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ITEM 2.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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The following discussion should be read in conjunction with our condensed consolidated financial statements and the related notes included herein and
our Annual Report on Form 10-K for the year ended December 31, 2006, where certain terms (including trust, subsidiary and other entity names and financial, operating and statistical measures) have been defined.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements. We have based these
forward-looking statements on our current plans, expectations and beliefs about future events. Actual results could differ materially because of factors discussed in “Risk Factors” in Part II, Item 1A and elsewhere in this report.
OVERVIEW
We are a provider of various
credit and related financial services and products to or associated with the underserved, or sub-prime, consumer credit market and “un-banked” consumers. One of the ways in which we serve these markets is through our marketing and
solicitation of credit card accounts and our servicing of various credit card receivables underlying both originated and acquired accounts. Because only financial institutions can issue general-purpose credit cards, we contract with third-party
financial institutions pursuant to which the financial institutions issue general purpose Visa and MasterCard credit cards and we purchase the receivables relating to such accounts on a daily basis. We market to cardholders other fee-based products,
including credit and identity theft monitoring, health discount programs, shopping discount programs, debt waiver and life insurance.
Our
product and service offerings also include “micro-loans”—generally small-balance short-term cash advance loans (generally for less than 30 days) and small-balance installment loans (the amortizing term of which generally is less
than one year)—marketed through various channels, including retail branch locations, direct marketing, telemarketing and the Internet. We also (1) originate auto loans through franchised auto dealers, (2) purchase and/or service auto
loans from or for a pre-qualified network of dealers in the Buy Here/Pay Here used car business and (3) sell used automobiles through our own Buy Here/Pay Here lots. Our licensed debt collections subsidiary purchases and collects previously
charged-off receivables from us, the trusts that we service and third parties. Lastly, through our Other segment, we engage in various new product research and development efforts, the extent of which are dependent upon currently available liquidity
and other necessary resources and our views regarding the relative returns we expect these efforts to yield for us versus our more established product lines and potential acquisition opportunities.
Our business experienced several significant changes during the three months ended September 30, 2007, including:
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Our net addition of approximately 529,000 accounts, which corresponds principally with an increase of over $270 million in receivables underlying our largely
fee-based credit card offerings to consumers at the lower end of the FICO scoring range, thereby bringing the gross face amount of these receivables to a balance of $1.2 billion as of September 30, 2007;
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•
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Our substantial reduction in marketing efforts in August corresponding with the widely publicized dislocation in global liquidity markets;
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•
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Our incurrence of $37.4 million of realized and unrealized losses unrelated to our core business operations associated with market volatility and price declines
continuing from the second quarter of 2007 with respect to investments that we hold in mortgage and other asset-backed securities; and
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•
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Our recording of a $4.8 million impairment charge related to the lease commitment on our previous corporate headquarters, which we vacated in August 2007 upon
relocation to our new corporate headquarters.
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The most significant of these developments is the disruption we saw in
global liquidity markets. We believe we have reacted prudently to this development, and while we were able to complete two major financing facilities subsequent to this development, we have reduced our marketing efforts relative to second and third
quarter 2007 levels. Whereas we averaged approximately 750,000 of gross account additions during each of the second and third quarters, our marketing levels now are targeted to produce between 150,000 and 200,000 gross account additions per quarter.
We continue to believe that the current environment supports more aggressive account additions at or near volumes we saw in the second and third quarters, and we are hopeful to be able to obtain additional growth capital under acceptable pricing and
terms during the fourth quarter of this year as the liquidity market normalizes.
Our credit card and other operations are heavily
regulated, and over time there will be changes to how we conduct our operations. For example, in response to comments about minimum payments and negative amortization received from the FDIC in the course of its examinations of the banks that issue
credit cards on our behalf, during the third and fourth quarters of 2006 we discontinued billing finance charges and fees on credit card accounts that become over 90 days delinquent. This change had significant adverse effects on our fourth quarter
2006 and first quarter 2007 managed receivables net interest margins and other income ratios. We also have made certain changes to our collections programs and practices throughout 2007 in response to comments from the FDIC about negative
amortization, and these changes have had the effect of increasing our delinquencies and expected future charge-off levels and ratios. Moreover, we anticipate making further changes to address negative amortization in the fourth quarter of 2007 that
could adversely affect our future net interest margins and/or delinquency and charge-off levels and ratios.
24
Commencing in June 2006, the FDIC began investigating the policies, practices and procedures used in
connection with our credit card originating financial institution relationships. In December 2006, the FTC commenced a related investigation. In general, the investigations focus upon whether marketing and other materials contained
misrepresentations regarding, among other things, fees and credit limits and whether servicing and collection practices were conducted in accordance with applicable law. We have provided substantial information to both the FDIC and FTC, and we
continue to respond to their requests. The FDIC and FTC have proposed limitations on certain marketing, servicing and collection practices, reimbursement of significant fees to affected customers and the payment of fines. We believe that our
marketing and other materials and servicing and collection practices comply with applicable law, and we are vigorously contesting the proposed reimbursement of fees and payment of fines. The matters under investigation involve a significant amount
of fees and a substantial number of accounts, and although it is premature to determine the outcomes of these investigations or their effects on our financial condition, results of operations, business position and consolidated financial statements,
an adverse outcome could have a materially adverse effect upon us.
Our shareholders should expect us to continue to evaluate and pursue
for acquisition additional credit card receivables portfolios and other business activities and asset classes that are complementary to our historic sub-prime credit card business. Our focus is on making good economic decisions that will result in
high returns on equity to our shareholders over a long-term horizon, even if these decisions may result in volatile earnings under GAAP—such as in the case of incurring significant marketing expenses in one particular quarter to facilitate
expected future long-term growth and profitability or in the case of the accounting requirements for securitizations under Statement No. 140. To the extent that we grow our overall portfolio of credit card receivables (through origination,
acquisition or other new channels) and then securitize these assets, for example, we will have securitization gains or losses, which may be material. For further discussion of our historic results and the impact of securitization accounting on our
results, see the “Results of Operations” and “Liquidity, Funding and Capital Resources” sections below, as well as our condensed consolidated financial statements and the notes thereto included herein.
RESULTS OF OPERATIONS
Three and Nine Months Ended
September 30, 2007, Compared to Three and Nine months ended September 30, 2006
Total interest income.
Total
interest income consists primarily of finance charges and late fees earned on loans and fees receivable we have not securitized in off-balance-sheet securitization transactions—principally receivables associated with our largely fee-based
credit card offerings to consumers at the lower end of the FICO scoring range and our Auto Finance segment. The $48.2 million and $108.2 million increases when comparing the three and nine months ended September 30, 2007 to the same respective
periods in 2006 are primarily due to growth in credit card receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. In addition, our newly acquired ACC and JRAS subsidiaries
contributed $10.6 million and $24.3 million, respectively, of interest income during the three and nine months ended September 30, 2007.
Also included within total interest income (under the other category) is interest income we earned on our various investments in debt securities, including interest earned on bonds distributed to us from our equity-method investees and on
our subordinated, certificated interest in the Embarcadero Trust. Principal amortization caused reductions in interest income levels associated with some of our bonds and the Embarcadero Trust interest. Nevertheless, our other interest income levels
for the three and nine months ended September 30, 2007 increased relative to the same respective periods in 2006 as interest paid on our investments in debt securities (including bonds issued by other third-party asset-backed securitizations)
increased with our additional investments in these securities.
Although our rate of receivables growth is expected to slow over the next
few quarters based on our desire to conserve liquidity in light of recent disruptions in the global liquidity markets, we expect continued growth in receivables associated with our largely fee-based credit card offerings to consumers at the lower
end of the FICO scoring range and within our Auto Finance segment. Unless we securitize these receivables in off-balance-sheet arrangements—which we are exploring—this expected growth will translate into continued growth in our total
interest income.
Interest expense.
Interest expense increased $9.9 million and $18.4 million for the three and nine
months ended September 30, 2007, respectively, compared to the same periods in 2006 principally due to interest expense on (1) debt of our newly acquired ACC and JRAS operations, which contributed an additional $2.8 million and $7.2
million in interest expense for the three and nine months ended September 30, 2007, respectively, and (2) new and expanded debt facilities associated with our largely fee-based credit card offerings to consumers at the lower end of the
FICO scoring range. While interest rates and spreads above underlying interest indices (typically LIBOR for our borrowings) were relatively stable over the comparison period, we expect to experience higher interest rates and associated higher
interest costs due to widening spreads above underlying interest indices based both on market conditions and on our efforts to expand the capacity of our debt facilities.
Fees and related income on non-securitized earning assets.
The following table details (in thousands) the components of fees and related income on non-securitized earning assets:
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For the three months
ended September 30,
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For the nine months
ended September 30,
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2007
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2006
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2007
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2006
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Retail micro-loan fees
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$
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31,396
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$
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26,811
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$
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85,892
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$
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69,254
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Fees on non-securitized credit card receivables
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197,756
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106,937
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465,563
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308,060
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Income on investments in previously charged-off receivables
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15,455
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12,329
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48,374
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32,687
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(Losses) gains on investments in securities
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(37,408
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)
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3,676
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(63,132
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)
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1,314
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Other
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10,510
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2,435
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19,044
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5,012
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Total fees and related income on non-securitized earning assets
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$
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217,709
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$
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152,188
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$
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555,741
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$
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416,327
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The increases of $65.5 million and $139.4 million in fees and related income on
non-securitized earning assets for the three and nine months ended September 30, 2007, respectively, were largely attributable to:
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growth in fees on our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, which increased $90.8 million and $157.5
million for the three and nine months ended September 30, 2007, respectively, principally due to increased originations throughout 2007;
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•
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growth in our Retail Micro-Loans segment, in which fees increased $4.6 million and $16.6 million for the three and nine months ended September 30, 2007,
respectively, primarily due to our expansion into Michigan, Texas, Nevada and the United Kingdom and our conversion of operations in Arkansas and Florida from bank-model servicing operations to direct lending operations in the second half of 2006;
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•
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an increase in income within our Investments in Previously Charged-Off Receivables segment of $3.1 million and $15.7 million for the three and nine months ended
September 30, 2007, respectively, which relates to growth in the segment’s balance transfer program and Chapter 13 bankruptcy activities and to heightened levels of previously charged-off receivables sales under our forward flow contract
with Encore and correspondingly greater accretion of deferred revenue in the nine months ended September 30, 2007 compared to the same periods in 2006;
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•
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$0.9 million and $3.3 million of fee income for the three and nine months ended September 30, 2007, respectively, from our MEM operations, which we acquired in
the second quarter of 2007; and
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•
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$4.1 million and $7.1 million of gross profits for the three and nine months ended September 30, 2007, respectively, on automotive vehicle sales within our
JRAS operations, which we acquired during the first quarter of 2007;
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partially offset, however, by:
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•
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significant net realized and unrealized losses on our portfolio of investments in debt and equity securities of $37.4 million and $63.1 million for the three and
nine months ended September 30, 2007, respectively, compared to modest levels of net gains on these investments in the same periods in 2006.
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Losses associated with our investment portfolio parallel losses experienced over the second and third calendar quarters of 2007 by many other investors in mortgage-backed bonds issued by similar asset-based
securitization structures. We originally allocated $52.1 million of capital to these investments between the fourth quarter of 2004 and late 2006, and the losses we have experienced within these investments appear to reflect a significant
dislocation in the market for mortgage-related and other asset-backed securities caused, in part, by leverage and liquidity constraints facing many market participants. Because our investment portfolio is held in a separate subsidiary (and not in a
third-party fund), and because the debt we incurred to leverage our original investment is recourse only to the underlying securities, our remaining exposure (i.e., exposure to pre-tax loss) associated with our investments in third-party
asset-backed securities is limited to $11.9 million as of September 30, 2007. While we believe the dislocation we are seeing is producing trading values for many securities that are irrationally low relative to the estimated discounted cash
flow value of the securities, our subsidiary may continue to experience trading weakness in its investments in the future that may result in further losses in our fourth quarter and beyond, limited however to our remaining $11.9 million investment.
With respect to the other category in the above table, we expect to see continued growth in gross profits from our JRAS operations and
fees from our internet micro-loan operations within MEM throughout 2007 and beyond. Likewise, we expect further continued growth in our retail micro-loans fees and fees on non-securitized credit card receivables categories.
Provision for loan losses.
Our provision for loan losses increased $167.2 million and $299.1 million, respectively, for the three and
nine months ended September 30, 2007 when compared to the same respective periods of 2006. These increases correspond with our significant year-over-year growth in on-balance-sheet loans and fees receivable principally related to our largely
fee-based credit card offerings to consumers at the lower end of the FICO scoring range.
Our provision for loan losses covers aggregate
loss exposures on (1) principal receivable balances, (2) finance charges and late fees receivable underlying income amounts included within our total interest income category, and (3) other fees receivable. Based on
26
our expectation of slower growth in on-balance-sheet loans and fees receivable relative to the past few quarters and considering the discussion below in our
Credit Cards Segment
section regarding asset quality, we expect our provision for loan losses to decrease over the next several quarters.
