Print this Article By Ramsey El-Assal and Edmund V. Tribue

T oday's stalling U.S. economy shows many of the classic symptoms of a general economic downturn. Consumer confidence and spending are both withering rapidly. The housing market is weak as a result of the sub-prime mortgage crisis. Household debt levels are at an all-time high, fueling an increase in bankruptcy filings. Though card delinquency and charge-off rates are at manageable levels for now, both are trending upward quickly.

As a credit card issuer, you might well ask: Will this economic downturn play out like previous down cycles, or will my customers act differently this time? Will their behavior have unexpected consequences for my portfolio?

Indeed, the sources of today's crisis are quite different from those responsible for prior economic slowdowns. Non-traditional mortgages are producing previously unseen patterns of consumer behavior and credit default. The traditional consumer payment hierarchy—which placed payment of mortgages and other secured debt above unsecured credit card debt—has been turned on its head among some consumer segments. Acting in their rational self-interest, consumers may pay their credit card bills, or a subset of those bills, before they pay their mortgage.

This new consumer attitude presents unfamiliar challenges to issuers and their risk strategies. To prepare for what lies ahead, issuers should tailor their risk strategies and operational processes to the current crisis. By understanding these new consumer payment patterns, issuers will be able to better identify at-risk cardholder segments, as well as devise strategies and processes to handle them. But they must act quickly.

Why This Economic Crisis Is Different

All credit crises are not created equal. What sets them off—their catalyst—determines how they develop, progress, and eventually end. In many previous crises, high inflation or unemployment hobbled the economy and left many households unable to pay their bills or service their debt. The global "stagflation" of the 1970s fits this scenario: High energy costs combined with excessive growth of the money supply (due to aggressively low interest rates) created persistent inflation, which in turn led to high unemployment and corresponding loan defaults.

The current credit crisis is different. Instead of an underlying economic weakness, it was an excess of liquidity that encouraged (in Alan Greenspan's memorable parlance) "irrational exuberance." Too much money in circulation translated into undisciplined home mortgage lending, which in turn created a bubble in real estate prices. When home values reached unsustainable levels, they crashed. Many borrowers were left under water—they owed more on their mortgages than their homes were worth. They haven't defaulted on loans because they lost their jobs, but rather they stopped paying because they realized that they had significantly overextended themselves. Of course, there is a certain point at which both types of crises begin to resemble one another—a high unemployment rate is a high unemployment rate, no matter what ignites it—but in the early stages, each type of crisis has a telltale signature.

Won't Payers Versus Can't Payers

This distinction is critical. To understand why, it helps to recall a common collections industry adage: There are only two types of defaulters—those who won't pay, and those who can't pay. The sub-prime mortgage crisis has created a cohort of defaulters consisting of many more Won't Payers than in the past. As U.S. households have taken on more debt, income growth has stagnated, and home values have fallen, even the credit-worthy are forced to make choices about which bills to pay. The following key statistics help us understand why:

• Thirty-three percent of all homes purchased in the U.S. in 2007 were bought as second homes (which
  also includes vacation properties), rather than primary residences.1 By contrast, in 2001 only 5.5 percent
  of homes sold were second homes.2
• The average U.S. homeowners' home equity fell below 50 percent for the first time since 1945 to 47.9%
  in Q4 2007—due to the popularity of low- and zero-down payment mortgages and the surge in home
  equity lines of credit and cash-out refinancing.3
• More than half (61 percent) of sub-prime loans in 2006 were actually made to people with prime
  credit scores. Brokers realized a premium on the higher yields generated by these more expensive products.
  Borrowers got access to more funds by taking these higher rates.4
• Even though the unemployment rate in the U.S has averaged only 5 percent over the past three years,5
  per capita disposable income has been growing anemically (1.7 percent annually from 2000 to 2007),6
  which may be why consumer debt keeps rising steadily year over year.7

These indicators all point to a sizable number of borrowers who took advantage of the excess liquidity in the system to make small down payments on non-traditional mortgages that were larger than they could handle. Many of these homeowners have the capacity to pay some of their obligations but not all, so they opt to default on debts deemed non-critical. These Won't Payers may not make up the majority of current defaulters, but they represent a growing and newly significant segment—one that many risk analysts have failed to detect and take into account.

That's because Won't Payers behave differently than expected, making them harder to spot and manage. Unlike past borrowers, who made large down payments and needed to keep the roofs over their heads, these debtors are not inspired to fight vigorously to keep their properties. Their monthly payments have risen precipitously, while the value of their properties has plummeted. They simply cannot meet the higher monthly payments and it is easier for them to walk away from their debt. Unlike the Can't Payer—who loses the ability to pay their bills but would rather not default—the Won't Payer makes a deliberate decision to cease payments on some debts in order to preserve the ability to pay other, more critical obligations.

This is where credit cards enter the equation. Borrowers usually have three categories of debt: credit cards, mortgage, and auto loans. In the first months of the sub-prime mortgage crisis, mortgage lenders reported that borrowers protected their credit cards and auto loans at the expense of servicing their mortgages. Over-extended borrowers needed their credit cards to pay for groceries, and a car to get to work. In contrast, losing the home on which they made merely a token down payment, or which was purchased strictly as an investment property, became surprisingly painless.

But the payment hierarchy is not clean-cut. Won't Payers do not necessarily organize their defaults by category of debt, but may instead choose to pay or not pay specific debts spread across multiple categories. That is, they may decide which obligations are essential and which are not, regardless of category, and then continue to pay obligations deemed core while defaulting on the rest. Borrowers might, for example, choose to default on the mortgage for their investment property, their third car, and their secondary credit card, while continuing to service their primary mortgage, their other two cars, and the primary credit card they use every day.

