Print this Article By Richard Openshaw and Tommy Lee

W ith mortgage delinquencies at a 29-year high, credit card charge-off rates continuing to climb, and consumer bankruptcies surging,2 the U.S. credit crisis poses major challenges for all card portfolios. Indeed, the credit card charge-off rate has been steadily rising since the last quarter of 2005 and spiked in the second quarter of 2008 (see Figure 1). Card issuers everywhere are under pressure to reduce credit losses and operating costs while maintaining—if not increasing—their number of active, profitable accounts. The challenge: optimizing portfolio performance while carefully balancing risk against growth objectives.

During an economic downturn, many issuers are inclined to "lock everything down" and to focus solely on risk mitigation. But the experience of prior recessions has proven that practice to be short-sighted. MasterCard Advisors recommends that you continue to reward good cardholder behavior; don't just penalize bad behavior.

This column focuses on three strategies that you can put into practice today to better manage delinquencies, stem charge-offs, and maintain profitability. While these three recommendations are most effective if executed in concert, each on its own can produce positive results. The three strategies are:

1.  Tightly manage credit line increases and decreases
2.  Fine-tune pricing models for maximum profitability
3.  Deal with delinquencies at the earliest stage possible

Strategy One: Tightly Manage Credit Line Increases and Decreases

Better credit line management begins with deepening your knowledge of each customer and each customer segment. MasterCard Advisors believes that credit bureau scores can only approximate a cardholder's actual credit behavior and risk. We advocate monitoring the behavioral elements through which cardholders manifest their needs, desires, experience, and capacity to handle initial line assignments and subsequent line increases. Statistical methods can also help you target those segments with the highest propensity for card usage, while minimizing losses. We recommend a variety of qualitative and quantitative measures to identify market pressures within each segment. Among the behavior patterns we generally take into account are:

• Velocity - the speed of balance growth and/or transactional frequency
• Impulse - transactions that differ considerably from past spending levels
• Acceleration - the rate of change in balance or transaction frequency
• Utilization - the appetite for credit, relative to credit-level potential
• Capacity - the ability to manage card use, which is manifest in cardholder payment patterns
• Risk - score degradation over a short period of time

We also suggest selectively adjusting portfolio lines after three months of activity, compared to the six-month adjustments typical of most behavior scores. This enables you to increase the card's utility to the cardholder and to accelerate higher card usage and revenue generation.

Case in Point: Identifying Excessive Charge-Offs
A global issuer based in North America had booked accounts with consumers having strong FICO scores and allocated line assignments according to their anticipated risks. However, as the portfolio matured, the issuer began to experience excessive charge-off rates, far above what had been predicted. While the unit charge-off rate was in line with FICO risk scores, the portfolio's actual dollar losses were much higher. Upon investigation, Advisors found that line assignments were much too high for certain segments of responders. One segment in particular was comprised of students with strong FICO scores who lacked the capacity and maturity to handle high lines of credit. After re-segmenting the portfolio, we recommended changes in line management (both line increases and decreases) and delinquency strategy. Following implementation, charge-off rates were cut in half within 90 days—declining from a range of 7.6 to 8.0 percent to an average of 3.7 percent.

Case in Point: Spotting Profitable Cardholders Earlier
A regional North American issuer wanted to do a better job of identifying profitable cardholders early in the customer lifecycle in order to maximize revenues sooner, without materially increasing losses or delinquencies. Advisors developed a model to identify more profitable segments (as defined by net income). These early indicators gave strong evidence of each account's long-term performance prospects—and were available months before behavior scores were ready.

Advisors also offered best practices for monitoring accounts, learning from cardholder behaviors, and using that knowledge not only for account management, but for acquisitions as well. By reviewing the issuer's acquisitions strategy and criteria, then devising a profitability metric, we were able to identify additional prospects the bank was previously rejecting. These neglected prospects were a lost opportunity for the bank. Figure 2 summarizes the results: The bank's original acquisitions strategy ("Criteria A") was found to be too restrictive. Advisors uncovered additional customers who would be equally profitable, while representing no more risk ("Criteria B"). The results for the bank included a 12 percent lift in response rate or booked accounts, which in turn led to higher early month-on-book outstandings and sales.

Strategy Two: Fine-Tune Pricing Models for Maximum Profitability

The advantages of risk-based pricing are well established: Your best customers receive lower rates, which can stimulate further usage (particularly when credit line increases are also offered), while allowing higher rates to be set for customers found to represent greater risk. Improved credit line management goes hand in hand with more targeted risk-based pricing, and there is significant overlap in the steps that should be taken to achieve both. Each process begins with attaining better customer knowledge and better market segmentation, which ideally should be based on direct knowledge of the issuer's own customer base, as opposed to industry norms and averages.

We recommend using advanced analytics and segmentation techniques to conduct a thorough review of all of your company's risk-based pricing strategies—with an eye to determining the impact they are having on cardholder behavior. Carefully evaluate loss and attrition rates, as well as delinquencies. Using customer spending and payment histories, as well as credit bureau data, you can then devise strategies and payment elasticity models to fine-tune pricing adjustments. All of these steps should help reduce both account attrition and forced charge-offs.

During an economic downturn, many issuers are inclined to "lock everything down" and to focus solely on risk mitigation. But the experience of prior recessions has proven that practice to be short-sighted.

