28% of gross charge-offs in 2015 and we expect this ratio to fall to ~20% by 2017 adding about 50bps to the net loss ratio. However, changing recovery rates do not affect delinquency statistics.


“What we are seeing is nothing more than credit quality normalizing to a long-term loss rate of about 5.5% which is about 50 basis points this year and 50 basis points next year and then it should sort of level out” Ed Heffernan, CEO ADS, Mar 2016

Normalization is the statistical theory that things tend to revert to the mean and can be invoked by management to explain the deterioration of business metrics as if it were a force of gravity; it is not and, indeed, makes strong distributional assumptions that may or may not hold. ADS’ CFO makes three arguments around the quality of its credit risk management that, but for qualifiers, appear false:

  1. “You’ve got a small open-to-buy. A general-purpose card can have a $2,000 open to buy – ours is probably $250 … so what that means is you can’t push it up, charge it off, and move away”. We are not sure why this argument is made in conjectural terms; the 2016 10K discloses that the average unused line of credit for the ~60mm accounts at ADS is $1,980.
  2. “At the very worst of the recession, it [the charge-off rate] probably maxxed out around 8%”. Again, why the “probably”? We know the max loss ratio for ADS; it was 10.2% in May 2009.
  3. “Primarily a single utility. If it’s the Victoria Secret card it can only be used in Victoria’s Secret which means it is also a discretionary spend. So it’s not something you can live off”. The CFO’s remark is true is so far as it goes but it does not go very far given the CEO has acknowledged that “a lot of our stuff are (sic) dual card programs” meaning that the cards carry the Visa or MasterCard brands and so can be used at the grocery store and to live off. Furthermore, the loan-mix at ADS is likely to tilt to dual-brand cards (from the current 15% given dual-brand is ~25% of new loans) because of the improved growth opportunity. For example, “women love private label cards [and] men don’t; men tend to like the joint utility of a co-brand [i.e. dual brand].”

In the meantime, there is meaningful credit deterioration at ADS portfolio (Chart 1) and we are doubtful of management’s assertion that the loss ratio will level off at 5.5% in 2017 from the 4.5% reported for January.

Chart 1: Change in Delinquency Rates at ADS


“When you look at charge-offs and what is flowing through in the aggregate, it’s still as good as it’s ever been. And we think at least for the next 12 months or so that credit will continue to be relatively stable” Brian Doubles, CFO SYF, Feb 2016

SYF makes the interesting observation that early-stage delinquencies “have never been better in our business” but that late-stage roll-rates remain above pre-recession levels so that a greater percentage of consumers in late-stage delinquency go through to charge-off rather than being able to cure through, for example, the use of home-equity or financing of last-resort. In 2015Q4, for example, the 30-days+ delinquency rate was 4.06% versus 4.14% for the year-ago quarter. SYF insists it has not “changed our underwriting profile materially in the last five years” and describes its discipline about raising open-to-buy: “we tend to start consumers off with a very small open to buy, then we monitor their behavior over time, and we upgrade them to a bigger line and then ultimately we upgrade them to a dual card”; dual cards currently represent 20-25% of total balances. The firm is guiding to a stable 2015 loss ratio of 4.3-4.5%, versus 4.4% in 2015 which was slightly lower than in 2015 due to “improved consumer fundamentals.”


“When we look at our own metrics, delinquency rates, delinquency roll rates, credit trends in our portfolio, and our customers, we are not seeing any signs of any kind of credit deterioration” Jeff Norris, Director IR, COF, Mar 2016.

COF has provided guidance for the loss ratio to increase from the mid-to-high 3’s at the end of 2015, to around 4% for full-year 2016, and then the low 4’s for full-year 2017. The firm has been insistent that this increase is “independent of anything having to do with the economy [and] anything having to do with consumer health” but rather is due to seasoning effects in the portfolio. More specifically, as COF has returned to growth in card-lending (Chart 2), the loss ratio tends to increase because, with any new vintage of loans, there is a seasoning effect: “they tend to have losses that are higher at the beginning, essentially peak after a couple of years, and gradually go down from there”. COF’s new vintages are being layered onto a “back book” of loans that, having seasoned through the 2008 recession, has unusually low loss rates. This is reflected in rising delinquency rates for the domestic card business which, for balances 30-days or more past due, came in at 3.39% in 2015Q4 versus 3.27% in the year-ago quarter.

Chart: Loan Growth for COF Domestic Card (Green) vs. SYF (Grey)

Source: Company Reports, SSR Estimates)

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, WFC, and GS.

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