The percentage of our allowance for uncollectible loans and fees receivable to gross period-end loans and fees receivable at September 30, 2007 (25.4%) is higher than it was at both June 30, 2007 (21.4%) and
September 30, 2006 (19.7%). Additionally, our provision for loan losses as a percentage of average gross loans and fees receivable in the third quarter of 2007 (20.0%) is higher than it was in the second quarter of 2007 (16.1%) and
the third quarter of 2006 (17.0%). The above figures for 2007 include the acquisition of ACC, which under the accounting guidance of SOP 03-3 results in a net loan balance presentation with no corresponding allowance for uncollectible loans and fees
receivable. Removing the balances attributable to the ACC acquisition ($117.8 million at September 30, 2007, $132.6 million at June 30, 2007 and $147.9 million at March 31, 2007) would result in a 27.3% and 23.8% allowance for
uncollectible loans and fees receivable as a percentage of gross period-end loans and fees receivable at September 30, and June 30, 2007, respectively, and an 21.8% and 18.2% provision for loan losses as a percentage of average gross loans
and fees receivable for the three months ended September 30, and June 30, 2007, respectively.
The above statistics are
overwhelmingly influenced by the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, which is by far the most significant category of receivables reflected on our
consolidated balance sheets. Furthermore, our provision for loan losses percentage is affected by (1) the timing of account originations in that a significant portion of our gross loans and fees receivable at the time of origination relate to
activation and annual fees for which revenues are deferred, (2) the timing of finance charge, fee and principal charge offs against the allowance for uncollectible loans and fees receivable, and most significantly (3) the necessary levels
of our allowance for uncollectible loans and fees receivable as of the close of each reporting period. Observations concerning our allowance levels are as follows:
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The above statistics reflect the mix change over the past year in the receivables comprising our gross loans and fees receivable, such that an increasing percentage
of the overall balance is comprised of receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, for which loss rates are higher than for the remaining receivables within our
gross loans and fees receivable balance, which consist primarily of receivables within our Auto Finance and Retail Micro-Loans segments.
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•
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Relative to our typical allowances for uncollectible receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the
FICO scoring range, we provide allowances at a higher rate for the portion of these receivables originated over the Internet and television—a portion which grew significantly in the second and third quarters of 2007. While we expect that these
receivables will perform at levels close to the performance of our other receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range over the long term, these higher allowances are
necessary based on our relative lack of experience in these particular channels and based on differences in underwriting standards used for many of the accounts originated through these channels.
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Fees and related income on securitized earning assets.
Fees and related income on securitized earning assets include
(1) securitization gains, (2) income from retained interests in credit card receivables securitized and (3) returned-check, cash advance and other fees associated with our securitized credit card receivables, each of which is detailed
(in thousands) in the following table.
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For the three months
ended September 30,
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For the nine months
ended September 30,
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2007
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2006
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2007
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2006
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Securitization gains
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$
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2,089
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$
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929
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$
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103,046
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$
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5,333
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Income from (loss on) retained interests in credit card receivables securitized
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21,773
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44,734
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3,794
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125,276
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Fees on securitized receivables
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5,780
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5,174
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14,492
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15,837
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Total fees and related income on securitized earning assets
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$
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29,642
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$
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50,837
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$
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121,332
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$
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146,446
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The $21.2 million and $25.1 million decreases in total fees and related income on securitized
earning assets for the three and nine months ended September 30, 2007, respectively, when compared to the same periods in 2006 reflect:
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$1.2 million and $49.0 million in respective losses on retained interests in the securitization trust underlying our UK Portfolio, which we acquired and securitized
during the second quarter of 2007—such losses being principally attributable to our quarter-end mark-to-market of these retained interests;
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•
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a first quarter 2007 reduction in the income from retained interests in credit card receivables attributable to the fourth quarter 2006 implementation of our
billing practice change to no longer bill finance charges and fees on credit card accounts that become more than 90 days delinquent;
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a reduction in income from retained interests in credit card receivables associated with the desecuritization of the Fingerhut Trust III receivables in the fourth
quarter of 2006; and
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•
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contraction in income from retained interests in our purchased portfolios of securitized credit card receivables due in part to continued reductions in managed
receivables levels within their respective securitization trusts throughout 2006 and thus far in 2007; and
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•
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slower growth in the receivables within our originated portfolio master trust for the nine months ended September 30, 2007, which produced only $2.7 million of
securitization gains, compared to $5.3 million during the same period of 2006;
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partially offset, however, by:
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•
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a securitization gain of $100.4 million related to our UK Portfolio, which we acquired and securitized during the second quarter of 2007; and
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•
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slight growth in the receivables within our originated portfolio master trust for the three months ended September 30, 2007, which produced $2.1 million of
securitization gains, compared to $0.9 million during the same period of 2006.
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In our Credit Cards segment discussion
below, we provide further details concerning delinquency and credit quality trends, which affect the level of our income from retained interests in credit card receivables securitized and fees on securitized receivables.
Servicing income.
Servicing income increased $6.4 million and $1.1 million, respectively, for the three months and nine months ended
September 30, 2007 when compared to the same periods in 2006. These increases were due to the April 2007 acquisition and securitization of our UK Portfolio for which we have been engaged as servicer, partially offset, however, by the effects on
our servicing compensation of liquidations in our purchased credit card receivables portfolios and those of our equity-method investees for which we have been engaged as servicer. We expect a gradual decrease in servicing income for the remainder of
this year as we do not expect to experience growth in our originated portfolio master trust receivables at levels that will exceed net liquidations of the securitized acquired portfolios (including the UK Portfolio) for which we have been engaged as
servicer.
Offsetting other increases in servicing income was the decline in servicing income within our Retail Micro-Loans segment during
this comparison period. In February 2006, the FDIC effectively asked FDIC-insured financial institutions to cease cash advance and installment micro-loan activities conducted through processing and servicing agents such as our Retail Micro-Loans
segment subsidiaries. As such, we did not earn any servicing income within our Retail Micro-Loans segment during the three and nine months ended September 30, 2007, while we earned $0.3 million and $5.8 million of servicing income in this
segment for the three and nine months ended September 30, 2006, respectively. We subsequently converted the Retail Micro-Loans segment’s operations in two of the four states affected by this FDIC action to a direct lending model; as such,
this lost servicing income has been partially replaced by lending fees, which are reported within fees and related income on non-securitized earning assets.
Ancillary and interchange revenues.
Ancillary and interchange revenues increased $9.3 million and $20.4 million for the three and nine months ended September 30, 2007, respectively, compared to the
same periods in 2006, correlating with both growth in our managed receivables levels based on our origination of new credit card accounts and a commensurate mix change in our cardholder account base for which a greater percentage of our cardholder
account base now is comprised of newer credit card accounts for which we typically experience higher ancillary revenues and higher purchasing volumes and associated interchange fees than for more mature cardholder accounts. While growth in ancillary
and interchange revenues throughout 2008 is less certain at our current marketing levels, we do expect further growth in our ancillary and interchange revenues in the fourth quarter of this year.
Equity in income of equity-method investees.
Notwithstanding our July 2006 purchase of an additional 11.25% interest in CSG and a
correspondingly higher income allocation from CSG, equity in income of equity-method investees decreased $34.6 million and $66.8 million for the three and nine months ended September 30, 2007, respectively, when compared to the same
periods in 2006, primarily due to (1) diminished earnings over time as we continue to liquidate the receivables balances associated with these equity-method investees and (2) the fact that one of our equity-method investees experienced a
sizable gain upon the securitization of its portfolio of credit card receivables in the third quarter of 2006.
Total other operating
expense.
Total other operating expense increased by $45.5 million and $125.9 million for the three and nine months ended September 30, 2007, respectively, when compared to the same periods in 2006 due principally to:
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$4.0 million and $13.1 million of respective increases in salaries and benefits primarily due to (a) growth in receivables within our originated portfolio
master trust and receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, (b) personnel additions in connection with our acquisitions of JRAS in January 2007, ACC in
February 2007 and the UK Portfolio in April 2007, (c) additional information technology and other management personnel that we have hired associated with new product and systems launches within our Credit Cards, Retail Micro-Loans, Auto Finance
and Other segments and (d) $0.3 million and $2.4 million of respective increases in salaries and benefits expense associated with the amortization of restricted stock and stock option grants based in large part on grants to our President in May
2006;
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•
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$17.6 million and $45.1 million of respective increases in card and loan servicing expense due to (a) servicing costs for our newly acquired JRAS, ACC and MEM
operations, (b) servicing costs related to growth in receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and net growth in our originated portfolio master trust
receivables, (c) higher servicing costs associated with our expanded number of issuing bank relationships and new product lines, and (d) servicing costs associated with the acquisition of our UK Portfolio, all such increases being offset
partially by diminished servicing costs associated with our credit card portfolios acquired in prior years given their continuing liquidations during 2006 and 2007;
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•
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$13.5 million and $47.9 million of respective increases in marketing and solicitation costs (including significantly higher advertising costs through
television and the Internet, which represented significantly expanded marketing channels for us in the second and third quarters of 2007) aimed at growing account originations within our largely fee-based credit card offerings to consumers at the
lower end of the FICO scoring range and our originated portfolio master trust and micro-loan receivables originated over the Internet; and
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•
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$10.4 million and $37.0 million of respective increases in other expenses, including depreciation and occupancy and related expenses, due primarily to
(a) increased costs associated with infrastructure build-out to handle growth within our originated portfolio and our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range (along with associated
customer service enhancements), (b) our implementation of an advanced data analytics platform that allows us to access, query and analyze our large data sets with increased efficiency, speed and power, thereby decreasing our unit costs for
data management while contributing to our competitive advantage in data analysis, (c) heightened legal, regulatory and compliance efforts and costs associated with the FDIC and FTC investigations and our establishment of an expanded number of
issuing bank relationships and new product offerings, (d) new product and systems launches within our Credit Cards, Retail Micro-Loans, Auto Finance and Other segments, (e) added expense related to our newly acquired JRAS, ACC and MEM
operations, (f) the addition of our UK Portfolio and its associated infrastructure costs, (g) accelerated depreciation in primarily the first and second quarters of 2007 associated with shortened useful lives of our leasehold improvements
within our former Atlanta, Georgia headquarters office facilities given our mid-2007 move from those facilities, (h) additional rent expense related to our new Atlanta, Georgia headquarters office lease, (i) additional operating costs
associated with the move of our Atlanta, Georgia corporate headquarters, including the physical costs of moving, heightened levels of technology spending associated with the move, $0.8 million of lease termination costs that we incurred in the
second quarter of 2007 associated with the termination of one of our Atlanta-area office leases to facilitate movement of personnel to our new headquarters office, $4.8 million of loss recognition in the third quarter of 2007 given our realization
of sublease rates below the costs of our leases underlying our former Atlanta, Georgia headquarters office space, and additional depreciation for leasehold improvements and furniture and fixtures related to the new Atlanta, Georgia headquarters
office space;
|
partially offset, however, by:
|
|
•
|
|
$17.1 million of impairment charges (including $10.5 million for goodwill impairment recorded during the first quarter of 2006) incurred in nine months ended
September 30, 2006 within our Retail Micro-Loans segment associated with the February 2006 FDIC decision effectively asking FDIC-insured financial institutions to cease cash advance and installment micro-loan activities conducted through
processing and servicing agents such as our Retail Micro-Loans segment subsidiaries.
|
While we incur certain base levels
of fixed costs associated with the infrastructure we have built to support our growth and diversification into new products and services, the majority of our operating costs are highly variable based on the levels of accounts that we market and
receivables that we service (both for our own account and for others) and the pace and breadth of our search for, acquisition of and introduction of new business lines, products and services. Based on the recent disruption we have seen in global
liquidity markets, we have reduced our marketing efforts and expect significantly reduced marketing costs and significantly slower growth in other expense categories (and potentially even some reductions in expenses within these other categories).
We also have reduced our exploration of new products and services and research and development efforts pending improvements in the liquidity markets.
Minority interests.
We reflect the ownership interests of minority holders of equity in our majority-owned subsidiaries (including management team holders of shares in our subsidiary entities; See Note
12, “Stock-Based Compensation”) as minority interests in our condensed consolidated statements of operations. The minority interests expense associated with these subsidiaries totaled $1.3 million and $2.8 million for the three and nine
months ended September 30, 2007, respectively, and $6.4 million and $11.8 million for the three and nine months ended September 30, 2006, respectively. Generally, this expense is declining, which is consistent with (1) liquidations of
acquired credit card portfolios within securitization trusts, the retained interests of which are owned by our majority-owned subsidiaries and (2) the resulting relative decline in contributions of our majority-owned subsidiaries (as discussed
in “
Fees and related income on securitized earning assets
,” above) to income from retained interests in credit card receivables securitized as noted above.
