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Industry Surveys

Financial Services: Diversified

Sonia Parechanian, Consumer Finance Equity Analyst June 14, 2012

Current Environment ............................................................................................ 1 Industry Profile ...................................................................................................... 7 Industry Trends ..................................................................................................... 9 How the Industry Operates ............................................................................... 18 Key Industry Ratios and Statistics................................................................... 27 How to Analyze a Financial Services Company ............................................ 30 Glossary................................................................................................................ 33 Industry References........................................................................................... 35
CONTACTS: INQUIRIES & CLIENT RELATIONS 800.852.1641 clientrelations@ SALES 877.219.1247 MEDIA Michael Privitera 212.438.6679 michael_privitera@ S&P CAPITAL IQ 55 Water Street New York, NY 10041

Comparative Company Analysis ...................................................................... 36

This issue updates the one dated December 15, 2011. The next update of this Survey is scheduled for December 2012.

Topics Covered by Industry Surveys

Aerospace & Defense Airlines Alcoholic Beverages & Tobacco Apparel & Footwear: Retailers & Brands Autos & Auto Parts Banking Biotechnology Broadcasting, Cable & Satellite Chemicals Communications Equipment Computers: Commercial Services Computers: Consumer Services & the Internet Computers: Hardware Computers: Software Computers: Storage & Peripherals Electric Utilities Environmental & Waste Management Financial Services: Diversified Foods & Nonalcoholic Beverages Healthcare: Facilities Healthcare: Managed Care Healthcare: Products & Supplies Heavy Equipment & Trucks Homebuilding Household Durables Household Nondurables Industrial Machinery Insurance: Life & Health Insurance: Property-Casualty Investment Services Lodging & Gaming Metals: Industrial Movies & Entertainment Natural Gas Distribution Oil & Gas: Equipment & Services Oil & Gas: Production & Marketing Paper & Forest Products Pharmaceuticals Publishing & Advertising Real Estate Investment Trusts Restaurants Retailing: General Retailing: Specialty Semiconductor Equipment Semiconductors Supermarkets & Drugstores Telecommunications: Wireless Telecommunications: Wireline Thrifts & Mortgage Finance Transportation: Commercial

Global Industry Surveys

Airlines: Asia Autos & Auto Parts: Europe Banking: Europe Food Retail: Europe Foods & Beverages: Europe Media: Europe Oil & Gas: Europe Pharmaceuticals: Europe Telecommunications: Asia Telecommunications: Europe Tobacco: Europe

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Things are looking up
In December 2011, at the time we published the last issue of this Survey, the outlook for the economy was uncertain and the tone of the financial markets was quite nervous. Now, six months later, we see a more promising future for the financial services industry. Today, credit quality concerns are in the back seat, capital levels are high, fundamentals are healthy, and eyes are focused on the road ahead. The industry is investing heavily in the area of social networking as a form of marketing, new technologies, and mobile payments. This Industry Survey focuses on two related but distinct areas of operation: diversified financial services, and consumer finance operations. Included in the former are the largest banks in the USJPMorgan Chase & Co., Bank of America Corp., Citigroup Inc, Wells Fargo & Co., and US Bancorp. Given that they are major competitors in the consumer finance industry, we touch on them in this Survey, but for more details about their operations, see the Banking and Thrifts & Mortgage Finance issues of Industry Surveys. The major companies that characterize the consumer finance industry are American Express Co., Discover Financial Services, and Capital One Financial Corp. We also include relatives Visa Inc. and MasterCard Inc. as they operate card networks that are major competitors to American Express and Discover. We note, however, that although many financial services investors own the stocks of Visa and MasterCard, these companies are classified by S&P as technology companies under the Global Industry Classification Standard (GICS) methodology. The largest credit cardfocused issuers and lendersAmerican Express, Capital One, and Discoversaw revenues and card usage grow in 2011 versus 2010, and through the first quarter of 2012. They are seeing faster growth in spending than receivables growth, as we believe Americans have been wary of piling on debt, given their strong recent negative memories of credit challenges, unemployment, and financial distress. We also believe consumers are spending more on necessities, delayed wants, and small luxuries (such as iPhones, iPads, and Androids) rather than taking on big home improvement projects and personal debt. These companies invested significantly in marketing during 2011 to attract new customers, boost name recognition, and gain market share. They also took windfall credit improvement as an opportunity to invest in their future within the mobile payments space. We continue to look for top-line improvements from these three companies, as managements time is now free to focus on growth. The Conference Board Consumer Confidence Index dropped to a near-term low of 39.8 in October 2011, reflecting consumers concerns over the economic recovery, but it subsequently recovered to 76.4 as of April 2012. Profits were boosted by reserve releases in 2011. Reserve releases happen when financial firms book quarterly loan loss provisions that are lower than their quarterly net charge-off (loan write-off) levels. As a result, their reserves (also called allowances for loan losses) are released. Credit quality is so strong right now that charge-off and delinquency ratios are at historical lows and, in our view, are unsustainable. Nevertheless, we think this scenario is acceptable, as the lending business requires a risk-reward balance among credit quality, growth, and profitability. In order to grow, companies cannot, and should not, maintain credit standards at overly tight great recession levels. The major companies in the consumer finance sector are experienced survivors of the credit crisis, and we think they will behave prudently, at least over the foreseeable future. Capital levels are looking good now as companies have been working toward new regulatory requirements and are enjoying healthy credit trends. In March 2012, the US Federal Reserve Board (the Fed) released results of its analysis of the capital plans of the top 19 US-headquartered financial institutions. Of these 19, American Express and Capital One were the only consumer finance companies evaluated; both companies

capital plans were approved. Moreover, both were among the top four best-capitalized companies based on a hypothetical Tier 1 common capital ratio for fourth-quarter 2013: 10.8% for American Express and 8.8% for Capital One. Companies under 5% (such as Citigroup and Ally Financial) did not pass and were directed to resubmit revised capital plans.
TIER 1 RATIOS (In percent)
TIER 1 CAPITAL --------- RATIO --------- ----- TCE* RATIO ----Q1 2011 Q1 2012 Q1 2011 Q1 2012


American Express Capital One Discover Bank Of America 11.32 CitiGroup 13.30 JP Morgan 12.30 *TCE-Tangible common equity. Source: Company reports. 13.37 14.20 12.60

10.57 8.20 12.00 6.58 7.80 5.90

The Basel III capital standards, which are still being determined, will likely take effect in January 2013 and will require financial services companies to bolster equity capital over a period of six years, and keep extra levels of capital as a buffer. However, consumer finance company management teams are well aware of the date and have been working to be compliant.

