New legislation may have a much more dire effect on credit card lenders' earnings than analysts had expected, and 2010 could be a brutal year for the companies.
In perhaps the most serious sign of what is ahead for credit card lenders, Discover Financial Services reported that the yield on its loans for the three months ended Nov 30, a measure of the profitability of its assets, fell by more than half a percentage point from the prior quarter.
The credit card company cited new legislation as a major reason for the decline. Discover's shares fell 7 percent on the news, their biggest one-day decline since July.
Discover is the fourth-largest credit card network in the United States and the sixth-largest credit card issuer, meaning it is relatively small, but like the canary in a coal mine, it could be an indicator of things to come.
The legislation in question, known as the CARD act, was signed into law in May. Some of its provisions — for example, requiring credit card issuers to give customers at least three weeks, instead of 15 days, to pay their bills — went into effect in August.
Another round of changes in February will likely be much harsher for credit card companies.
Lenders will not be able to raise interest rates on existing credit card balances unless the account is at least 60 days past due, and they will not be able to charge fees for customers spending more than their limit, unless cardholders agree to the fees.
The precise impact of these moves on credit card lenders is hard to estimate, but Discover's most recent results imply that investors may be underestimating the revenue impact, analysts said.
"The card act is really a game changer for the industry," Jason Arnold, an analyst at RBC Capital Markets.
Most credit card lenders' shares have risen more than the Standard & Poor's 500 index since the beginning of 2009.
Shares of the companies are expensive relative to the Standard & Poor's 500 index. Capital One Financial Corp's shares trade at 20 times expected 2010 earnings, while Discover's trade at 21.2 times. The S&P 500 average is 15 times.
"These companies are not what I call high growers," said Keith Wirtz, president and chief investment officer of Fifth Third Asset Management.
"I think the market investors are going to rotate in new directions and probably away from these stocks," Wirtz added.
Some companies have been explicit about the expected impact of the new rules.
JPMorgan Chase & Co. estimated its annual card services business' net income would be reduced between $500 million and $750 million.
KBW analysts mentioned Capital One among the most adversely impacted credit card lenders, and American Express among the least impacted companies, given its reliance on affluent and corporate customers.
Capital One said the revenue margin of its credit card business will decline modestly in the fourth quarter.
Credit card lenders enjoyed hefty profits earlier in the decade, as cheap money ignited a lending boom.
But the party ended abruptly as the housing slump and the financial crisis sent default rates to record highs.
"The credit card act makes it a little more cloudy in terms of how quickly the rebound is going to be in the profits," said Scott Valentin, an analyst at FBR Capital Markets.
"The expectation of a slow decline in unemployment does not help," Valentin added. Higher unemployment typically corresponds with higher credit card defaults.
Keefe, Bruyette & Woods (KBW) analysts said if bankruptcy filings increase another 35 percent in 2010 after rising a similar amount in 2009, credit card lenders could face more pressure.
"We do not assume significant improvements in credit quality in 2010 and even in 2011," KBW analysts wrote in a note to clients.
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