29
Income taxes.
Our effective tax rate was 36.0% for both the three and nine months ended
September 30, 2007 and the three and nine months ended September 30, 2006.
Credit Cards Segment
Our Credit Cards segment consists of our credit card investment and servicing activities, as conducted with respect to receivables underlying accounts
originated and portfolios purchased by us. This segment represents aggregate activities associated with substantially all of our credit card products, including our largely fee-based credit card offerings to consumers at the lower end of the FICO
scoring range. Because we have not yet securitized the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range through an off-balance-sheet securitization, revenues associated
with these offerings include interest income (along with late fees), fees and related income. With respect to our securitized credit card receivables (which represent the majority of our credit card receivables), our fees and related income on
securitized earning assets within the Credit Cards segment include (1) securitization gains, (2) income from (loss on) retained interests in credit card receivables securitized and (3) returned-check, cash advance and other fees
associated with our securitized credit card receivables. Also within our Credit Cards segment are equity in the income of equity-method investees and servicing income revenue sources. We earn servicing income from the trusts underlying our
securitizations and the securitizations of our equity-method investees. Our revenue categories most affected by delinquency and credit loss trends are the net interest income, fees and related income on non-securitized earnings assets category
(which is net of a provision for loan losses) and the income from (loss on) retained interests in credit card receivables securitized category.
In April 2007, we acquired our UK Portfolio of approximately £490 million ($970 million) in face amount of credit card receivables (associated with 594,000 underlying managed accounts) from Barclaycard, a division of Barclays
Bank PLC. We paid the purchase price of £383.5 million ($766.4 million) in cash and securitized the UK Portfolio’s receivables.
We did not acquire any credit card receivables portfolios during the nine months ended September 30, 2006.
Background
For our credit card securitizations that qualify for sale treatment under GAAP, we remove the securitized receivables from our
consolidated balance sheets. The performance of the underlying credit card receivables will nevertheless affect the future cash flows we actually receive. Various references within this section are to our “managed receivables,” which
include our non-securitized credit card receivables and the credit card receivables underlying our off-balance-sheet securitization facilities. Managed receivables data also include our equity interest in the receivables that we manage for our
equity-method investees but exclude minority interest holders’ shares of the receivables we manage for our majority-owned subsidiaries.
Financial, operating and statistical data based on these aggregate managed receivables are key to any evaluation of our performance in managing (including underwriting, valuing purchased receivables, servicing and collecting) the aggregate
of the portfolios of credit card receivables reflected on our balance sheet and underlying our securitization facilities. In allocating our resources and managing our business, management relies heavily upon financial data and results prepared on a
so-called “managed basis.” It is also important to analysts, investors and others that we provide selected financial, operating and statistical data on a managed basis because this allows a comparison of us to others within the specialty
finance industry. Moreover, our management, analysts, investors and others believe it is critical that they understand the credit performance of the entire portfolio of our managed receivables because it reveals information concerning the quality of
loan originations and the related credit risks inherent within the securitized portfolios and our retained interests in our securitization facilities.
Managed receivables data assume that none of the credit card receivables underlying our off-balance-sheet securitization facilities was ever transferred to securitization facilities and present the net credit losses
and delinquent balances for the receivables as if we still owned the receivables. Reconciliation of the managed receivables data to our GAAP financial statements requires: (1) recognition that a majority of our credit card loans and fees
receivable (i.e., all but $1.2 billion of GAAP credit card loans and fees receivable at gross face value) had been sold in securitization transactions as of September 30, 2007; (2) an understanding that our managed receivables data are
based on billings and actual charge offs as reported to us through underlying systems of record (i.e., without regard to an allowance for uncollectible loans and fees receivable); (3) a look-through to our economic share of (or equity interest
in) the receivables that we manage for our equity-method investees; and (4) removal of our minority interest holders’ interests in the managed receivables underlying our GAAP consolidated results.
The historical period-end and average managed receivables data (as well as delinquency and charge off statistics) that follow within this section exclude
some receivables associated with accounts in late delinquency status in sellers’ hands as of the dates of our acquisitions of the receivables or interests therein. Pursuant to this treatment, the only activity within the following statistical
data associated with these excluded accounts are recoveries, which we include within the numerator of the other income ratio computation, as well as the costs of pursuing these recoveries, which we include within the numerator of the operating ratio
computation. As of September 30, 2007, no accounts fell into this category of excluded accounts.
30
We typically have purchased credit card receivables portfolios at substantial discounts. All or some
portion of each acquisition discount is related to the credit quality of the acquired receivables, which we calculate as the expected future net charge offs of pre-acquisition receivables balances (i.e., those receivables that existed at the
acquisition date). This credit quality discount is used to offset these pre-acquisition receivables net charge offs as they occur over the life of the portfolio. Such is the case with our UK Portfolio acquisition in April 2007; the full amount of
the acquisition discount associated with the UK Portfolio acquisition was allocated to credit quality and will be used to offset charge offs on pre-acquisition receivables as they occur over the life of the portfolio. We refer to the balance, if
any, of the discount for each purchase not needed for credit quality as accretable yield, which we accrete into net interest margin using the interest method over the estimated life of each acquired portfolio. As of the close of each financial
reporting period, we evaluate the appropriateness of the credit quality discount component of our acquisition discount and the accretable yield component of our acquisition discount based on actual and projected future results.
Asset quality
Our delinquency and charge off
data at any point in time reflect the credit performance of our managed receivables. The average age of our credit card accounts, the timing of portfolio purchases, the success of our collection and recovery efforts and general economic conditions
all affect our delinquency and charge off rates. The average age of our credit card receivables portfolio also affects the stability of our delinquency and loss rates. We consider the delinquency and charge off data reflected herein in determining
our allowance for uncollectible loans and fees receivable with respect to our loans and fees receivable, net on our condensed consolidated balance sheets, as well as the valuation of our retained interests in credit card receivables securitized
which is a component of securitized earning assets on our condensed consolidated balance sheets. As we charge off receivables, we reflect the charge offs of non-securitized receivables within our provision for loan losses, and we reflect the charge
offs of securitized receivables as an offset in determining income from (loss on) retained interests in credit card receivables securitized within fees and related income on securitized earning assets on our condensed consolidated statements of
operations.
Late in the third quarter and continuing into the fourth quarter of 2006, we discontinued our practice of billing finance
charges and fees on credit card accounts that become over 90 days delinquent. Prior to this change, our policy was to bill finance charges and fees on all credit card accounts, except in limited circumstances, until we charged off the account and
all related receivables, finance charges and other fees. In such prior periods, however, we excluded from our GAAP income and gross yield, net interest margin and other income ratio managed receivables data the finance charge and fee income on all
significantly delinquent on-balance-sheet credit card receivables for which we believed that collectibility was significantly in doubt on the date of billing. As such, managed receivables charge-off data associated with our on-balance-sheet credit
card receivables were largely unaffected by our billing practice change. This change in billing practice has affected, however, our securitized off-balance-sheet managed receivables data.
Our strategy for managing delinquency and receivables losses consists of account management throughout the customer relationship. This strategy includes
credit line management and pricing based on the risks of the credit card accounts.
Delinquencies.
Delinquencies have the potential
to impact net income in the form of net credit losses. Delinquencies also are costly in terms of the personnel and resources dedicated to resolving them. We intend for the account management strategies that we use on our portfolio to manage and, to
the extent possible, reduce the higher delinquency rates that can be expected in a managed portfolio like ours. These account management strategies include conservative credit line management, purging of inactive accounts and collection strategies
(as described under the heading “How Do We Collect from Our Customers?” in “Item 1. Business” of our Annual Report on Form 10-K for the year ended December 31, 2006) intended to optimize the effective
account-to-collector ratio across delinquency buckets. We measure the success of these efforts by measuring delinquency rates. These rates exclude accounts that have been charged off.
31
The following table presents the delinquency trends (dollars in thousands; percentages of total) for our
managed receivables, including: (1) all of the credit card receivables underlying the securitizations by our consolidated subsidiaries (adjusted to exclude the receivables associated with minority interest holders’ equity in our
majority-owned consolidated subsidiaries); (2) our respective 61.25%, 33.3% and 47.5% shares of the receivables that we manage on behalf of our equity-method investees; and (3) all non-securitized credit card receivables ($1.2 billion face
amount of receivables at September 30, 2007) except for those associated with our Investment in Previously Charged-Off Receivables segment’s balance transfer program:
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At or for the three months ended
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2007
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|
|
2006
|
|
|
2005
|
|
|
|
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Sep. 30
|
|
|
Jun. 30
|
|
|
Mar. 31
|
|
|
Dec. 31
|
|
|
Sep. 30
|
|
|
Jun. 30
|
|
|
Mar. 31
|
|
|
Dec. 31
|
|
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Period-end managed receivables
|
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$
|
3,722,315
|
|
|
$
|
3,501,413
|
|
|
$
|
2,525,856
|
|
|
$
|
2,599,477
|
|
|
$
|
2,544,797
|
|
|
$
|
2,472,122
|
|
|
$
|
2,351,667
|
|
|
$
|
2,317,751
|
|
|
Period-end managed accounts
|
|
|
5,268
|
|
|
|
4,756
|
|
|
|
3,797
|
|
|
|
3,700
|
|
|
|
3,611
|
|
|
|
3,502
|
|
|
|
3,414
|
|
|
|
3,248
|
|
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Receivables delinquent:
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|
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|
|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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30 to 59 days past due
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|
$
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206,346
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|
|
$
|
162,107
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|
|
$
|
104,051
|
|
|
$
|
121,149
|
|
|
$
|
119,432
|
|
|
$
|
115,441
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|
|
$
|
84,081
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|
|
$
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93,583
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|
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60 to 89 days past due
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|
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167,809
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|
|
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153,488
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|
|
|
91,156
|
|
|
|
101,615
|
|
|
|
102,920
|
|
|
|
89,164
|
|
|
|
71,213
|
|
|
|
68,531
|
|
|
90 or more days past due
|
|
|
408,620
|
|
|
|
336,958
|
|
|
|
258,918
|
|
|
|
277,896
|
|
|
|
269,752
|
|
|
|
206,234
|
|
|
|
184,693
|
|
|
|
156,414
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
|
|
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Total 30 or more days past due
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|
$
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782,775
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|
|
$
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652,553
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|
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$
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454,125
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|
|
$
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500,660
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|
|
$
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492,104
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|
|
$
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410,839
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|
|
$
|
339,987
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|
|
$
|
318,528
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|
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|
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|
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|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
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Total 60 or more days past due
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|
$
|
576,429
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|
|
$
|
490,446
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|
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$
|
350,074
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|
|
$
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379,511
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|
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$
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372,672
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|
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$
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295,398
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|
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$
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255,906
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|
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$
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224,945
|
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|
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|
|
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|
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|
|
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|
|
|
|
|
|
|
|
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Receivables delinquent as % of period-end loans:
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|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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30 to 59 days past due
|
|
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5.5
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%
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|
|
4.6
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%
|
|
|
4.1
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%
|
|
|
4.7
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%
|
|
|
4.7
|
%
|
|
|
4.7
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%
|
|
|
3.6
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%
|
|
|
4.0
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%
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60 to 89 days past due
|
|
|
4.5
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%
|
|
|
4.4
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%
|
|
|
3.6
|
%
|
|
|
3.9
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%
|
|
|
4.0
|
%
|
|
|
3.6
|
%
|
|
|
3.0
|
%
|
|
|
3.0
|
%
|
|
90 or more days past due
|
|
|
11.0
|
%
|
|
|
9.6
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%
|
|
|
10.3
|
%
|
|
|
10.7
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%
|
|
|
10.6
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%
|
|
|
8.3
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%
|
|
|
7.9
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%
|
|
|
6.7
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%
|
|
|
|
|
|
|
|
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|
|
|
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|
|
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|
|
|
|
|
|
|
|
|
|
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|
|
|
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Total 30 or more days past due
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|
|
21.0
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%
|
|
|
18.6
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%
|
|
|
18.0
|
%
|
|
|
19.3
|
%
|
|
|
19.3
|
%
|
|
|
16.6
|
%
|
|
|
14.5
|
%
|
|
|
13.7
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
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Total 60 or more days past due
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|
|
15.5
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%
|
|
|
14.0
|
%
|
|
|
13.9
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%
|
|
|
14.6
|
%
|
|
|
14.6
|
%
|
|
|
11.9
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%
|
|
|
10.9
|
%
|
|
|
9.7
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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We have experienced a trend-line of generally increasing delinquencies over the past 8 quarters as
noted in the above table, predominantly attributable to a mix change resulting from disproportionate growth in our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, the receivables of which experience
greater delinquency and charge-off levels than we experience with respect to our other credit card receivables. As the receivables underlying our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range become
a larger component of our overall managed receivables balance, this mix change tends to cause further trending increases in our overall delinquency and charge-off levels. Nevertheless, we believe that the heightened delinquency and charge-off levels
associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range are reasonable based on the relative returns offered.