Given the backdrop of excellent credit quality and healthy fundamentals, we see an industry in transition over the next three to five years. We anticipate significant changes in the way people think about cards, cash, and mobile technology. In our view, it is quite possible that half of America will be using their mobile phones to purchase their gas and morning coffee, and will leave their wallets at home.

6.10 7.15 5.75


Credit quality (measured by delinquencies and net charge-offs) improved significantly in 2011, compared with 2009 and 2010, as consumers are spending cautiously. Credit card credit quality is improving According to data from the Federal Reserve Board, the credit card delinquency rate for the top 100 banks in the US declined to 1.71% in the fourth quarter of 2011, from its peak of 6.87% in the second quarter of 2009. Based on the same data, the credit card charge-off rate fell to 4.31% in the fourth quarter of 2011, from its peak of 11.06% in the second quarter NET CHARGE-OFF RATIOS of 2010.
9 8 7 6 5 4 3 2 1 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 201 201 0 1 American Express Bank of America Source: Company reports. Capital One Discover JP Morgan Citigroup


The major credit card issuers have seen their delinquency and net charge-off rates plunge to historically low levels as consumers and households pare back debt. At American Express, the net write-off rate (for principal and fees on loans) in the US card division fell to 2.9% in 2011, from 5.7% a year earlier. At Discover Financial, the net charge-off rate fell to 4.2% from 7.6%. Lastly, at Capital One Financial, the charge-off ratio fell to 2.9% from 5.2% in 2010. We believe delinquencies and charge-offs will rise from these historically low levels as companies look to grow their businesses and we see a return of typical seasonal trends.

Improving auto lending conditions in the US as delinquency rates decline The declining automotive delinquency rate by borrowers is improving lending conditions in the US. According to Experian, a global data and analytical services company, the 30-day and the 60-day delinquency rates fell significantly in the fourth quarter of 2011 compared to the fourth quarter of 2010. While the 30-day delinquency rate fell by 6.57% to 2.79% in the fourth quarter of 2011 from 2.98% in the

fourth quarter of 2010, the 60-day delinquency rate fell by 9.51% to 0.72% from 0.79%. In addition, the volume of loans at risk dropped by nearly 10% to $18.5 billion in the fourth quarter of 2011. The delinquency rate for automotive financing in the US improved for all four lender categories in 2011. Financing companies benefitted the most in this segment as they recorded a 32 basispoint drop in 60-day delinquency rates, declining to 1.78% in the fourth quarter of 2011 from 2.10% in the fourth quarter of 2010. All other lenders in this segment (Banks, Captives, and Credit Unions) recorded a six basispoint improvement in the 60-day delinquency rates during the same period. In response to improved loan repayments by borrowers, the auto lenders have come up with a series of offerings, such as low interest rates and longer duration of loans, for consumers to buy a vehicle. According to Experian, the average interest rate for new cars and used cars dropped to 4.52% and 8.68%, respectively, in the fourth quarter of 2011, from 4.84% and 8.71% in the fourth quarter of 2010. Also mentioned in the report were new car loans of 7384 months duration were up 47.1%, to 14.1% of all new vehicle loans, and used car loans of 73-84 months duration increased by 41.1%, to 9.04% of all used vehicle loans. Besides charging lower interest rates and allowing a longer payback period, lenders also took more risks in 2011 to gain more business. According to Experian, the minimum average credit score required to extend a loan fell for both new cars and used cars. While the average credit score required for new cars fell by six points to 761 in the fourth quarter of 2011, compared with the fourth quarter of 2010; for used cars, it fell by nine points to 670. The outlook for the auto loan industry appears strong. In February 2012, J.D. Power and Associates (a global marketing research firm and a unit of The McGraw-Hill Companies Inc.) forecast US auto volumes totaling 14 million vehicles in 2012 (growth of over 9%), and a continuing decline in delinquency rates.


Student loans appear to be falling into the cracks of the political debate. On one side, Democrats appear to be student/graduate friendly and in support of relief. On the other, the cost of government subsidization of these loans appears to have led the Republicans to oppose anything that raise government outlays. Thus, while President Obama pledges help for students, it appears that students with government student loans could be paying higher interest rates as of July 2012. Subsidized rates on federal student loans to increase from July 2012 The interest rate on loans subsidized by the federal government was halved (to 3.4%, from 6.8%) after Congress passed the College Cost Reduction and Access Act in 2007. The reduction was temporary, however, and interest rates are scheduled to revert to 6.8% as of July 1, 2012. Democrats, who oppose the reversion, are asking for a one-year extension of the reduced interest rate. Republicans favor the reversion, due to the estimated $5.6 billion (according to cost to the government of subsidizing the interest rate for one more year. While the increase to the subsidized interest rate would potentially provide an opportunity for private lenders to gain market share, we think it could moderate the spending power of the younger generation and slow the economic recovery. It also puts pressure on a generation that has a high unemployment rate and limited income. Easing the student loan burden: pay as you earn program In October 2011, President Obama announced a pay-as-you-earn program to reduce the debt burden for students. For those eligible for the income-based repayment program, which covers only outstanding federal loans, the payment cap would be lowered to 10% of income (from 15%) beginning July 1, 2014. Monthly payments would be reduced for around 1.6 million graduates, according to White House estimates. Students would also have the option to bundle multiple loans and make one monthly payment. The plan includes an education program that aims to increase student awareness of the numerous loan options available to them. In addition, the program would waive repayment of outstanding balances on loans after 20 years of regular payments (versus 25 years currently). The combination of rising inflation, which has resulted in increased

tuition costs, and higher levels of unemployment, has resulted in higher debt levels for young people, but this plan is expected to offer some relief to borrowers.


