Credit when it's due: how hedge funds profit from card portfolios

US consumer debt's ascent and Basel II provisions are bringing credit-card debt portfolios to hedge funds' attention

Hedge funds are eyeing up credit-card debt portfolios as potential revenue sources as economic distress and rising rates hit consumers, particularly in the US.

Buying portfolios directly can be time consuming, but deal flow is increasing. While managers see winning portfolio auctions as a profitable pursuit, credit-card portfolio experts caution careful analysis before buying.

Peter Bennett, managing director of San Francisco's Applied Income Sciences (AIS), has said that over 10 years, "US consumer debt has doubled to over $1trn, and does not appear to be getting any better."

Debt-servicing costs are around 19% of US household disposable income, up from 15.5% in the 1980s.

Edmund Tribue, global practice leader of the credit risk management practice at MasterCard Advisors (the consulting arm of MasterCard International), counsels careful scrutiny of portfolios before purchase. "History," he says, "is littered with companies buying what they believed to be profitable loan portfolios that turned out to contain a significant percentage of non-performance accounts."

Portfolio performance is typically ranked into three categories, 'prime', 'non-prime' and 'sub-prime', which can all contain active card users with varying degrees of non-performance risk and delinquency.

Hedge funds, says Tribue, have targeted sub-prime, which seem attractive due to potential for high revenue streams. However, they carry associated high servicing costs, potentially giving thin margins.

Tribue says buyers should request historic portfolio performance for the last 24 months, examining key metrics like delinquency and loss rates, revenue and associated costs, and overall profitability of the portfolio. Activation rates and the portfolio's average balance ($3,000 for US consumers, from $2,500 three years ago) are also key metrics.

Other metrics Tribue counsels looking at include percentage of 'revolvers' (someone with a credit card balance that carries to the next billing cycle, by making the minimum payment, for example), versus 'transactors,' who pay off the balance every month. "These percentages will be key, and will tie directly back to determine the percentage of revenue earnings potential that is non-fee generated."

Revenue will come from a few channels; interest rates - from revolvers, and fee income, (late or over-limit fees, for example) - which together represent a "significant portion" of a sub-prime portfolio's revenue.

Over the past 24 months, foreign banks have shown increased interest in buying US portfolios or entire lending institutions - RBoS and Bank of the West, for instance - with hedge funds not far behind.

"Typically, you see the sales decisions begin to escalate when the economy starts to experience a downturn and institutions are looking for ways to raise capital very quickly," Tribue says. How lenders are implementing the requirements from Basel II can also hit banks' profitability via capital adequacy positions, which can be determining for issuers to list portfolios as early candidates for sale.

On a macroeconomic level, interest rates and consumer debt ratios are important, but Tribue says a portfolio's performance characteristics should be evaluated in conjunction with leading indicators.

"As a buyer, you want to base your evaluation by analysing the trends of the portfolio like the rate of average balance increases, in conjunction with movements in the economy. Approaching a bull market, you would expect...an increase in average balances (and) reductions in delinquency and losses, and an increase in revolvers purchasing higher ticket items.

"If you see a portfolio performing inversely to the economy...your pricing decisions should take that into account, and your due diligence should be at a much more detailed level. Also, ask: is this a trend that will continue or one you can impact via management decisions?"

Buyers should understand sellers' operations, credit policies, and ones who can define what delivery channels were for their applications, and those using best-practice servicing.

Tribue adds, a service MasterCard Advisors offers is based on decompositional analytics helping investor or seller identify and measure the impact of macroeconomic factors versus firms' management decisions, such as marketing campaigns and their objectives, changes in credit policy, changes in credit strategy, how card holders are identified and originated - and try to correlate that with the portfolio's performance.

A final metric is a portfolio's maturity, what stage of the typical credit-card life cycle the portfolio is at. A typical credit-card lifecycle is somewhere between 36-60 months of profitable earnings potential.

hedge funds: fixed income

01/04/05 01/07/04 01/07/04 -- 01/07/04 --

01/07/05 01/07/05 01/07/05 -- 01/07/05 --

% chg Rk % chg Rk Volatility + Mths - Mths

Global IR HF - Aggressive 4.09 6 18.02 1 1.65 10 2

Global IR HF Ltd - Aggressive 4.09 7 18.02 2 1.65 10 2

Y2K Finance Inc 5.12 3 17.88 3 0.66 12 0

Compass Income Fund (Cl D Shrs) 2.02 19 15.93 4 0.93 11 1

Argo Fund Ltd 3.65 10 14.38 5 0.58 12 0

Rivoli Long/Short Bond Fund -0.25 35 14.1 6 2.67 8 4

New Ellington Partners LP 3.65 9 13.84 7 0.36 12 0

Picus Venator Fund -0.01 33 11.84 8 1.77 9 3

Julius Baer Diversified FI GBP Cls A -3.26 47 11.68 9 2.57 9 3

Julius Baer Diversified FI GBP Cls B -3.5 48 11.55 10 2.58 9 3

Mean/count -0.18 58 7.23 52 1.82 8.71 3.25

Source: Standard & Poor's with underlying data supplied by Hedge Fund Research Inc. Calc basis: NAV-NAV, gross income reinvested US$

KEY POINTS

Hedge funds are eyeing up credit card portfolios, particularly in the US, as profitable purchases.

Buyers of portfolio should assess how many card holders are past the portfolio's typical 60-month profitability lifespan.