Because of seasonality factors, the most relevant comparison in the above table is the comparison of our delinquency levels year over year between September 30, 2006 and September 30, 2007. Based upon this
comparison, our 30-plus day delinquencies increased 170 basis points and our 60-plus day delinquencies increased 90 basis points over September 30, 2006 levels. Factors relevant to an analysis of these increases and expected future delinquency
trends include:
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•
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The effects of the aforementioned change in the mix of our managed receivables (i.e., with a greater and increasing percentage of our managed receivables being
comprised of those associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range for which delinquencies and charge-off levels are much higher than for many of our other upper-tier and near-prime
credit card offerings) on delinquencies was significantly muted in the second quarter of 2007 by our UK Portfolio acquisition, the receivables of which bear delinquencies significantly below the delinquency levels of our receivables associated with
our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range—that is to say that the UK Portfolio acquisition had the effect of offsetting the otherwise expected significant increase in delinquencies
associated with our mix change toward a greater percentage of our receivables being comprised of those associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range.
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•
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Delinquencies for our acquired UK Portfolio run several hundred basis points higher than delinquency levels we typically experience for our other upper-tier and
near-prime credit card receivables, thereby also contributing to the delinquency increases between September 30, 2006 and September 30, 2007.
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•
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Disregarding the effects on our delinquencies of our acquired UK Portfolio and our mix change toward a greater proportion of our credit card receivables being
comprised of those receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, we remain pleased with the overall delinquency levels that we are seeing for our other credit card
receivables; while certain of our receivables show delinquency rate declines relative to September 30, 2006 levels, overall levels of delinquencies for our other credit card receivables are up only modestly from September 30, 2006, and we
believe that this increase reflects primarily the changes that we have made to some of our collection programs in order to reduce negative amortization.
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32
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|
•
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The fourth quarter 2006 implementation of our billing change under which we no longer bill finance charges and fees on credit card accounts once they become over 90
days delinquent accounts has helped to reduce the level of delinquency increases since June 30, 2006.
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|
•
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|
Recent marketing of our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range at historically high levels generated an
average of 750,000 of gross account additions during each of the second and third quarters of 2007 along with significant growth in new receivables that have not yet seasoned through delinquency and charge-off categories. The all-time high growth
rates for these new receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range have served to depress September 30, 2007 delinquency levels relative to September 30, 2006
levels. With our recent (September 2007) reduction in our marketing levels which are now targeted to produce between 150,000 and 200,000 gross account additions per quarter, we expect to see rising delinquencies as the unusually large vintages of
second and third quarter 2007 receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range season through delinquency categories and on to peak charge-off levels by eight to nine
months after card activation.
|
Considering all of the above, we continue to be pleased with the overall credit quality of
our managed receivables, including those underlying our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. While our analysis of vintage data suggests that there is some modest softening of credit
quality in certain of our portfolios, we have not seen any trends to date that make us uncomfortable with our ability to earn adequate long-term returns that comport with our general performance expectations. Certain account management actions we
expect to take in the fourth quarter to address negative amortization could have the effect of reducing our net interest margins and/or increasing our delinquency and charge-off levels and ratios. Yet, we remain comfortable that any margin
compression that we may see as a result of these actions will not significantly undermine our ability to earn attractive returns on our credit card product offerings.
Charge offs.
We generally charge off credit card receivables when they become contractually 180 days past due or within 30 days of notification and confirmation of a customer’s bankruptcy or
death. However, if a cardholder makes a payment greater than or equal to two minimum payments within a month of the charge-off date, we may reconsider whether charge-off status remains appropriate. Additionally, in some cases of death, receivables
are not charged off if, with respect to the deceased customer’s account, there is a surviving, contractually liable individual or an estate large enough to pay the debt in full.
The following table presents charge-off and other data (dollars in thousands; percentages annualized) for: (1) all of the credit card receivables
underlying the securitizations by our consolidated subsidiaries (adjusted to exclude the receivables associated with minority interest holders’ equity in our majority-owned consolidated subsidiaries); (2) our respective 61.25%, 33.3% and
47.5% shares of the receivables that we manage on behalf of our equity-method investees; and (3) all non-securitized credit card receivables except for those associated with our Investment in Previously Charged-Off receivables segment’s
balance transfer program ($1.2 billion face amount of receivables at September 30, 2007):
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|
|
For the three months ended
|
|
|
|
|
2007
|
|
|
2006
|
|
|
2005
|
|
|
|
|
Sep. 30
|
|
|
Jun. 30
|
|
|
Mar. 31
|
|
|
Dec. 31
|
|
|
Sep. 30
|
|
|
Jun. 30
|
|
|
Mar. 31
|
|
|
Dec. 31
|
|
|
Average managed receivables
|
|
$
|
3,613,868
|
|
|
$
|
3,419,192
|
|
|
$
|
2,576,300
|
|
|
$
|
2,557,897
|
|
|
$
|
2,512,066
|
|
|
$
|
2,420,272
|
|
|
$
|
2,341,712
|
|
|
$
|
2,256,994
|
|
|
Gross yield ratio
|
|
|
29.2
|
%
|
|
|
28.6
|
%
|
|
|
28.8
|
%
|
|
|
32.9
|
%
|
|
|
35.3
|
%
|
|
|
32.6
|
%
|
|
|
32.9
|
%
|
|
|
31.1
|
%
|
|
Combined gross charge offs
|
|
$
|
269,341
|
|
|
$
|
295,341
|
|
|
$
|
222,805
|
|
|
$
|
227,869
|
|
|
$
|
196,697
|
|
|
$
|
173,709
|
|
|
$
|
129,111
|
|
|
$
|
162,917
|
|
|
Net charge offs
|
|
$
|
125,360
|
|
|
$
|
143,816
|
|
|
$
|
86,067
|
|
|
$
|
76,384
|
|
|
$
|
64,773
|
|
|
$
|
57,572
|
|
|
$
|
47,571
|
|
|
$
|
75,708
|
|
|
Adjusted charge offs
|
|
$
|
94,449
|
|
|
$
|
81,237
|
|
|
$
|
84,201
|
|
|
$
|
68,377
|
|
|
$
|
59,642
|
|
|
$
|
51,225
|
|
|
$
|
39,344
|
|
|
$
|
62,078
|
|
|
Combined gross charge off ratio
|
|
|
29.8
|
%
|
|
|
34.6
|
%
|
|
|
34.6
|
%
|
|
|
35.6
|
%
|
|
|
31.3
|
%
|
|
|
28.7
|
%
|
|
|
22.1
|
%
|
|
|
28.9
|
%
|
|
Net charge off ratio
|
|
|
13.9
|
%
|
|
|
16.8
|
%
|
|
|
13.4
|
%
|
|
|
11.9
|
%
|
|
|
10.3
|
%
|
|
|
9.5
|
%
|
|
|
8.1
|
%
|
|
|
13.4
|
%
|
|
Adjusted charge off ratio
|
|
|
10.5
|
%
|
|
|
9.5
|
%
|
|
|
13.1
|
%
|
|
|
10.7
|
%
|
|
|
9.5
|
%
|
|
|
8.5
|
%
|
|
|
6.7
|
%
|
|
|
11.0
|
%
|
|
Net interest margin
|
|
|
19.1
|
%
|
|
|
19.0
|
%
|
|
|
17.9
|
%
|
|
|
22.6
|
%
|
|
|
25.6
|
%
|
|
|
23.7
|
%
|
|
|
25.2
|
%
|
|
|
22.6
|
%
|
|
Other income ratio
|
|
|
13.1
|
%
|
|
|
8.5
|
%
|
|
|
10.6
|
%
|
|
|
11.2
|
%
|
|
|
10.3
|
%
|
|
|
12.4
|
%
|
|
|
14.9
|
%
|
|
|
12.4
|
%
|
|
Operating ratio
|
|
|
10.5
|
%
|
|
|
10.5
|
%
|
|
|
12.0
|
%
|
|
|
13.7
|
%
|
|
|
11.2
|
%
|
|
|
10.0
|
%
|
|
|
10.7
|
%
|
|
|
12.9
|
%
|
Through the third
quarter of 2006 we experienced a general trend-line of improving gross yield ratios, net interest margin and other income ratios due to the change in mix of our managed receivables toward a greater proportion of them being comprised of receivables
associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range; these receivables have significantly higher delinquency rates and late fee and over-limit assessments than do our other originated
and purchased receivables portfolios, which overshadow the fact that these offerings bear lower APRs than our other credit card product offerings. This trend was largely reversed in the fourth quarter of 2006, and these ratios generally have been
depressed during 2007 by one or more of the following factors:
|
|
•
|
|
Our late third quarter 2006 decision to discontinue finance charge and fee billings on credit card accounts that become over 90 days delinquent and our transitional
implementation of that decision in the fourth quarter of 2006 has reduced our
|
33
|
|
ongoing gross yield ratio as we no longer bill finance charges and fees on any accounts over 90 days delinquent. This billing practice change had only a
modest effect on our net interest margin and our other income ratio in the second and third quarters of 2007 and is expected to have only a modest effect on these ratios in future quarters; these effects are modest because a large percentage of
finance charge and fee billings on 90-day plus delinquent accounts ultimately charge off and because we net such finance charge and fee charge offs against our net interest margin and other income ratio as they occur. The billing practice change
did, however, profoundly reduce our fourth quarter of 2006 and first quarter of 2007 net interest margins and other income ratios; in these two quarters, we experienced a mismatch between gross finance charge and fee billings and charge offs of
finance charges and fee because charge offs of finance charges and fees netted against these ratios included balances attributable to finance charges and fees assessed on accounts that became over 90 days delinquent prior to our change to
discontinue these billings.
|
|
|
•
|
|
Marketing volume-based volatility for the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring
range caused a peak in delinquencies at the end of the third and fourth quarters of 2006 and higher charge-off levels in the fourth quarter of 2006 and first quarter of 2007. This class of receivables reaches peak charge off on a vintage basis
between approximately eight to nine months after card activation, and we experienced marketing-based volatility in our volumes associated with this product offering as we ramped up its growth rates significantly late in 2005 and in the first half of
2006. As such, we experienced a heightened level of charge offs and delinquencies for this class of receivables in both the fourth quarter of 2006 and the first quarter of 2007 as significant vintages of receivables reached their charge-off peak
during these quarters. The higher charge offs cited here depressed our net interest margin (which is net of finance charge and late fee charge offs) and our other income ratio (which is net of other fee charge offs) in both the fourth quarter of
2006 and the first quarter of 2007 with some modest residual impact on our second quarter of 2007. We expect to see a similar phenomenon during the first and second quarters of 2008 as we have temporarily slowed our marketing and growth rates from
an average of 750,000 gross activated account additions in the second and third quarters of 2007 to a level expected to generate 150,000 to 200,000 quarterly gross activated account additions. As such, the unusually large vintages of new second and
third quarter 2007 receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range will season through delinquency categories and on to peak charge-off levels by eight to nine months
after card activation, and our currently targeted 150,000 to 200,000 of quarterly gross activated account additions will not produce finance charges and fees at levels that will offset these peak charge-offs.
|
|
|
•
|
|
Our April 4, 2007 acquisition of our UK Portfolio significantly muted the gross yield ratio, net interest margin and other income ratio relative to the ratios
we otherwise would have experienced in light of our ongoing mix change toward a greater percentage of our managed receivables being comprised of those associated with our largely fee-based credit card offerings to consumers at the lower end of the
FICO scoring range. While ratios associated with the UK Portfolio are performing as expected, the yields associated with these card offerings are much lower than those of our largely fee-based credit card offerings to consumers at the lower end of
the FICO scoring range and are more typical of those experienced within our originated portfolio master trust. As the UK Portfolio receivables continue to liquidate over time and the receivables associated with our largely fee based credit card
offerings to consumers at the lower end of the FICO scoring range continue to grow, we expect that these ratios will continue to grow.
|
|
|
•
|
|
We experienced better than expected early delinquency bucket roll rates and lower than expected delinquencies in the first quarter of 2007, which significantly
reduced our expected late fee assessments, thereby resulting in a lower first quarter of 2007 gross yield ratio and net interest margin. This phenomenon also caused some marginal depression in our other income ratio as over-limit billings included
in the other income ratio are typically higher for delinquent cardholder accounts. While adversely affecting first quarter 2007 income, the lower than expected first quarter 2007 delinquencies resulted in lower charge offs for us during the third
quarter of this year.
|
|
|
•
|
|
Our gross yield, net interest margin and other income ratios have been affected by the ongoing investigations by the FDIC and FTC. Throughout the course of the
investigations and, in particular, in the first quarter of 2007, we have made certain account management decisions in deference to our relationships with our issuing bank partners. For example, in the first quarter of 2007, we systematically issued
certain late fee and over-limit fee billing credits to 85,000 customer accounts related to the potential for customer confusion over a change we made to their minimum payment requirements. As we have previously noted, certain account management
actions we expect to take in the fourth quarter to address negative amortization could have the effect of reducing our net interest margins and/or increasing our delinquency and charge-off levels and ratios.