Below we highlight some of the major provisions of the financial regulatory reform legislation known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173). This law, signed by President Obama on July 21, 2010, affects almost every aspect of the financial services industry. It contains such provisions as prohibiting proprietary trading, putting restrictions on ownership of hedge funds and private equity funds, establishing the Financial Stability Oversight Council (FSOC), and eliminating the Office of Thrift Supervision (OTS), an agency within the Department of the Treasury. While the FDICs final rules about the assessment of fees are still to be determined, we think all financial institutions will have higher fees in order to pay for the costs of the new regulations. Durbin Amendment The Durbin Amendment to the Dodd-Frank Act, which directs the Federal Reserve to regulate interchange fees, went into effect on October 1, 2011. The amendment capped debit interchange fees (the prices banks charge to merchants for their customers use of debit cards) at 21 cents plus 0.05% of the transaction, with the possibility of an additional cent if certain criteria are met. It reduces average swipe fees by almost 50%, thus directly affecting a banks top line. However, banks with assets of under $10 billion are exempted. The American Bankers Association (ABA), a trade group for the banking industry, estimates that the Durbin Amendment would lead to a 45% reduction in the revenue banks use to provide low-cost accounts, fraud coverage, and a safe and efficient US payments system. Several banks have tried to lessen the impact of the amendment by terminating rewards programs associated with debit cards. Banks are also trying to mitigate the impact by charging additional fees. For instance, Bank of America tried to charge $5 per month for those who use their debit cards for purchases, but rescinded the charge after a consumer backlash. Establishing the Consumer Financial Protection Bureau Many lawmakers have focused on consumer protection as they re-regulate the financial world. Predatory lending activities that helped consumers purchase more expensive homes than they could readily afford are often cited as a reason for the recent financial collapse. In the Dodd-Frank Act, the new Consumer Financial Protection Bureau (CFPB) was established as an agency of the Federal Reserve Board. The CFPB will supervise and regulate consumer financial laws and products, including credit cards, mortgage loans, student loans, and auto loans. With a better-informed consumer and restrictions placed on lenders, the goal is to provide fair, sustainable, and transparent financial products for consumers. We expect rules will be enacted to cover deposit and payment products, plus lending activities. We think this will likely affect banking results by limiting non-interest income (such as overdraft and ATM fees) associated with banking products. In January 2012, President Obama announced the appointment of former Ohio Attorney General Richard Cordray as the first director of the CFPB. Mr. Cordray also served as the Ohio State Treasurer and as treasurer of Franklin County, Ohio, prior to his appointment as Attorney General. As Ohio Attorney General, Cordray came to national prominence with a challenge to Bank of Americas 2008 takeover of Merrill Lynch, and an antitrust claim against American International Group. In 2010, he sued lender Ally Financial after its subsidiary, GMAC, was found to have rubber-stamped foreclosure documents. Cordray also went after Bank of America, Citigroup, JPMorgan Chase, and other big banks over their own robo-signing activities. Too big to fail After the collapse of Lehman Brothers and the bailout of American International Group Inc. (AIG) and Citigroup Inc., among others, a constant reference throughout the re-regulation discussions was too big to fail. In order to avoid having financial services providers that are too big to fail in the future, the DoddFrank Act states that the US government will not cover the cost of liquidation or support a failing financial company. The Act created the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) agencies under the Treasury Department.

The FSOC is given the authority to monitor, review, and respond to any systemic risks to the US financial system. While the OFR will provide support for the FSOC and other agencies, it is charged with data collection, and research and analysis, for monitoring risk in the financial system. In addition, an orderly liquidation process and a liquidation fund (funded by the financial companies themselves, not the US government) were created for all financial and non-bank financial companies, including too big to fail firms. While we believe these new rules may create a roadmap for the liquidation of a distressed financial firm, we think it creates new regulatory burdens for large, complex financial companies. Government regulators believe that implementing stricter laws on bailout provisions for big firms will foster more discipline among firms and make them more responsible. However, the implications may be too risky if a big organization actually fails. A recent research paper titled The network of global corporate control by S. Vitali, J.B. Glattfelder, and S. Battiston from Chair of Systems Design, ETH Zurich (published September 19, 2011), has discovered a strong ownership interconnectivity among major transnational firms, and a failure of one will result in domino-like effect across the world. The findings reveal that of the 147 super-connected companies identified, the top 50 are in financial services. The Financial Stability Board, an international organization that monitors and makes recommendations about the global financial system, has also come up with its list of the 29 global systemically important financial institutions. The report findings clearly indicate that irrespective of the rules, government officials and regulators are bound to save these behemoths if such a need arises in the future. Regulation E Regulation E provides the rights, liabilities, and responsibilities of parties involved in Electronic Fund Transfers (EFTs). It also establishes a mechanism to report ETF errors, unauthorized transactions, and fraud. In 2010, the Federal Reserve Board changed Regulation E by prohibiting banks from charging overdraft transaction fees for ATM withdrawals or one-time debit card transactions unless the consumer has specifically opted in for this overdraft coverage. These changes were expected to affect gross revenues for banks and credit unions. In May 2011, the Federal Reserve Board further revised Regulation E in order to implement changes required by the Dodd-Frank Act. Under the new provisions, consumers who send remittance transfers to designated recipients in foreign countries will be covered under these regulations (such transfers were exempted previously). However, market participants believe such revisions will increase costs and add unnecessary burdens to a system that is already functioning properly.