Case in Point: Taking Care When Repricing
An international issuer trying to raise funds for further acquisition efforts decided to randomly reprice half of its portfolio in hopes that increased interest rates would garner more revenue. Unfortunately, the issuer raised fees and rates without regard to the pay-downs, early payment defaults, and account closures that might result from cardholder resistance to the new pricing. And indeed, the issuer's revenues took a steep dive from what it had originally forecast, damaging both quarterly results and share price. MasterCard Advisors stepped in to help the client get a better picture of its accounts (see Figure 3). We examined bureau credit files to determine their effectiveness, then created a sensitivity model and conducted various what-if scenarios to identify those customers who would be either positively or negatively affected by price changes. We integrated new criteria and business rules into the model so that the issuer could apply the new pricing only to those customers who would produce a positive net effect for the bank. Based on results thus far, the client anticipates a payoff of up to 30 percent in profit, with a 120 basis-point reduction in its charge-off rate.

Strategy Three: Deal with Delinquencies at the Earliest Stage Possible

A primary goal of any strategy aimed at improving delinquency management should be to keep cardholders as customers whenever possible. The challenge is to maximize collections without unnecessarily turning accounts into charge-offs or otherwise alienating those cardholders who, although they are late payers, still have the potential to remain valuable customers over time.

MasterCard Advisors' approach begins with segmenting delinquent accounts by likelihood of payment, based on each account's payment history, amount of debt, and change in score. Modeling is an integral part of customer lifecycle management, and a customized model—based on the issuer's own data—is nearly always better than an off-the-shelf one. It is critical to use an effective scorecard that incorporates such factors as size of spend, utilization, on-time payment history, and any history of broken payment promises. Each cardholder is unique and requires a different approach. A group of delinquent customers who have broader relationships with the bank, for example, should receive preferential treatment over delinquent cardholders who use only one or two of the bank's products.

Advisors uses a statistical scoring method to determine each customer's inherent risk level. We then target the issuer's riskiest accounts, so we can reach out to cardholders before they become charge-offs. Armed with better insight into each cardholder segment, the issuer can also increase credit limits to low-risk accounts. And we combine it all with workflow applications to manage the day-in and day-out routing of accounts to the appropriate customer service units so that resources are used most effectively. It is important to solicit feedback from both sides of the bank—risk management and collections—because each has different goals. Achieving alignment between these two units on overall strategy and business valuation can insure that both groups' needs are met.

Case in Point: Improving Recovery Rates
A leading international issuer wanted to act on its own to collect as many of its charged-off accounts as possible, before outsourcing the remaining work to external collection agencies. Its principal challenge was to do a better job of predicting and targeting customers in order to improve recovery rates. The bank quickly discovered, however, that there was no alignment between its credit and collections functions. The issuer had been segmenting accounts simply by the length of time the account had been delinquent. MasterCard Advisors assessed the client's infrastructure and operations before developing, testing, and validating a new scorecard model based on an advanced statistical algorithm. We helped the bank identify those accounts that collections could easily recover, thereby minimizing the number of accounts that needed to be outsourced. Finally, we created a new decision tree, along with new processes for choosing which accounts to outsource, selecting the right collections agency, and prioritizing customers based on payback ratios. The client successfully implemented Advisors' model and, as a result, improved its recovery rate by 40 percent—in half the time that the old model would have taken.

In Times of Crisis, Measured Responses Are More Effective than Hasty Ones

The present credit crisis poses enormous challenges for all card issuers, who must manage credit risk across product lines and customer segments—and in close coordination with marketing, so as not to unnecessarily dampen new acquisitions. The challenge is even more acute than in past credit cycles because consumer payment patterns are changing. (See "A Growing Group of 'Won't Payers' Raises the Risk of Default" in this issue.) Whereas card payments once took a back seat to mortgages, home equity lines, utility bills, and food expenditures, they're now often the first bills that consumers pay. The reason: Many people now view their credit cards as their last remaining lifeline to credit. Thus, spending and revolving levels are rising, and so are delinquencies.

Managing credit risk should be an ongoing process, not a one-shot corrective. In the face of rising credit risk, it is ill advised to make sudden, draconian moves—such as eliminating pro-active credit line increases—that might have severe unintended consequences on portfolio performance. Instead, adopt the practice of constantly challenging the status quo. Review your segmentation models; use statistical tools to identify cardholders with the greatest propensity to remain profitable, as well as those with the least propensity. Meanwhile, fine-tune your pricing models and proactively target your riskiest accounts in order to avoid rising charge-offs. Using this approach, you can balance portfolio growth against risk to come out ahead, increasing profitability even in challenging times.

1. Seasonally adjusted delinquency rate for U.S. mortgage loans on one-to-four-unit residences was 6.35 percent in Q1 2008. Mortgage Bankers Association, "Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey," June 5, 2008.
2. American Bankruptcy Institute, "May Consumer Bankruptcy Filings Increase Nearly 31 Percent Over Previous Year," June 5, 2008.

Richard Openshaw is a Global Solutions Leader in MasterCard Advisors' Risk Management, Fraud, and Operations Efficiency practice. He and his team provide strategic lifecycle risk management consulting that helps issuers increase the profitability of their portfolios. Based in Purchase, N.Y., Mr. Openshaw can be reached at richard_openshaw@mastercard.com.

Tommy Lee is a Managing Consultant in MasterCard Advisors' Risk Management, Fraud, and Operations Efficiency practice. He helps clients identify and implement risk strategies and tools that improve the performance of their card portfolios. Based in Miami, FL., Mr. Lee can be reached at tommy_lee@mastercard.com.

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