|
|
|
•
|
|
As noted previously, we experienced $25.5 million and $37.4 million of respective second and third quarter 2007 losses on our portfolio of investments in debt and
equity securities – principally related to investments in CDOs and CMOs backed by mortgages as well as trading positions in an ABX index. Gains and losses on these investment activities
|
34
|
|
historically have been reflected in our Credit Cards segment’s other income ratio, hence the significant reduction in the other income ratio in the
second quarter of 2007 and the depression of the other income ratio in the third quarter of 2007 relative to the level that otherwise would have been achieved based on second and third quarter growth in receivables and associated fees earned with
respect to our largely fee based credit card offering to consumers at the lower end of the FICO scoring range. But for the $37.4 million of investment portfolio losses, the Credit Cards segment’s other income ratio would have been 17.2% in the
third quarter of 2007.
|
Other factors relevant to an analysis of the above table include:
|
|
•
|
|
Higher trending quarterly gross yield ratios through the third quarter of 2006 correlate with (1) interest rate increases associated with cardholder accounts,
such rates being indexed to prime rates that increased along with Federal Reserve Board rate increases during that time period, (2) higher quarterly delinquency rates (and hence higher quarterly late fee billings) experienced in the latter half
of 2006 for the receivables within our originated portfolio master trust and purchased portfolios, and most significantly (3) higher trending quarterly delinquency rates (and hence higher quarterly late fee billings) associated with our change
in receivables mix toward a greater percentage of our receivables being comprised of those receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. As noted previously, these
receivables experience greater delinquency and charge-off levels than we experience with respect to our other credit card receivables.
|
|
|
•
|
|
While our charge off levels and ratios recently have benefited (particularly during 2006) from our marketing of new accounts underlying our originated portfolio
master trust, the favorable effects of new account additions have been offset by growth in our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, the receivables of which experience (a) greater
gross charge off levels than we experience within our originated portfolio master trust and with respect to any of our acquired receivables portfolios, and (b) adjusted net charge off rates higher than with those we experience within our
originated portfolio master trust and with respect to our acquired receivables portfolios. These phenomena will be further evident during the first and second quarters of 2008 as new account originations are targeted at the 150,000 to 200,000 of
quarterly gross activated account level and will not outpace expected charge offs of very large vintages of receivables added during the second and third quarters of 2007 when we averaged 750,000 of quarterly gross activated account additions.
|
|
|
•
|
|
Our April 4, 2007 UK Portfolio acquisition caused a higher second quarter 2007 combined gross charge off ratio and net charge off ratio than we would have
experienced absent the acquisition. A significant number of receivables within the UK Portfolio were in a late stage of delinquency at the time of our acquisition and have charged off in the months following the close of our acquisition. These
charge offs were substantially offset in the second quarter and to a lesser extent in the third quarter by our purchase price (or “credit quality”) discounts on the UK Portfolio, which led to a lower adjusted charge off ratio in the second
quarter than we have experienced in recent prior quarters and a lower adjusted charge off ratio than we otherwise would have experienced in the third quarter based on our continuing mix change toward a greater percentage of our receivables being
comprised of those associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. As our credit quality discount is used over the next several quarters and as we begin to experience charge offs
of new UK Portfolio cardholder purchases that we have funded sterling for sterling with no discount, we expect that our adjusted charge off ratio will continue climb and that the gap between our net charge off ratio and adjusted charge off ratio
will continue to narrow as is typical following our portfolio acquisitions. Also typical of our prior acquisitions, we expect to derive improved charge off performance (i.e., lower charge offs) from our account management actions with respect to the
UK Portfolio, and we are very encouraged by the early improvements we have seen compared to the seller’s historical experiences with the portfolio.
|
|
|
•
|
|
The rush of consumers to file for bankruptcy prior to the October 2005 effective date of the new bankruptcy laws caused unusually high fourth quarter 2005 charge
offs. This rush of bankruptcy filings served to accelerate certain charge offs that we otherwise would have experienced in 2006; as such, we experienced significantly lower bankruptcy and other delinquency charge offs than normal during the first
quarter of 2006. Bankruptcy-related charge offs during the subsequent quarters of 2006 also were somewhat lower than normal as well due to the October 2005 bankruptcy law changes, but the effects of these lower bankruptcy-related charge offs were
and continue to be offset by increased charge offs associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range.
|
|
|
•
|
|
Given the shorter life cycle of many of the accounts underlying the receivables associated with our largely fee-based credit card offerings to consumers at the
lower end of the FICO scoring range, we can experience greater volatility in our charge offs depending on the timing and relative volumes of quarterly account originations underlying these receivables in the months preceding their charge off. As
noted above, we experienced significant adverse effects of this volatility in the fourth quarter of 2006 and first quarter of 2007 as a significant level of high volume vintages reached peak charge-off
|
35
|
|
vintage during these two quarters. Not only did these peak charge-off vintages adversely affect our net interest margin and other income ratio as noted
above, but they also significantly increased our net charge off and adjusted charge off ratios in the fourth quarter of 2006 and to a much greater degree in the first quarter of 2007. As noted above, we expect to experience a similar phenomenon in
the first and second quarters of 2008.
|
|
|
•
|
|
Our net interest margin declined between the first and second quarter of 2006 principally due to (1) diminished second quarter 2006 beneficial effects of the
October 2005 bankruptcy law changes on finance charge and late fee charge offs, (2) increased interest costs on higher balances drawn on our structured financing facilities secured by those receivables associated with our largely fee-based
credit card offerings to consumers at the lower end of the FICO scoring range and (3) heightened levels of finance charge and late fee non-accruals into our net interest margin associated with greater amounts of delinquent receivables
underlying our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, which we marketed heavily in the last two quarters of 2005. This general decline reversed in the third quarter of 2006 (1) in part
because the percentage of managed receivables against which we had leverage and incurred interest costs as an offset to our net interest margin decreased in the third quarter and (2) in part due to lower levels of finance charge and late fee
non-accruals into our net interest margin in the third quarter given normalization of delinquencies for our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range coming into that particular quarter.
|
|
|
•
|
|
Our general trend-line of improving net interest margins (through the third quarter of 2006) correlates with improved gross yield ratios during that time period.
Additionally, the October 2005 bankruptcy law changes discussed above resulted in significantly diminished first quarter of 2006 and somewhat lower second and third quarter of 2006 bankruptcy charge offs—thereby favorably influencing our net
interest margins during those quarters.
|
|
|
•
|
|
Growth in our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range accounts for much of the trending increase in the
combined gross charge off ratio throughout 2006 and into 2007 relative to the respective quarters of 2005 and 2006, notwithstanding that the net charge off ratio actually declined slightly in the fourth quarter of 2006 relative to the fourth quarter
of 2005. The mix change in our receivables based on disproportionately larger growth in our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range can be expected to increase our combined gross charge off
ratios; however, the fact that the ratio of principal receivables to total receivables for this category of receivables is smaller than for our other originated and purchased credit card receivables means that the effects of the mix change are not
as great for our net charge off and adjusted charge off ratios as they are for our combined gross charge off ratio.
|
|
|
•
|
|
While some of the significant rise in the combined gross charge off ratio between the third quarter of 2006 and the fourth quarter of 2006 can be explained by our
receivables mix change as discussed previously, much of this increase is attributable to marketing volume-based volatility for our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Given the shorter
life cycle of many of the accounts underlying the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, we can experience greater volatility in our combined gross charge off
statistics depending on the timing and relative volumes of quarterly account originations underlying these receivables in the months preceding their charge off. We experienced adverse effects of this volatility in the fourth quarter of 2006 and the
first quarter of 2007 as a significant level of high volume vintages flowed through to peak charge-off vintage during these two quarters.
|
|
|
•
|
|
The change in receivables mix toward greater percentages of our receivables being comprised of those receivables associated with our largely fee-based credit card
offerings to consumers at the lower end of the FICO scoring range has adversely affected our net charge off ratios throughout 2006 and in 2007 as these offerings experience higher principal charge offs and principal charge off ratios than we
generally experience for our other originated and purchased credit card receivables. The magnitude of these adverse effects on our net charge off ratio increased in the fourth quarter of 2006 and into the first quarter of 2007 as a significant level
of high volume vintages flowed through to peak charge-off vintage during these two quarters.
|
|
|
•
|
|
Prior to our second quarter 2007 UK Portfolio acquisition, our most recent purchase of a credit card receivables portfolio purchased at a discount to the face
amount of the portfolio’s receivables was in the first quarter of 2005. The gap between our net charge off ratio and our adjusted charge off ratio generally narrowed throughout the 2005 and 2006 quarters subsequent to that first quarter 2005
purchase. As each quarter passes from our most recent purchase of a portfolio purchased at a discount to the face amount of the portfolio’s receivables, there is a greater percentage of our total managed receivables and charge offs thereon that
is comprised of receivables that we have originated at par rather than purchased at discounts off of their par value; this phenomenon causes the gap between our net charge offs and adjusted charge offs (and their associated ratios) to narrow with
each such passing quarter.
|
36
|
|
•
|
|
Our decision in the third quarter of 2006 to discontinue billing finance charges and fees on credit card accounts that become over 90 days past due was in part in
response to prior discussions with the FDIC concerning negative amortization and minimum payments. Leading to this decision, we also experimented with potential revisions to our over-limit fee billing practices, which had the effect of depressing
our other income ratio in the third quarter of 2006 relative to its level in prior quarters. While we have not ruled out future changes to our over-limit fee billing practices, some of which, if implemented, would adversely affect our other income
ratio, we concluded late in the third quarter that the discontinuation of billing finance charges and fees on credit card accounts that become over 90 days past due was an appropriate step at that time in response to concerns regarding negative
amortization.
|
|
|
•
|
|
The fulfillment of our commitments under the assurance agreement with the New York Attorney General contributed to the increase in our operating ratio in the second
quarter of 2006, and our fourth quarter 2006 and 2005 operating ratios bear the respective effects of a $15.0 million charitable contribution and a $12.0 million charitable contribution. Our 2006 and 2007 operating ratios are higher than they have
been in prior years principally associated with a mix change in our receivables toward lower balance receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. This
disproportionately growing category of receivables is comprised of accounts with smaller receivables balances than those accounts underlying our originated portfolio master trust and acquired portfolios. The addition of these many new accounts with
small receivables balances means many more customer service interactions, and hence higher costs as a percentage of average managed receivables, than we have historically experienced with our originated portfolio master trust and acquired
portfolios’ receivables. Also throughout 2006 and into 2007, we have experienced heightened legal, regulatory and compliance efforts and costs associated with the New York Attorney General, FDIC and FTC investigations and our establishment of
an expanded number of issuing bank relationships and new product offerings. Our expanding number of issuing bank relationships and new product lines also has contributed to higher credit card servicing costs. We summarize other factors influencing a
shift to higher operating ratio levels in the explanation of total other operating expense within the “Results of Operations” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
|
A summary of future expectations relative to the financial, operating and statistical data noted in the above table is as follows:
|
|
•
|
|
With our previously discussed decision to reduce marketing levels while the liquidity environment normalizes, we expect that unusually large vintages of new second
and third quarter 2007 receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range will season through delinquency categories and on to peak charge-off levels by eight to nine
months after card activation, thereby causing significantly higher charge-off levels and ratios, lower net interest margins, and lower other income ratios late in the fourth quarter of 2007 and into the first two quarters of 2008.
|
|
|
•
|
|
As we have previously noted, certain account management actions we expect to take in the fourth quarter to address negative amortization could have the effect of
reducing our net interest margins and/or increasing our delinquency and charge-off levels and ratios.
|
|
|
•
|
|
Our acquisition of approximately £490 million ($970 million) in face amount of UK Portfolio receivables at a discount to face is expected to continue to
have profound effects on our financial, operating and statistical data. Considering the effects of this acquisition (coupled with the mix change dynamics for our largely fee-based credit card offerings to consumers at the lower end of the FICO
scoring range), we expect to see a gradually increasing adjusted charge off ratio after the third quarter of 2007 as our net charge off ratio and adjusted charge off ratio narrows with the charge off of cardholder purchases that we have funded
sterling for sterling since our acquisition of the UK Portfolio. We also expect a lower operating ratio than we have experienced in recent prior quarters based on the fact that UK Portfolio is comprised of accounts with larger balance receivables
than those receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. This operating ratio trend will reverse over time and our operating ratio will again rise as the UK Portfolio
liquidates and as we continue to disproportionately grow our receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range.
|
37
Investments in Previously Charged-off Receivables Segment
The following table shows a roll-forward (in thousands) of our investments in previously charged-off receivables activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
For the three
months ended
September 30, 2007
|
|
|
For the nine
months ended
September 30, 2007
|
|
|
Unrecovered balance at beginning of period
|
|
$
|
13,357
|
|
|
$
|
12,871
|
|
|
Acquisitions of defaulted accounts
|
|
|
10,206
|
|
|
|
34,060
|
|
|
Cash collections
|
|
|
(21,899
|
)
|
|
|
(69,292
|
)
|
|
Accretion of deferred revenue associated with Encore forward flow contract
|
|
|
(3,886
|
)
|
|
|
(12,780
|
)
|
|
Cost-recovery method income recognized on defaulted accounts (included as a component of fees and related income on non-securitized earning
assets on our condensed consolidated statements of operations)
|
|
|
15,455
|
|
|
|
48,374
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at the September 30, 2007
|
|
$
|
13,233
|
|
|
$
|
13,233
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated remaining collections (“ERC”)
|
|
$
|
67,476
|
|
|
$
|
67,476
|
|
|
|
|
|
|
|
|
|
|
|
The above table reflects our use of the cost recovery method of accounting for our investments in
previously charged-off receivables. Under this method, we establish static pools consisting of homogenous accounts and receivables for each portfolio acquisition. Once we establish a static pool, we do not change the receivables within the pool. We
record each static pool at cost and account for it as a single unit for payment application and income recognition purposes. Under the cost recovery method, we do not recognize income associated with a particular portfolio until cash collections
have exceeded the investment. Additionally, until such time as cash collected for a particular portfolio exceeds our investment in the portfolio, we will incur commission costs and other internal and external servicing costs associated with the cash
collections on the portfolio investment that we will charge as an operating expense without any offsetting income amounts.