The Basel III committee announced preliminary capital guidelines in September 2010. The main part of the new guidelines will require 7.0% core capital to risk-weighted assets, comprised of 4.5% minimum Tier 1, plus a 2.5% cushion. The implementation period will likely be completed by 2018. We believe almost all companies in the other diversified financial services and consumer financial sub-industries will be able to comply with the new Basel III guidelines within the required timeframe. However, the guidelines that require banks to hold higher levels of capital would lead to increased costs for the banks, affecting their returns. The additional surcharge provision of 1%2.5% would require the top financial institutions to raise more capital, beyond the already-increased capital requirements. The committee proposal of the new rules for the large banks is crucial, as failure at these banks would affect the financial markets during any downturn. However, the large banks wish to alter or scrap the additional surcharge provision as it could affect the economic recovery. (For a more detailed discussion, see Capital Requirements under the Industry Trends section of this Survey.)

Year to date through May 17, 2012, the S&P Consumer Finance Index was up 17.6%, while the S&P Other Diversified Financial Services Index rose 7.2%, versus a 4.3% increase for the S&P 1500 SuperComposite Stock Index. In 2011, the S&P Consumer Finance index rose 9.8%, while the S&P Other Diversified index declined 40.0%, compared to a 0.3% increase for the S&P 1500.



Consumer finance Our fundamental outlook for the consumer finance sub-industry is positive, due to a dramatic improvement in credit quality in 2011 (particularly due to cautious underwriting standards employed through the downturn) and signs of receivables growth coming from consumer credit turning positive in late 2011. We believe credit quality will be stable in 2012 and that receivables and spending will be slightly higher. Capital levels for most companies appear to us to be adequate, although we wait for more guidance on Basel III. That said, while we are finally seeing improvement in employment trends, high levels of unemployment persist and the weak economic environment makes expected improvements in 2012 likely to be more modest than seen from the economic trough. We forecast a slight gain in receivables and loans for 2012, and expect card issuers to attempt to maintain high interest rates, but they could loosen credit standards a tad in search of account growth, in our view. Standard & Poors Economics (which operates separately from S&P Capital IQ) expects personal consumption expenditures to rise 2.0% in 2012. Industry receivables growth and discount revenues for the networks will likely continue to be limited by weak consumer confidence, cautious attitudes toward debt, conservative lending standards, dampened home prices (less ability to do a cash out/refinance) and lackluster spending. We think receivables growth and spending should pick up as consumer confidence improves. With credit back to stability, we believe managements time can now be better spent on strategic growth initiatives. For the longer term, we think pricing pressure and competition will remain intense and we expect the larger credit card issuers to continue to pursue product diversification strategies and international growth. The US credit card industry is relatively mature, but its players are experienced with competition, and balancing account growth, margin, and expenses. The industry is now under a higher level of regulatory scrutiny (a positive for credit, a negative for fee income, in our view); we believe they will act prudently. These companies are sophisticated marketers that are information rich and we expect them to develop innovative new products. We will watch for new mobile payment systems, and with it, new industry competitors. Diversified financial services The S&P Other Diversified Financial Services sub-industry is a group of three of the four largest banks in the United StatesJPMorgan Chase, Bank of America, and Citigroup. We have a neutral fundamental outlook on this sub-industry. Our neutral outlook is based on our concerns about the exposure these banks have to the troubled eurozone, the uncontained legacy costs of mortgages underwritten and securitized during the peak of the housing market, increasing regulatory costs and limitations, and the costs of implementing Basel III. We think the eurozone deficit crisis will be kept alive by the large funding needs of many of Europes governments, resistance by the European Central Bank to purchase more government bonds, refusal by Germany to increase bailout packages, and by what we view as shaky capital levels at many European banks. We think the chance is higher than not that the capital levels of the three banks in the Other Diversified Financial Services sub-industry will be challenged until the eurozone crisis is contained. This may not happen for years, in our view. In addition, the foreclosure documentation scandal, as well as high legal costs, and the costs of forced buybacks of securitized mortgages could pressure earnings for the foreseeable future. Regulatory reform has led to permanently higher legal and compliance costs, and the Volcker rule could hurt market-making activities. Basel III compliance will divert profits to capital, away from dividend expansion, and will likely lower the banks returns on equity (ROEs), by our analysis. Finally, on a positive note, despite recent financial regulatory reform that outlawed the concept of too big to fail, we think all three banks will thrive on their ultra-low-cost funding bases, and on the common perception that the US government will always backstop them, due to their multitrillion-dollar asset bases, and complex interconnections with the global economy.



Diverse industry deals with challenging environment
The consumer finance industry is comprised of companies that historically placed the greatest emphasis on credit card loans and/or consumer loans; however, the division between banks and consumer finance companies is no longer as clear as it once was. To add to the confusion, major consumer finance companies now have banking subsidiaries and/or are banks that are primarily focused on consumers. We generally define consumer finance companies as those included in the S&P Consumer Finance Index. The players that make up the largest piece of the indexAmerican Express Co., Capital One Financial Corp., and Discover Financial Servicesoffer a wide variety of products and services, including various consumer lending

Domestic credit card International credit card Domestic installment loans

Discover Card branded credit cards Prepaid cards

Domestic credit card Co-brand international credit cards Charge card Corporate cards Third-party bank card partners Global prepaid & gift cards Deposits


Auto finance Home loans Retail banking Commercial and multifamily real estate Middle Market Specialty lending Small-ticket commercial real estate
Payment Services

B12: CREDIT Personal loans CARD Student loans COMPANIES' Other consumer loans MAJOR Depositsdirect & brokered BUSINESS LINES
PULSEATM, debit, and EFT network Diners Clubglobal payments network Third Party issuers on Discover Network

vPaymentvirtual payments Buyer-Initiated Payments (BIP) electronic automated payments Global payments network Servemobile payments application Identity protection & assistance Purchase & returns protection Fraud protection Credit score & reports

Protection & Credit Services

Identity protection Payment protection Wallet protection Credit score tracker Extended warranties
Other Services

Insurance agency Broker-dealer Registered investment advisor

Travel insurance (car rental loss & damage, flight, baggage, roadside assistance) Online money manager Cardmember events Expense management services Global business travel services Supplier relations Meetings & events spending services Advisory services

*Some services are fee-based. Sources: Company reports; SP Capital IQ.