Linking Wallet Share to Default Rates

This behavior of selective defaulting presents unique challenges for card issuers worried about the risk of write-offs. First, this type of default is often sudden and final. Even though an issuer may roll the delinquent amount from bucket to bucket for six months, from the Won't Payer's perspective the debt might as well be charged off immediately. Unlike Can't Payers, these individuals have no intention of picking up these payments again or trying to work out a settlement. Once they have decided to sacrifice a specific card, these debtors move on.

One window into the mind of Won't Payers is wallet share. These consumers try to hang onto the cards they rely on the most. Cards that lack significant wallet share are more vulnerable to default. Won't Payers may have many rationales for this choice, but the most important reason is often that the top-of-wallet card has been open the longest, carries the highest credit line, and has the highest percentage of that line utilized. (It might very well be a rewards card, too, with lots of accumulated "miles" or points.) That makes it tougher and costlier for a consumer to walk away from such an obligation.

In addition, cardholders with multiple cards tend to segregate their spend by product—devoting one card to travel and entertainment and another to retail purchases, for example. In an economic downturn, consumers use their cards more for indispensable goods and services across the board. But the cards earmarked for non-essential categories of spend become more vulnerable to default.

Even though an issuer may roll the delinquent amount from bucket to bucket for six months, from the Won't Payer's perpective the debt might as well be charged off immediately.

Complicating matters further, this type of default is hard to see coming. The cards about to be sacrificed by Won't Payers do not necessarily manifest a noticeable increase in balance, a rapid draw-down on the line, or a change in spending categories. In many instances, these accounts appear fine one moment and become delinquent the next.

How Issuers Can Protect Themselves

The current credit crisis has shuffled the historic consumer payment hierarchy, causing many senior banking executives to ask Advisors if the changes they are seeing are unique to their customer base or a universal market phenomenon. MasterCard Advisors' Risk Management practice has, in fact, observed that growing number of consumers worldwide are giving credit cards, especially their primary cards, higher payment priority over mortgages and other secured debt.

This new behavior pattern in the face of an economic downturn makes portfolio risk assessment more challenging for issuers. Now more than ever, issuers must take the time to identify the connections between economic trends, large and small, and the behaviors of specific cardholder segments in each portfolio. To better protect themselves, Advisors recommends a few approaches that can lower risk exposure considerably:

Be proactive. Put in place a proactive account management strategy that begins by analyzing your current portfolio to identify cardholder behaviors that indicate at-risk accounts. Segmenting consumers by FICO score and spend/payment history is no longer sufficient; pay attention to behavioral and other indicators (see "Rethinking Your Credit Risk Strategies" in this issue). A comprehensive analysis of historical delinquency will help surface changes in behavior patterns and the timing of those changes. Using these insights, you can reach out to cardholders exhibiting at-risk behaviors to propose possible remedies on a case-by-case basis. Only your customer can provide the full context and background necessary for an accurate analysis. While cardholders who have already defaulted are understandably cautious when dealing with collections agents, those who are at risk of default—but not yet quite there—are usually more receptive to exploring possible solutions.

Realign your organization. Consider dedicating staff to reaching out to customers before their situation gets critical. While your collections staff is usually charged with reacting to a default when it happens, rather than acting preemptively, issuers can reap substantial dividends by changing that practice. Many issuers are concerned—and quite reasonably so—about disrupting what was, and might continue to be, a profitable account. However, this approach may be less effective today, and offering a work-out or settlement to a potentially defaulting customer may be a risk worth taking.

Update and validate your risk models. This is a time to validate the effectiveness of your risk models and collections strategies. Perform regular portfolio-level analyses to evaluate the credit quality and risk exposure of the various segments in your portfolio. Experiment with alternative segmentation schemes based on various performance levels to uncover opportunities for improvement and to identify adverse performance trends. Models that indicate a propensity to default can help issuers determine which customers would be best suited for preemptive treatment. Make sure to arm collections agents with a "tool box" of appropriate solutions to offer overextended cardholders.

Look both externally and internally when forecasting. Develop a forecast that gives sufficient weight to external factors, not just internal data. We recommend measuring five dynamics: origination quality, lifecycle phase, seasonality, management actions, and macroeconomic factors. Likewise, perform "what-if" scenario-based forecasting to explore how risk strategies may hold up in unforeseen circumstances. Finally, limit your forecast periods to only the current fiscal year and the next, since the credit landscape is changing rapidly.

1. National Association of Realtors, Investment and Vacation Home Buyers Survey, 2008.
2. National Association of Realtors, Profile of Home Buyers and Sellers, 2002.
3. Center for Economic and Policy Research, "Ratio of Home Equity to Value Plunges to Record Low," March 12, 2008.
4. Wall Street Journal, "Subprime Debacle Traps Even Very Credit-Worthy," December 3, 2007.
5. Bureau of Labor Statistics, News, "The Employment Situation: May 2008," June 6, 2008.
6. Bureau of Economic Analysis, Department of Commerce, "Personal Income and Its Disposition," June 26, 2008.
7. Federal Reserve Board, "Consumer Credit," June 6, 2008.

Ramsey El-Assal, a Client Business Leader for MasterCard Advisors, helps issuers strengthen their card businesses by increasing profitability and maximizing return on investment. He specializes in emerging payments, with a focus on prepaid, as well as retail payment card programs. Based in New York City, Mr. El-Assal can be reached at ramsey_elassal@mastercard.com.

Edmund V. Tribue is Global Practice Leader for the Risk Management, Fraud, and Operational Efficiency practice of MasterCard Advisors. He and his teams help issuers worldwide to enhance their performance by providing profit-based risk management strategies, optimizing fraud mitigation practices, and improving operational efficiency. Based in Purchase, N.Y., Mr. Tribue can be reached at edmund_tribue@mastercard.com.

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