Previously
charged-off receivables held as of September 30, 2007 are principally comprised of those associated with Chapter 13 Bankruptcies and those acquired through our balance transfer program, which we expect to continue to service and grow through
future acquisitions. We expect our Investments in Previously Charged-Off Receivables segment to continue its acquisitions and servicing of Chapter 13 Bankruptcies, its acquisitions through its balance transfer program and other previously
charged-off receivables activities throughout 2007 and beyond. Such activities will include its acquisition of previously charged-off receivables from the securitization trusts that we service and from us and its sales of these charge offs for a
fixed sales price under its five-year forward flow contract with Encore.
We generally estimate the life of each pool of charged-off
receivables that we typically acquire to be between 24 and 36 months for normal delinquency charged-off accounts and approximately 60 months for Chapter 13 Bankruptcies. We anticipate collecting approximately 45.0% of the ERC of the existing
accounts over the next twelve months, with the balance to be collected thereafter. Our acquisition of charged-off accounts through our balance transfer program results in receivables with a higher than typical expected collectible balance. As the
composition of our defaulted accounts includes more of this type of receivables, the resulting estimated remaining collectible portion per dollar invested is expected to increase.
During the three and nine months ended September 30, 2007, our Investments in Previously Charged-off Receivables segment’s pre-tax income
increased 20.5% and 59.1%, respectively, compared with the same periods in 2006, reflecting increased volumes of charged off accounts sold under its 5-year forward flow agreement with Encore and continued growth in charged-off
receivables purchases through its balance transfer and Chapter 13 Bankruptcy purchasing niches. During 2007, Jefferson Capital has modestly increased its purchases of third-party normal delinquency charge offs (which are not connected to the
Encore forward flow agreement) as it has seen pricing for certain charge-off portfolios become more attractive. Any significant portfolio acquisition of third-party normal delinquency charge offs could have a short-term negative impact on Jefferson
Capital’s income as operating expenses would be incurred under its cost recovery accounting method, while revenue recognition would be delayed until complete recovery of the acquired portfolio’s basis. We expect our Investments in
Previously Charged-off Receivables segment to continue to experience growth in its balance transfer and chapter 13 bankruptcy business and to continue to gain momentum and increased market share in these areas. Its growth and performance for its
purchase and sale activities under the Encore forward flow agreement, however, are expected to grow more modestly, and continue to be conditioned on its ability to purchase flows of previously charged-off receivables from the securitization trusts
that we service and from us at attractive prices.
Retail Micro-Loans Segment
Our Retail Micro-Loans segment consists primarily of a network of storefront locations owned by our subsidiaries that, depending on the location, provide
some or all of the following products or services: (a) small-denomination, short-term, unsecured cash advances that are typically due on the customer’s next payday; (b) installment loan and other credit products; and (c) money
38
transfer and other financial services. As of September 30, 2007, our Retail Micro-Loans segment subsidiaries operated a total of 513 storefront
locations in 16 states as well as the United Kingdom.
In most of the states in which they have historically operated, our Retail
Micro-Loans subsidiaries have made cash advances and other micro-loans directly to customers. However, in four states (Arkansas, Florida, North Carolina and West Virginia), they previously acted only as a processing and servicing agent for a
state-chartered, FDIC-insured bank that issued loans to the customers pursuant to the authority of the laws of the state in which the bank was located and federal interstate banking laws, regulations and guidelines. During February 2006, we learned
from our bank partner that the FDIC had effectively asked insured financial institutions to cease deferred presentment and installment micro-loan activities conducted through processing and servicing agents. In response to the FDIC’s actions,
our subsidiaries began to evaluate strategic alternatives within these states, including the possibility of switching to a direct lending model in compliance with the regulatory frameworks within each of the four states, or, alternatively, closing
certain branch locations within the four affected states. In addition, effective March 11, 2006, our North Carolina Retail Micro-Loans subsidiary agreed with the Attorney General of the State of North Carolina to cease its traditional marketing
and servicing of deferred-presentment and installment micro-loans in North Carolina. As a result of this agreement, our North Carolina Retail Micro-Loans subsidiary began pursuing a direct lending model in North Carolina in compliance with existing
State regulatory frameworks, as well as closing several North Carolina locations. Subsequently, during the second quarter of 2006, our subsidiaries decided to abandon the pursuit of these alternative lending models in both North Carolina and West
Virginia, as they could not see the alternative lending products as providing acceptable long-term returns for the business. By the end of the third quarter of 2006, our North Carolina subsidiary had closed all of its original 52 branch locations
and our West Virginia subsidiary had closed all of its original 11 branch locations. In Arkansas, during the second quarter of 2006, our subsidiary began offering loans directly to customers under an alternative lending model, in compliance with
state law. This alternative lending model has been well-received by customers, and, during the third quarter of 2006, our subsidiary succeeded in returning its Arkansas operations to profitability. In Florida, the fourth state in which a subsidiary
previously processed and serviced micro-loans on behalf of its bank partner, our subsidiary began offering loans directly to customers during the fourth quarter of 2006.
During the three and nine months ended September 30, 2007, our subsidiaries opened 26 and 55 branch locations, respectively, including 50 locations in Texas, 3 locations in the United Kingdom, 1 location in
Arizona and 1 location in Louisiana in the nine months ended September 30, 2007. During the three and nine months ended September 30, 2007, our subsidiaries closed zero and 17 branch locations, respectively. During the first quarter of
2007, one of our subsidiaries closed all 7 of our branch locations in Virginia. The decision to close all of the Virginia locations was driven by the exit from North Carolina and West Virginia, which left the Virginia branches isolated
geographically and made it more difficult to scale the Virginia operations toward profitability. As of September 30, 2007, one of our subsidiaries operated 70 locations in the state of Texas, where our Texas micro-lending subsidiary offers and
provides credit services under a credit services organization (“CSO”) program to customers who apply for micro-loans offered by NCP Finance Limited Partnership, an independent third-party lender. In addition to assisting customers with
loan applications, if the customer is approved for and accepts the loan, our Texas subsidiary provides a letter of credit to the third-party lender to secure the customer’s payment obligations in the event of a customer default. The customer is
charged a fee under the CSO program (“CSO fees”) for the provision of these credit services.
During the first half of 2006, we
began exploring potential international market opportunities for our Retail Micro-Loans segment. As part of this effort, we focused on potential opportunities in the United Kingdom, where we believe customers will be receptive to the kind of
“multi-line” financial centers that have characterized our recent store expansion strategy in the United States. As of September 30, 2007, our United Kingdom subsidiary had 4 de novo stores operating in the greater London area.
39
Financial, operating and statistical metrics for our Retail Micro-Loans segment are detailed (dollars in
thousands) in the following tables.
|
|
|
|
|
|
|
|
|
|
|
For the nine months
ended September 30,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Beginning number of locations
|
|
475
|
|
|
509
|
|
|
Opened locations
|
|
55
|
|
|
32
|
|
|
Closed locations
|
|
(17
|
)
|
|
(71
|
)
|
|
|
|
|
|
|
|
|
|
Ending locations
|
|
513
|
|
|
470
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For the three months
ended September 30,
|
|
For the nine months
ended September 30,
|
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
Gross retail micro-loans fees (exclusive of processing and servicing revenues from FDIC-chartered bank)
|
|
$
|
31,396
|
|
$
|
26,810
|
|
$
|
85,892
|
|
$
|
69,253
|
|
|
Processing and servicing revenues from FDIC-chartered bank
|
|
|
—
|
|
|
325
|
|
|
—
|
|
|
5,840
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total gross revenues
|
|
$
|
31,396
|
|
$
|
27,135
|
|
$
|
85,892
|
|
$
|
75,093
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes
|
|
$
|
888
|
|
$
|
3,431
|
|
$
|
4,568
|
|
$
|
(14,333
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Period end loans and fees receivable, gross
|
|
$
|
93,734
|
|
$
|
86,073
|
|
$
|
93,734
|
|
$
|
86,073
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The loss before income taxes for the nine months ended September 30, 2006 reflects
impairment, indemnification, loan loss, and other charges of $17.1 million (including $10.5 million of associated goodwill impairment) primarily related to operating changes resulting from the FDIC’s actions in February 2006. While the
FDIC’s February 2006 actions resulted in the losses cited above, we are pleased with the revenue growth evident in our subsidiaries’ core direct storefront micro-loan operations. We believe this growth demonstrates positive momentum and
favorable operating trends in the core ongoing business of our Retail Micro-Loans segment. Throughout the remainder of 2007, we expect the new products that our subsidiaries have been rolling out under our multi-product line strategy to continue
contributing to revenue growth within our Retail Micro-Loans segment, and we expect to see continued profitability improvement, both overall and on a per-store basis. As noted in the above tabular comparison of third quarter 2007 versus third
quarter 2006 pre-tax income and the higher pace of new store openings has contributed to lower 2007 versus 2006 pre-tax earnings; new stores typically do not achieve profitability until several months after their opening. Also reflected in the lower
third quarter 2007 pre-tax results are the effects of increased charge offs and allowances for uncollectible loans and fees receivable in the third quarter of 2007, which we believe to be consistent with industry trends.
Auto Finance Segment
Our Auto Finance segment now
includes a variety of auto sales and lending activities.
Our original platform, acquired in April 2005, consists of a nationwide network
of pre-qualified auto dealers in the “Buy Here/Pay Here” used car business, from which our Auto Finance segment purchases auto loans at a discount or for which we service auto loans for a fee. We generate revenues on purchased loans
through interest earned on the face value of the installment agreements combined with discounts on loans purchased. We generally earn discount income over the life of the applicable loan. Additionally, we generate revenues from servicing loans on
behalf of dealers for a portion of actual collections and by providing back-up servicing for similar quality securitized assets. In the second quarter of 2006, we launched a new product, Dealer Equity Advance Loan (“DEAL”), whereby we earn
interest income on loans made directly to dealers. In the DEAL program, the dealer maintains the responsibility to service the customer accounts securing the loan to the dealer. Also during the second quarter of 2006, we launched a contract
custodial program to service smaller line of credit loan providers in the markets it services. We began a limited test launch of a second new product, Dealer Select Advance or DSA, in 2006, which continued into 2007. It is expected that this new
product will see growth through the remainder of 2007 as it is rolled out in a general release. In addition to these offerings, we also form strategic alliances with aftermarket product and service providers in an effort to cross-sell to their
existing customer base and are testing our ability to cross-sell other CompuCredit segment products to a select number of customers from within our existing customer base.
In January 2007, we acquired a 75% ownership interest in JRAS, a “Buy Here/Pay Here” dealer, for $3.3 million. Through the JRAS platform, we
sell vehicles to consumers and provide the underlying financing associated with the vehicle sales. Customer purchases are financed for periods of time between 24 and 36 months and credit is approved and payments are received in each storefront. We
currently retain all loans and servicing for all contracts. At acquisition date, our JRAS platform operated 4 retail
40
locations in Georgia. As of September 30, 2007, JRAS had 10 retail locations. Assuming the availability of liquidity at attractive pricing and terms, we
intend to expand these operations over the next year.
We acquired the assets of San Diego, California-based ACC in February 2007. In
conjunction with this purchase, we also acquired a $195.0 million auto loan portfolio from Patelco Credit Union. These assets were originated and serviced by ACC on behalf of Patelco. The total purchase price paid for the two acquisitions was $168.5
million. ACC serves a consumer niche that, from a customer quality perspective, is slightly above the niche historically served by our Auto Finance segment. While we had historically acquired existing retail installment contracts directly from
buy-here/pay-here dealers and small finance companies, ACC directly extends loans to consumers of predominantly franchised automobile dealerships.