products (such as automobile loans, home equity loans, and credit cards, insurance, debit cards, and securities and investment products). Given the advantages of scale for efficiency, access to deposit funding and capital, the lines between consumer finance companies and banks are no longer clear. The consumer finance industry is harder to quantify in terms of its size and scope than is the banking industry. Like traditional banks, consumer finance companies record interest income and fees from lending products, establish reserves for potential credit losses, and generally compete aggressively with each other. However, consumer finance companies tend to be slightly less diversified and prefer to focus on relatively higher-margin consumer businesses. Consumer finance companies used to be unregulated, but now, like banks, most are subject to a wide range of regulations by numerous regulatory agencies; specific regulators vary based on the companys product offerings. Most are regulated by the Federal Reserve Board and the Consumer Financial Protection Bureau, while some of these companies subsidiaries are also insured by the Federal Deposit Insurance Corporation (FDIC) and, therefore, subject to the agencys regulatory capital requirements. (For a more detailed discussion, see the Regulation heading in the How the Industry Operates section of this Survey.) The FDIC maintains and distributes useful aggregate industry data, making a comparative analysis easy to conduct. Consumer finance companies historically operated in disjointed niche markets and had little similarity with one another; however, due to consolidation and exchange of assets, we now see much bigger players and many monoline companies have disappeared. Trade publications Specialty Finance and the Nilson Report cover the specialty finance and consumer payment systems industries, respectively.

--------- TOTAL ASSETS ---------12/31/2010 12/21/2011 % CHG.

JPMorgan Chase 2,118 2,266 Bank of America 2,268 2,137 B03: TOP 20 Citigroup 1,914 1,874 Wells Fargo & Co. US-BASED 1,258 1,314 BANK Goldman Sachs Group 911 924 HOLDING MetLife 731 800 COMPANIES Morgan Stanley 808 750 BY ASSETS Taunus Corp.* 373 355 U.S. Bancorp 308 340 HSBC North America 344 331 Bank of New York Mellon 247 326 PNC Financial Services 264 271 State Street 159 216 Capital One Financial 198 206 TD Bank US Holding Co. 177 201 Ally Financial 172 184 SunTrust Banks 173 177 BB&T 157 175 American Express 146 152 Citizens Financial Group 130 130 Total 12,855 13,128 *North American subsidiary of Deutsche Bank AG. Source: American Banker, Capital IQ.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

7.0 (5.8) (2.1) 4.4 1.4 9.4 (7.2) (4.8) 10.5 (3.6) 31.8 2.6 36.2 4.4 13.6 6.9 2.3 11.1 4.3 (0.1) 2.1

The landscape of the consumer finance industry has changed dramatically from the mid-1990s. The industry came into its own as securitization gave access to capital to small companies that focused their efforts on market niches rather than trying to meet the borrowing needs of all people. However, many of these companies behaved like cowboys in the Wild West or kids in the candy store with a $10 allowance. Access to capital was easy and the urge to grow lured many companies into growing too fast. Further, accounting rules at the time were not prepared for the new-fangled business models. Underwriters found that in practice, assumptions in securitizations were not easy to predict and that while securitizations were structured as bankruptcy remote and were off balance sheet, if a companys securitization experienced higher losses than expected, it could prevent the company from securitizing more assets. Companies generally securitized assets quarterly to fund new loan originations. If a company could no longer securitize, it could face a liquidity crisis and a quick demise. Consumer finance experienced its first bubble long before the bubble burst, but back then, the industry was so small that it did not cause global shocks to the system.

Payment processors Payment processors are third-party technology providers whose network of banks, merchants, and acceptance locations provide the rails over which many consumer and business payments are made across the globe. These payments are typically processed over large-scale processing platforms at relatively low

marginal cost due to economies of scale. Payment processors include some of the largest companies in the processing services space. Some of the best-known participants in the space have invested billions to support market acceptance of their services across thousands (and, in some cases, millions) of locations globally. We include credit and debit card networks such as Visa and MasterCard in this category. Moreover, they compete with other network providers, including American Express and Discover. Other vendors include reloadable prepaid card services provider, Green Dot Corp. Vendors in this space provide their services to businesses and to consumers directly, and some of their brands are well known globally, reflecting their significant investments. Many payment processors serve the financial services industry, but some vendors have extended their services to individuals who are underserved or un-served by the banking industry, or have been priced out of the traditional financial services system due to rising costs. Providing financial services to these individuals should be a growing market as the traditional providers themselves face rising costs and have limited ability to either price for risk or garner certain other revenue streams. We think payment processors are among the primary beneficiaries of the secular shift to electronic payment methods and away from paper-based payment forms, including cash and checks. We expect this shift to remain in place despite more onerous regulation in such key markets as the United States. A recovery in the global economy has spurred cross-border travel, and under-penetrated markets with limited payment infrastructure, such as India, are viewed as avenues of growth for these vendors, who have been expanding overseas for some time. Many payment processors operate under long-term contracts and have significant recurring revenue streams, although we think competition remains intense.

Global governments responded to the credit crisis of 200709 with capital infusions and subsidy programs to get world markets back on track. Now, the financial markets and all of their participants have found themselves faced with more regulations. However, with a tremendously improved credit profile for the industry, company managements appear done licking their wounds and are hard at work shaping the future of the industry through mobile payments. While we refer to the concept as mobile payment, it is really the marriage of online and offline worlds and mobile that will transform the appearance of network payment systems. In some cases, the crisis hastened the consolidation and globalization already occurring in the financial service industry. While many companies loosened lending standards, particularly in 2005 and 2006a time when the economy remained strong, housing prices were rising, and interest rates were lowthe precipitous decline in home prices and the increase in delinquencies and foreclosures caused these firms to reevaluate their lending standards. Starting in the spring and summer of 2007, as delinquencies began to rise, companies raised their lending standards, albeit from very low levels. As a result, delinquencies and consumer bankruptcies peaked in 2010, and improved dramatically in 2011.


The hottest topic in the consumer finance space today is mobile payments; and we believe changes are potentially game changing and there is a new set of competitors. According to Bank Technology News, an industry trade publication, it is clear that the (50-year-old) magnetic stripe-dominated payment system is on its way to the museum and that it will be replaced by a standard that links mobile, web, point of sale, and contactless payments. The game will be played on a more global scale than ever and there appears to be substantial opportunity. There are nearly five billion mobile phone users worldwide, and seven out of 10 people worldwide have a mobile phone while only half the worlds households have bank accounts. Nearly 98 million peopleand about 40% of all mobile subscribersowned smartphones at the end of 2011, according to digital marketing company comScore. We expect mobile payments to gain exposure, as they are being embraced by the Obama and Romney campaigns use of Square to raise money for the 2012 elections. (A competing

technology is Intuits GoPayment, available in the Apple App store and Android marketplace.) The market for mobile payments is expected to reach more than $600 billion globally by 2013, according to mobile telecom information firm Juniper Research. Some of the activities that we expect to take place in the mobile strategy include the following: developing merchant acceptance of the new technology; creating apps and encouraging consumers to use them through advertising, coupons, and rewards; integrating mobile, online, and traditional payments; and creating and insuring security. The players Major competitorssuch as MasterCard, American Express, Visa, eBay Inc., and Google Inc.are busy loading their ammunition. For more than a decade, MasterCard has pioneered the technology that has turned mobile phones into devices for making payments across the global network. The company has been partnering with companies to enable consumers to purchase goods and services via their mobile phones. In conjunction with Citigroup and Google, it was one of the first to mass-market Google Wallet (a digital wallet app). In the US, American Express has disclosed that it established a $100 million fund aimed at expanding digital commerce. The company very quietly rolled out its Serve app in late 2011 and has partnered with companies that reach three-quarters of the adult population through relationships with Verizon, Sprint, and Ticketmaster. The telecom companies plan to pre-install the Serve app as they roll out new phones. Visa is also continuing to expand into the digital-wallet strategy. The company is working with technology firm Monitise to significantly enhance Visas issuer processing platform, Visa DPS. The platform will offer mobile services that are fully managed by Visa and accessed with any mobile device, any mobile channel, and with any eligible debit, credit, or prepaid account. Other services in development include mobile check deposit and mobile (NFC) payments. Earlier this year, Visa and Visa Europe announced that NFC-enabled smartphones from Samsung Electronics, LG Electronics, and Research In Motion have been certified for use with Visa payWave, which is Visas mobile application for payments at the point of sale. PayPal, owned by eBay, is also a formidable competitor. It has a considerable account base and early-mover competitive advantage. The company has a mobile application for consumers and in March 2012 introduced one for business called PayPal Here. The PayPal Here app can accept card payments through the phones camera as well as through a mobile card reader similar to Square; merchants pay a similar 2.7% transaction fee for debit and credit cards (there are no fees for check acceptance). The technology: Near Field Communications Certifying smartphones to use Near Field Communication (NFC) technology paves the way for mobile device makers, mobile operators, and retailers to partner with financial institutions. NFC technology is a short-range communications standard that enables mobile phones to securely transmit payment information to a contactless payment terminal. In practice, the early systems appear to work like zapping a contact from one Palm Pilot to another. The user prepares to make payment, sends the signal while holding the device close to the terminal. The range is very short, limiting the ability of someone in the vicinity to pick it up. Further, it has security protection so that the same transaction cant be performed multiple times. Merchant acceptance, terminals, and point-of-sale hurdle One of the key aspects of success for a network is merchant acceptance. A high level of merchant acceptance provides an initial competitive advantage to existing network providers. Thus, if a consumer would like to make all his payments through a specific account, he has the option of using a traditional credit card if a merchant is not yet set up for a mobile payment. A challenge that has media attention is the cost of upgrading point of sale terminals to take mobile payments. However, we think this is a lesser challenge than is portrayed by the headlines, as network providers can specify changes that coincide with a natural upgrade schedule. According to VeriFone Systems, which holds about five million terminal systems (60%70% of the US market for terminal

systems), the typical terminal upgrade has fallen to an average of five years. The company estimates that another three to four million locations with only a cash register or restaurant system will need customerfacing devices. In our view, five years is not far off. New terminals are expected to run existing electronic payment methods, as well as NFC and EMV (which stands for Europay, MasterCard, and Visa, a global standard for security chips in payment cards/smartcards that is standard in Europe and much of Asia, but just taking hold in the US; they are said to be harder to counterfeit). The new terminals are also expected to cooperate with Card networks from Visa (payWave), MasterCard (PayPass), Discover (Zip), and American Express (ExpressPay), as well as Wallets from Google, ISIS (ISIS Mobile Commerce is an AT&T Mobility, T-Mobile USA, and Verizon Wireless joint venture), PayPal (eBay), GROUPON, Facebook, and more. Some kinds of payment may adapt to mobile earlier than others. For instance, of the 100,000 gas stations in the US, 65,000 use VeriFones Gemstone systems (Ruby, Topaz, and Sapphire) in their kiosks; moreover, the company has enticed 75% of customers to enroll in annual software maintenance within 12 months of rollout. Thus, it will be easy for VeriFone to upgrade their systems to reflect changing technology. Mobile retailing is cheaper for store merchants An alternative to traditional terminals is Mobile Retailing, where merchants can make sales outside of the typical register environment, For instance, at the Apple Store, not only can you be checked out by a traditional cashier, you can check yourself out on your iPhone or iPad. Mobile point of sale is estimated by Verifone to be one-half to one-third the cost of the traditional cash register point of sale system for the merchant. The company offers mobile retailing through mobile retail software applications it acquired through the purchase of GlobalBay Mobile Technologies in November 2011, and the companys Payware Mobile Enterprise (PwME) device, a small attachment that fits around iPad, iPhone, and other devices to securely take Credit, Debit, PIN Entry, NFC, and scan barcodes. Changing consumer behavior A challenge in conversion to mobile payments is changing customers habits. We think that development of easy-to-use and widely accepted secure payments will ultimately draw usage. We expect companies to provide coupons, discounts, or points to get consumers to first try out mobile payments. If the process is perceived as easy and convenient, we think it will have a high success rate. It could start as simply as using a coupon to Starbucks from a network provider and soon the user finds no need to carry his wallet on his 10minute daily coffee break. While some people may look at a credit card as something to be used to purchase big ticket items, others, especially younger people, increasingly look at cards as a daily purchase vehicle. The role of prepaid accounts We think the potential for mobile wallets and prepaid accounts is significant as it is a logical way to bank the unbanked, especially in countries with less developed banking systems. No credit score or credit bureau infrastructure is necessary to provide recommendations as to an individual payment history or potential credit quality. Thus, anyone with a smartphone or Internet connection and a few cents cash could potentially load up his mobile wallet by creating a prepaid account. Security Suzanne Martindale, an attorney with Consumers Union, testified that US payments law is fragmented, and the degree of protection that consumers have depends on whether their mobile payment accounts are linked to a debit card, credit card, a prepaid card, or another form of payment. While it is still too early to know how things play out, we suspect that linkage of a traditional credit card will likely be the most protected way to use a mobile account: credit card issuers and networks have sophisticated fraud detection strategies, and they have shown commitment to the customer relationship as many purchases have moved online. Given the lack of clear regulation, prepaid accounts are likely to be the least secure method of mobile payment, at least initially. According to American Banker, financial policymakers are starting to turn their attention to the issue of mobile payments because currently there is no clear regulator. Electronic transactions are regulated by the Electronic Fund Transfer Act (EFTA); for mobile payments linked to a card or other credit account, the Truth in Lending Act applies (TILA) applies. Both fall under the Consumer Financial Protection Bureau