Collectively, we serve 1,813 dealers through our Auto Finance segment in 45 states. Selected financial, operating and statistical data (dollars in thousands) for our Auto Finance segment are as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For the three months
ended September 30,
|
|
For the nine months
ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
2007
|
|
|
2006
|
|
Gross revenue from financing/servicing activities
|
|
$
|
21,121
|
|
|
$
|
13,680
|
|
$
|
58,344
|
|
|
$
|
38,832
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Automotive sales gross profits
|
|
$
|
4,111
|
|
|
$
|
—
|
|
$
|
7,089
|
|
|
$
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Loss) income before income taxes
|
|
$
|
(11,710
|
)
|
|
$
|
2,652
|
|
$
|
(15,366
|
)
|
|
$
|
6,686
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Period-end loans and fees receivable, gross
|
|
$
|
309,596
|
|
|
$
|
145,718
|
|
$
|
309,596
|
|
|
$
|
145,718
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of automobiles sold
|
|
|
931
|
|
|
|
—
|
|
|
1,691
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of loans held/serviced as of period end
|
|
|
53,571
|
|
|
|
43,282
|
|
|
53,571
|
|
|
|
43,282
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Relative to comparable prior year and first quarter 2007 data, the above third quarter 2007 data
reflect solid growth in our top-line revenues, gross loans and fees receivable, and loan origination activities. While our acquisition activities have obviously contributed to these growth trends, we are pleased with most of the origination
activities within our Auto Finance segment. Our loan originations through franchised dealers and our loans underlying our own buy-here/pay-here auto dealerships have grown at a pace that has more than offset liquidations of the Patelco portfolio
receivables. We continue to experience loan contractions, however, with respect to our loan purchase and lending activities to other third-party buy-here/pay-here dealers.
Our third quarter and year-to-date 2007 losses reflect in part our continuing need to reduce overhead and expense levels with respect to our loan
purchase and lending activities to third-party buy-here/pay-here dealers. Our Auto Finance segment management team has undertaken a series of expense reduction initiatives to right-size expense levels based on its lower loans receivable levels in
this area, and we expect to see further reductions associated with these and future initiatives throughout the remainder of 2007. The more significant of the contributions to our Auto Finance segment’s losses, however, are (1) fixed costs
that we now are incurring within our franchised dealer lending operations and buy-here/pay-here auto dealerships as we ramp up these immature business activities, (2) a third quarter 2007 impairment loss on the Patelco receivables portfolio,
which reflects our reassessment of the timing and amount of future expected cash flows on that portfolio and (3) high provisions for loan losses given the buildup of allowances for uncollectible loans and fees receivables associated with our
growth in auto loan originations. Because we must provide an allowance for uncollectible loans and fees receivable under GAAP on all new extensions of credit as we grow our auto loan originations and GAAP gives no effect to the value of the I/O
strip embedded within these new loan originations, we expect that our current and planned pace of loan originations will keep us at a GAAP loss for at least the next 15 months.
Other Segment
Our Other segment encompasses various activities that are start-up in nature. As
reflected in the financial data for the Other segment within our segment data (see Note 3, “Segment Reporting,” to our condensed consolidated financial statements included herein), we have invested significantly in a variety of start-up
businesses in keeping with our diversification strategy. Moreover, as with any start-up effort, there is testing that needs to occur as we work to refine our product offerings and businesses within our Other segment. For example, we have
experimented over the past couple of years with different underwriting processes and thresholds for a variety of Internet-based micro-loan and credit card products—this all in an effort to determine the right mix of marketing and systems costs
versus defaults.
Through our April 2007 acquisition of MEM, we now have a platform for the expansion of Internet-based micro-loan
underwriting in the United Kingdom. MEM is the UK’s leading online provider of micro-loans, offering cash advances as its predominant product. We expect in the future to be able to leverage MEM’s platform for our U.S.-based online
micro-loan operations, which have been limited in recent months to our subsidiaries’ role as simply a processing and servicing agent for a state-chartered, FDIC-insured bank under a so-called “bank model” program—a role that we
ceased playing in the third quarter of 2007. Similar to our
41
retail micro-loans operations, we expect our future online micro-loan operations to shift exclusively to a direct lending model, which will require a system
with state-level functionality to ensure compliance with state-enabling legislation and state regulations.
Additionally, our overall
direction has shifted significantly over the past few years with respect to our stored-value card offering. Our customer responses to this product offering support our belief that “un-banked” consumers want the convenience and flexibility
of a stored-value card. Nevertheless, the financial investments associated with our initial strategy of tying our technologies together with third-party retail partners proved too great relative to the revenue potential of this product offering.
While we may still continue exploring out-sourcing relationships related to a stored value card product as an adjunct to our credit card offerings, we began the process of unwinding our own stored-value card operations entirely during 2007. The
process of exiting this business was effectively completed during October 2007.
Despite our exit from the stored-value card business, we
continue to develop an underwriting, servicing and collections platform that uses non-traditional processes to offer credit products directly to consumers. These techniques include the utilization of external databases other than the traditional
credit bureaus, the application of proprietary scoring models built off of internal and external data attributes, proprietary application processing and approval methods and payment processing tools that currently are unique in the marketplace. We
generally refer to these collective methods, models and processes as our Market Expansion Platform (or “MEP”), and we consider them proprietary in nature. To date (and after an extensive research and development effort), we have launched
the Imagine MasterCard credit card product utilizing the MEP; we now include the costs and revenues associated with this product within our Credit Cards segment. The MEP has enabled us to expand the scope of consumers we can approve profitably for
these credit card products beyond what we traditionally could approve using our credit bureau-oriented underwriting models. Customers acquired to date have lower average FICO scores than we see in our other credit card products, a very limited
credit bureau history or no credit bureau history at all. The MEP also has allowed us to market our products on television, the Internet and through retail distribution at the point-of-sale, channels that until now have proven to be unsuccessful in
generating large numbers of profitable credit card customers for us. Starting in the third quarter of last year, we began to utilize the MEP in connection with our installment lending activities, and we believe we can use it to enter other product
lines, including retailer financing, auto lending and consumer receivables factoring, in the future. Although the August 2007 disruption in the global liquidity markets has caused us to limit the extensive levels of marketing of credit cards and
micro-loans through television and Internet channels that we saw earlier this year, we are hopeful that we can ramp up marketing through these channels in the near future as the liquidity markets normalize and additional financing becomes available.
Also based on third quarter changes in the global liquidity environment, we have discontinued—at least temporarily if not
permanently—some of our new product development activities for which we had not made any material infrastructure investments. The discontinued activities include our (1) underwriting, servicing, collecting and investing in asset-secured
consumer finance receivables such as loans secured by motorcycles, all terrain vehicles, personal watercraft and the like and (2) testing of an on-line mall of consumer electronics and other products for which we would have provided the
underlying consumer financing. Additionally, we are still evaluating over the next several months the levels of investment that we plan to make in our initiative to sell and finance mobile phone handsets and market and finance underlying
minutes’ usage by the customers who purchase these handsets.
In summary, while the level of investment we make in Other segment
development activities is dependent upon the overall liquidity environment and our ability to obtain desired growth capital at reasonable terms and pricing, our Other segment does allow us to employ our credit and underwriting knowledge and
technology infrastructure to develop and test new credit delivery programs. With appropriate liquidity, we see tremendous opportunity to grow our lending businesses through the use of Internet lead generators and search engines, and we expect most
of the activities supported by the Other segment to ultimately be profitable for us. As an example, our Other segment has been instrumental in our effort to marry the MEP underwriting technologies with credit card product offerings as discussed
above. These product offerings are generating incremental profits for us within our Credit Cards segment, and we have reclassified costs initially incurred within the Other segment to our Credit Cards segment so as to reflect a consistent matching
of costs and revenues for these new products within the Credit Cards segment. We constantly review our various business activities within the Other segment to determine whether they represent an appropriate allocation of capital, and in the current
global liquidity environment, we expect reduced spending levels within the Other segment based on reductions in capital allocations to the Other segment as described above.
42
The following table details (in thousands) the pre-tax losses that we have incurred for our major
initiatives within the Other segment:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For the three months
ended September 30,
|
|
|
For the nine months
ended September 30,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
Stored-value card
|
|
$
|
(393
|
)
|
|
$
|
(1,582
|
)
|
|
$
|
(1,377
|
)
|
|
$
|
(8,078
|
)
|
|
Internet micro-loans
|
|
|
(2,868
|
)
|
|
|
(2,446
|
)
|
|
|
(6,090
|
)
|
|
|
(8,652
|
)
|
|
Third-party receivables servicing and asset-secured consumer finance receivables
|
|
|
(1,261
|
)
|
|
|
(1,508
|
)
|
|
|
(5,218
|
)
|
|
|
(6,183
|
)
|
|
Other
|
|
|
(712
|
)
|
|
|
(381
|
)
|
|
|
(4,362
|
)
|
|
|
(1,354
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
(5,234
|
)
|
|
$
|
(5,916
|
)
|
|
$
|
(17,047
|
)
|
|
$
|
(24,266
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Liquidity, Funding and Capital Resources
During 2007, primarily toward the end of the second quarter and the beginning of the third quarter, broad investor interest in providing liquidity to
originators of sub-prime loans, including credit card receivables, declined substantially. This decline in interest was precipitated by the well-publicized problems in the sub-prime mortgage lending business and the related secondary markets
and the global liquidity dislocation that resulted from these problems. While these problems appear to reflect problems distinctly related to the sub-prime mortgage industry, investors in that industry also are investors in other sub-prime
asset classes, and one repercussion from the problems in the sub-prime mortgage industry was a reluctance—at least temporarily—by many investors to invest in any sub-prime asset classes, at least at the levels at which or with the terms
under which they previously invested. This, in turn, has resulted in a decline in liquidity available to sub-prime market participants, a widening of the spreads above the underlying interest indices (typically LIBOR for our borrowings) for the
loans that lenders were willing to make, and a decrease in advance rates for those loans as well.
Although we are confident the liquidity
markets will return to more traditional levels in due course, we are not able to predict when that will occur. As discussed below, we have adequate available liquidity for our current needs and for modest growth. However, more aggressive
growth such as the growth that would result from the level of marketing that we executed during the first six months of 2007 would, over time, require additional liquidity beyond what is available under our current facilities. Since the terms
and timing of that availability cannot be assured, we reduced our marketing efforts to a level consistent with our existing facilities and available liquidity. Once liquidity is again available to us on attractive terms, we expect to increase
our marketing efforts and thereby growth.
At September 30, 2007, we had $199.2 million in unrestricted cash. Because the
characteristics of our assets and liabilities change, liquidity management is a dynamic process affected by the pricing and maturity of our assets and liabilities. We finance our business through cash flows from operations, asset-backed
securitizations and the issuance of debt and equity:
|
|
•
|
|
During the nine months ended September 30, 2007, we generated $538.0 million in cash flow from operations, compared to $145.7 million during the nine
months ended September 30, 2006. The $392.3 million increase is due in part to (1) the returns and cash flows that we experience with respect to our growing portfolio of receivables associated with our largely fee-based credit card
offering to consumers at the lower end of the FICO scoring range; (2) increased profitability associated with our UK portfolio purchase; and (3) increased income and cash flows recognized with respect to our Investment in Previously
Charged-Off Receivables segment based on increased sales under its 5-year forward flow agreement with Encore Capital and continued growth in charged-off receivables purchases through its balance transfer and chapter 13 Bankruptcy purchasing.
Partially offsetting these increases are reductions in profitability associated with our purchased portfolios as the receivables underlying these trusts continue to liquidate.
|
|
|
•
|
|
During the nine months ended September 30, 2007, we used $747.5 million of cash in investing activities, compared to using $462.1 million of cash for
the nine months ended September 30, 2006. This $285.4 million increase in cash used in investing activities reflects our use of $192.1 million related to our acquisitions of our UK Portfolio, ACC, MEM and JRAS which closed during the nine
months ended September 30, 2007, as well as our continued growth in our largely fee-based credit card offering to consumers at the lower end of the FICO scoring range.
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During the nine months ended September 30, 2007, our financing activities provided $459.5 million, compared to $192.4 million during the same period in
2006. Our respective financing activities in the nine months ended September 30, 2007 and September 30, 2006 were varied. Major financing activities thus far in 2007 have included draws of $500.0 million on our two structured financing
facilities secured by those receivables associated with our largely fee-based credit card offering to consumers at the lower end of the FICO scoring range, $146.0 million of borrowings related to our acquisition
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of ACC, $53.9 million of proceeds from the exercise of warrants and $15.0 million of draws against a maximum capacity $200.0 million structured financing
facility within our Auto Finance segment, offset by $86.5 million used to purchase treasury stock and the repayment of debt associated with our investments in debt securities.
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As of September 30, 2007, we had approximately $275 million in immediately available liquidity. This available liquidity is represented by
unrestricted cash balances, draw potential against our collateral base within our originated portfolio master trust and draw potential against our collateral base supporting our structured financing facilities secured by our credit card receivables
associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Based on our current marketing plans, which are targeted to produce 150,000 to 200,000 of quarterly gross activated account
additions, and the excess capacity available under our financing and securitization facilities, which supports our ability to both draw against our current collateral base of receivables and continue to grow our collateral base of receivables
against which we can make future draws, we expect our available liquidity to be sufficient to meet our operational funding needs for the foreseeable future. We also are pursuing a number of new financing facilities and liquidity sources that will
support more aggressive marketing levels and opportunities that we believe are attractive in the current environment. While we cannot provide any assurances, we anticipate being able to complete transactions to add our desired growth capital at
acceptable terms and pricing during the fourth quarter of this year.
One such transaction we are exploring is an off-balance-sheet
securitization of most if not all of our portfolio of credit card receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Should we complete such a transaction, it will have a
significant impact on our financial statements, including (1) material reductions in our total interest income, interest expense, fees and related income on non-securitized earning assets, and provision for loan losses balances on our future
consolidated statements of operations, (2) material reductions in our loans and fees receivable, net and notes payable and other borrowings balances on our future consolidated balance sheets, (3) material increases in our fees and related
income on securitized earning assets and servicing income balances on our future consolidated statements of operations (i.e., of an aggregate magnitude much greater than the material reductions in the aforementioned consolidated statement of
operations balances in (1) above), and (4) material increases in our securitized earnings assets, current and deferred income tax liabilities and retained earnings balances on our future consolidated balance sheets (i.e., with an increase
in net assets much greater than the material reductions in the aforementioned consolidated balance sheet balances in (2) above).
Beyond our current efforts, we expect for the foreseeable future to evaluate debt and equity issuances as a means to fund our financial products and services originations and our credit card receivables portfolio and other complementary
acquisitions, and we expect to avail ourselves of opportunities to raise additional capital if terms and pricing are attractive to us.
The
first quarter 2007 repurchase of an aggregate 2,884,163 shares of our common stock evidenced on our consolidated statements of cash flows was part of the share repurchase program that our board of directors authorized in May 2006. Following this
repurchase, we are authorized to repurchase 7,115,837 additional shares under our repurchase program. We will continue to evaluate our stock price relative to other investment opportunities and, to the extent we have available liquidity and believe
that the repurchase of our stock represents an appropriate return of capital, we will repurchase additional shares of our stock. At our discretion, we may use acquired shares in treasury to satisfy option exercises and restricted stock grants.
Securitization Facilities
Our
most significant source of liquidity is the securitization of credit card receivables. As of September 30, 2007, we had committed total securitization facilities of $2.3 billion, of which we had drawn $1.5 billion. At September 30, 2007,
the weighted-average borrowing rate on our securitization facilities was approximately 7.47%. The maturity terms of our securitizations vary.
In the table below, we have noted the securitization facilities (in millions) with respect to which a substantial majority of our managed credit card receivables serve as collateral as of September 30, 2007. Following the table are
further details concerning each of the facilities.
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Maturity date
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Facility Limit(1)
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September 2008(2)
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$
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306.0
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January 2010(3)
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750.0
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October 2009(4)
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299.5
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October 2010(4)
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299.5
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January 2014(5)
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125.1
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September 2014(6)
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23.4
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April 2014(7)
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530.6
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Total
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$
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2,334.1
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(1)
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Excludes securitization facilities related to receivables managed by our equity-method investees because such receivables and their related securitization facilities are
appropriately excluded from direct presentation in our condensed consolidated statements of operations or condensed consolidated balance sheet items included herein.
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(2)
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Represents the end of the revolving period for a $306.0 million conduit facility, which we renewed in September 2007.
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(3)
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This two-year variable funding note facility also contains one-year renewal periods (subject to certain conditions precedent) at the expiration of the term and an orderly
amortization of the facility at expiration. In July 2007, we renewed this facility through January 2010 at a reduced size of $750 million; the note holder consented to our reduction in the size of this facility, which we sought in order to save
costs associated with unused capacity as we have sufficient funding capacity within our originated portfolio master trust to meet our growth expectations within that trust.
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(4)
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In October 2004, we completed two term securitization facilities that we issued out of our originated portfolio master trust: a 5-year facility represented by $299.5 million
aggregate principal notes and a 6-year facility also represented by $299.5 million aggregate principal notes. To date, we have elected to sell only $287.0 million of the principal notes underlying the 5-year facility and $264.0 million of the
principal notes underlying the 6-year facility. However, assuming the continuation of current market conditions and performance within our original portfolio master trust, we believe we can sell the remaining principal notes under acceptable terms
should we need additional liquidity from the sale of the notes during the life of the facilities.
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(5)
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Represents a ten-year amortizing term series issued out of the Embarcadero Trust.
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(6)
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Represents the conduit notes associated with our 75.1% membership interest in our majority-owned subsidiary that securitized the $92.0 million (face amount) of receivables it
acquired in the third quarter of 2004 and the $72.1 million (face amount) of receivables it acquired in the first quarter of 2005.
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(7)
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In April 2007, we closed an amortizing securitization facility in connection with our UK Portfolio acquisition; this facility is denominated and referenced in UK sterling.
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Our commentary within this section is predicated on our ability to operate successfully without triggering early
amortization of our structured financing or securitization facilities. We never have triggered an early amortization within any of the series underlying our originated portfolio master trust securitizations or our on-balance-sheet structured
financing facilities, and we do not believe that we will. Still, it is conceivable that, even with close management, we may trigger an early amortization of one or more of these outstanding series. Early amortization for any of these outstanding
securitization or structured financing facility series would have adverse effects on our liquidity, certainly during the early amortization period and potentially beyond repayment of any such series as potential investors could elect to abstain from
future CompuCredit-backed facility issuances.
Contractual Obligations, Commitments and Off-Balance-Sheet Arrangements
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on
Form 10-K for the year ended December 31, 2006.
Commitments and Contingencies
We also have certain contractual arrangements that would require us to make payments or provide funding if certain circumstances occur (“contingent
commitments”). We do not currently expect that these contingent commitments will result in any material amounts being paid by us. See Note 10, “Commitments and Contingencies,” to our condensed consolidated financial statements
for further discussion of these matters.
Recent Accounting Pronouncements
See Note 2, “Summary of Significant Accounting Policies and Condensed Consolidated Financial Statement Components,” to our condensed
consolidated financial statements for a discussion of recent accounting pronouncements.
Critical Accounting Estimates
We have prepared our financial statements in accordance with GAAP. These principles are numerous and complex. We have summarized our significant
accounting policies in the notes to our condensed consolidated financial statements. In many instances, the application of GAAP requires management to make estimates or to apply subjective principles to particular facts and circumstances. A variance
in the estimates used or a variance in the application or interpretation of GAAP could yield a materially different accounting result. It is impracticable for us to summarize every accounting principle that requires us to use judgment or estimates
in our application. In our Annual Report on Form 10-K for the year ended December 31, 2006, we discuss the six areas (valuation of retained interests, investments in previously charged-off receivables, non-consolidation of qualifying
special purpose entities, allowance for uncollectible loans and fees, goodwill and identifiable assets and impairment analyses, and investments in securities) where we believe that the estimations, judgments or interpretations that we have made, if
different, would have yielded the most significant
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differences in our financial statements, and we urge you to review that discussion. In addition, in Note 7, “Off-Balance-Sheet Arrangements,”
to the condensed consolidated financial statements included in this report, we have updated a portion of our sensitivity analysis with respect to retained interest valuations.
Related Party Transactions
From 2001 until August 2007, we subleased 7,316 square feet of excess
office space to Frank J. Hanna, Jr., who is the father of our Chairman and Chief Executive Officer, David G. Hanna, and one of our directors, Frank J. Hanna, III. The sublease rate of $24.19 per square foot was the same as the rate that we
paid on the prime lease. Total rent for the three and nine months ended September 30, 2007 for the sublease was approximately $29,500 and $116,500, respectively.
In June 2007, we signed a sublease for 1,000 square feet of excess office space at our new Atlanta headquarters office location, to HBR Capital, Ltd., a corporation co-owned by David G. Hanna and Frank J. Hanna, III.
The sublease rate of $22.00 per square foot is the same as the rate that we pay on the prime lease. This sublease expires in May of 2022.
In June, 2007, a partnership formed by Richard W. Gilbert (our Chief Operating Officer and Vice Chairman of our Board of Directors), Richard R. House, Jr. (our President and a member of our Board of Directors), J.Paul Whitehead III (our
Chief Financial Officer), Krishnakumar Srinivasan (President of our Credit Cards segment), and other individual investors (including an unrelated third-party individual investor), acquired £4.7 million ($9.2 million) of class
“B” notes originally issued to another investor out of our UK Portfolio securitization trust. This acquisition price of the notes was the same price at which the original investor had sold $60 million of notes to another unrelated third
party. As of September 30, 2007, the outstanding balance of the notes held by the partnership was £4.2 million ($8.7 million). The notes held by the partnership comprise approximately 1.5% of the $600.8 million in total notes within
the trust on that date and are subordinate to the senior traunches within the trust. The “B” traunche bears interest at LIBOR plus 9%.
In December 2006, we established a contractual relationship with Urban Trust Bank, a federally chartered savings bank (“Urban Trust”), pursuant to which we purchase credit card receivables underlying
specified Urban Trust credit card accounts. Under this arrangement, in general Urban Trust receives 5% of all payments received from cardholders and is obligated to pay 5% of all net costs incurred by us in connection with managing the program,
including the costs of purchasing, marketing, servicing and collecting the receivables. Frank J. Hanna, Jr., owns a substantial minority interest in Urban Trust and serves on its Board of Directors. In December 2006, Urban Trust deposited $0.7
million with us to cover its share of future expenses of the program. Also in December 2006, we deposited $0.3 million with Urban Trust to cover purchases by Urban Trust cardholders. Through September 30, 2007, Urban Trust used all of the $0.7
million deposit to fund its share of the net costs of the program and was making additional contributions to cover further growth. Also through September 30, 2007, we increased our deposit with Urban Trust to $4.1 million to cover the growth in
purchases by Urban Trust cardholders. Urban Trust’s share of receivables under cardholder accounts was approximately $12.0 million as of September 30, 2007.
See Note 2, “Summary of Significant Accounting Policies and Consolidated Financial Statements Components,” to the consolidated financial statements included within our Annual Report on Form 10-K for the
year ended December 31, 2006 for a discussion of the investments in previously charged-off receivables by one of our subsidiaries from trusts serviced by us.
See Note 10, “Commitments and Contingencies,” to the condensed consolidated financial statements included in this report for discussion of a now-terminated indemnity agreement into which we had entered with
Maverick associated with its participation in loans originated by a financial institution for which we have provided micro-loan servicing and processing services. Richard W. Gilbert, a Director on our Board of Directors and our Chief Operating
Officer, has a 20% economic interest in Maverick, and Mr. Gilbert’s son is its manager.
Forward-Looking Information
We make forward-looking statements throughout this report including statements with respect to our expected revenue, income, receivables, income ratios,
net interest margin, marketing-based volatility in peak charge-off vintages, acquisitions and other growth opportunities, location openings, loss exposure and loss provisions, delinquency and charge-off rates, changes in collection programs and
practices, securitizations and gains and losses from securitizations, changes in the credit quality of our on-balance sheet loans and fees receivable, account growth, the performance of investments that we have made, operating expenses, marketing
plans and expenses, the profitability of our Auto Finance segment, expansion and growth of JRAS and ACC platforms, integration of our Auto Finance platforms, growth and performance of receivables originated over the Internet or television,
U.S.-based online micro-loan operations, our plans in the United Kingdom, the impact of the acquisition of our UK Portfolio of credit card receivables on our financial performance, performance of UK portfolio, sufficiency of available liquidity,
improvements in the liquidity markets, future interest costs, sources of funding operations and acquisitions, our ability to raise funds or renew financing facilities, the potential effects of off-balance-sheet securitizations on our financial
condition and results of operations, our income in equity-method investees, growth in our ancillary and interchange revenues, our servicing income levels, gains and losses from investments in securities (including asset-backed securities), new
product research and development efforts and other statements of our plans, beliefs or expectations are forward-looking statements. In some cases these statements are identifiable through the use of words such as “anticipate,”
“believe,” “estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,”
“would” and similar expressions.
You are cautioned not to place undue reliance on these forward-looking statements. The
forward-looking statements we make are not guarantees of future performance and are subject to various assumptions, risks and other factors that could cause actual results to differ
46
materially from those suggested by these forward-looking statements. Actual results may differ materially from those suggested by the forward-looking
statements that we make for a number of reasons including those described in Part II, Item 1A, “Risk Factors,” of this report.
We expressly disclaim any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.