(CFPB). However, making a payment using text messaging via a mobile network provider wouldnt fall under banking laws, so there will likely need to be more coordination with the Federal Communications Commission.

In response to the credit crisis of 2007 to 2009, governments around the world are evaluating ways to better regulate the financial markets to reduce the risk this would happen again. The US government has played a key role in stabilizing the economy and banking system since 2008. In February 2009, the Treasury put forth the Financial Stability Plan, which was designed to attack the credit crisis on all fronts. Part of the plan provided for a so-called stress test (formally called the Supervisory Capital Assessment Program, or SCAP) for the larger banks to ensure that they have enough capital in case the economy worsens. The stress tests, which were administered in April 2009, represented a major positive turning point for the banking sector. Banks that needed additional capitaland some that didntwere able to raise capital from the private sector. As a result, capital levels of banks in the US have become less of an issue. As part of the stress test, the government continues to offer additional capital (in the form of convertible preferred securities) via the Capital Assistance Program (CAP). Terms are more onerous than the original TARP capital, but were earmarked to securities prices dating back before February 9, 2009. We outline below some of the more important initiatives the government launched. Credit Card Act of 2009 In May 2009, President Obama signed the Credit Card Accountability, Responsibility and Disclosure Act (known as the CARD Act) into law. All of the included provisions have now taken effect. With this law, Congress and the White House took aim at controversial credit card practices, from higher interest rates on past balances to fees for paying by phone or online. The following is a summary of what companies can and cannot do under this new law: Cannot treat payments as late, unless consumers have a reasonable amount of time to make the payment (at least three weeks before due date) Must allocate minimum payments to balances with the highest rate first Cannot raise interest rates from the opening amount unless: the rate was variable rate or introductory, with the increase disclosed; its a year after the account opened and 45 days notice is given; or a minimum payment is received 30 days after due date Cannot use double-cycle billing; i.e., calculating interest based on a prior months balance in addition to the current month, even if the prior months balance had been paid. Even before the law took effect, banks and credit card companies had begun changing their practices to comply. Although the forced change in credit card billing has already hurt revenues, card companies betterpaying customers will likely make up some of the difference. For example, banks are switching customers to a variable rate from a fixed-rate plan, so they can bump up rates more easily. Banks are also paring their rewards programs and adding annual fees to cards that previously had none. We have already seen an impact on results of the big credit card issuers through reduced fee income. We think most of the revenue decline due to this and other new fee restrictions will be offset by higher interest rates charged consumers. Thus, though fees will likely continue to decline in the near term, interest rate hikes may mute the long-term total revenue impact, in our view. Regulation E Under separate legislation, changes have been made to Regulation E that require customers to opt-in for overdraft coverage and one-time debit card transactions. We think the two most important items that will have a moderately negative financial impact on diversified financial banks in 2011 are the higher FDIC assessment fees and the potentially lower fee income from the revised Regulation E rules.




Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 The bill was signed into law in July 2010. (For a full discussion of this legislation and its far-reaching impact, see the Current Environment section of this Survey.)


Capital is what banks must have on hand to meet the day-to-day obligations of staying in business. In its most basic form, capital is equity, calculated by taking the difference between a banks assets (loans, investments, cash, real estate, and intangible assets), and the banks liabilities (deposits and borrowings, mainly). If the value of a banks assets decline, while liabilities remain the same, equity and capital will fall. Banks must have a cushion of capital on hand to meet anticipated withdrawalsa cushion large enough, as a percentage of assets, to meet anticipated losses on loans and securities. Using the international Basel standardsthe common name for capital guidelines issued by the Bank for International Settlements (BIS) in Basel, Switzerlandthe Federal Reserve System has established two basic measures of regulatory capital adequacy with which US bank holding companies must comply: a risk-based measure and a leverage measure. These ratios are as follows: Tier 1 capital ratio. This ratio is calculated by dividing Tier 1 capital by risk-weighted assets. Total capital (Tier 1 and Tier 2) ratio. This ratio is calculated by dividing total capital (Tier 1 plus Tier 2 capital) by risk-weighted assets. Leverage ratio. This ratio is calculated by dividing Tier 1 capital by average total consolidated assets. The first two are risk-based standards, which consider differences in the risk profiles among banks to account for offbalance-sheet exposure and to encourage banks to hold liquid assets. Assets and off balance-sheet items are assigned to broad risk categories, each representing various weightings. Capital ratios represent capital as a percentage of total risk-weighted assets. To be considered adequately capitalized, a bank must have a Tier 1 capital ratio of at least 4.0% of risk-weighted assets; regulators consider a ratio of 6.0% to be well capitalized. The second ratio is the total capital ratio. To be considered adequately capitalized, the minimum ratio of total capital to risk-weighted assets is 8.0%. At least half of total capital must consist of Tier 1 capital (i.e., common equity and certain preferred stock, plus retained earnings, less goodwill and other intangible assets). A bank with total capital ratio of 10.0% is considered well capitalized. The current international Basel II capital standards allowed the largest banks to use internal models to calculate the risks of their assets to determine their capital levels. During the height of the recent financial crisis, the drawbacks of this approach became painfully clear, as many banks found they did not have the capital levels necessary to withstand the losses on loans and securities that proved to be much riskier than their models had suggested. The most important change to the banks may come from the Basel III capital standards that are now being formulated. This multiyear process, born out of the recent financial crisis, may result in capital rules that take a much more rigorous approach to the evaluation of bank capital levels and to the components of bank capital. While the Basel III capital rules will continue to rely on banks risk models, the international committee which is writing these rules has proposed stricter rules over what goes into those calculations, a narrower definition of what counts as capital, and a requirement for banks to set aside extra money when they hold certain riskier assets. It also may impose a limit on the amount of assets a bank can have in relation to its equity and require banks to have enough cash to meet short-term liabilities. The third ratio is the leverage ratio, which does not have a risk-weighted denominator. The Feds minimum leverage ratio guidelines for bank holding companies provide for a 4.0% minimum ratio of Tier 1 capital to average assets, less goodwill and certain intangible assets. Bank holding companies making acquisitions are expected to maintain capital positions substantially above the minimum supervisory level. To meet the

regulatory requirement to be classified as well capitalized, the financial institution must have a leverage capital ratio of at least 5%. In mid-September 2010, the Basel III committee announced preliminary guidelines. The Basel III capital guidelines, effective at the start of 2013, will require 4.5% common equity capital to risk-weighted assets, plus a 2.5% conservation buffer, totaling 7.0%. When Basel III fully kicks in, up to another 2.5% common equity may be required during economic boom times, to build for down cycles (the countercyclical buffer). In addition, as part of the Dodd-Frank Act, banks have five years to phase out the inclusion of trustpreferred securities as part of their Tier 1 capital calculations. Trust-preferred securities are hybrid securities that possess the characteristics of both subordinated debt and preferred stock and are a significant source of capital for many regional banks. We think it is a good idea, in the longer term, for banks to grow thicker capital cushions, even if this potentially affects lending and profitability now. In our view, more capital should mitigate the effects of the next economic downturn on financial stocks. In hindsight, its clear to us that most US banks entered the 200709 financial crisis with capital levels that were much too low. We believe this was largely due to pressure from US banking regulators, who did not want US banks to hoard capital, and then possibly manage earnings by strategically releasing un-needed reserves. Now, when the US enacts the Basel III guidelines, US banks must beef up their capital, and keep it high. The cost of higher capital cushions is that banks will need to keep more of their profits, as equity, in the next several years, at the expense of dividends and share buybacks. In addition, higher capital levels can lead to less lending. However, we think US banks, in general, are already well capitalized, so Basel III should not hurt lending in the foreseeable future, in our view.


As competition in domestic markets has intensified, financial services companies of all stripes have looked to build businesses overseas. The expansion of diversified financial services companies is widespread. Many firms with securities arms have moved into Europe, Latin America, and Asia, as the capital markets of these continents continue to grow and as these continents develop more equity-based cultures. Other services offered abroad vary widely, as companies must grapple with different regulatory standards and cultural preferences. Credit card companies that have expanded internationally have concentrated on most major emerging markets, and have sought to make inroads in developed markets such as Canada and the United Kingdom, where cultural attitudes toward credit are more in tune with those of the United States. As these markets mature, it is likely that issuers will look to other markets. For example, Citigroup Inc. has been aggressively expanding its consumer finance operations in a wide spectrum of regions, including South Korea, China, Russia, and Central America. For many diversified financial services companies, cross selling has been a part of their operations for years. Recently, however, it has taken on new importance. Firms are trying to maximize revenues without raising expenses by intensifying their communication capabilities and rewarding employees for building relationships across business lines. Several firms are accomplishing this by integrating platforms to check customer lists and attributes in order to maximize potential relationships. We believe that the larger financial companies will continue to expand internationally in order to benefit from faster-growing emerging markets, through either stand-alone expansion or joint ventures with current market participants. Given the continuing turmoil in the domestic credit and real estate markets, international expansion will become a greater focus for diversified financials, in our view. To take advantage of these opportunities, firms must have an expertise and sufficient capital. A presence in international markets (through current customers and/or a physical presence) and brand recognition are important as well. Recently, major banks have increased their focus on, and, in some cases, have entered the Asia-Pacific region, in general, and

China, in particular. We believe that larger financial companies will be able to allocate capital to markets perceived as faster growing. If such ventures do not prove fruitful, these companies should be able to retreat. We note that these companies used to have a greater ability to sustain losses. With capital levels constrained, however, companies are proceeding with expansion plans more cautiously. Continued focus on developing markets Financial services firms are continuing to focus on developing markets. The spotlight is on China, Russia, India, and Latin America, the main areas where these firms are looking to leverage and allocate capital. China has experienced several high-profile banking deals, as many of the global banking players try to enter this market, which has the potential to grow significantly. Although such investments may be necessary in order to gain a foothold in this promising market, they have been relatively small to date. We remain cautious and believe that it will take time for Chinas banking system to progress. We do not expect these investments to begin to benefit earnings on an operating basis for many years. In addition, we note that some banks were forced to sell their stakes in Chinese banks due to capital concerns. Although this was a short-term positive for the banks involved, it will likely hurt profitability in the long term. Several major US and international banks have entered the Russian market in the last few years. Although we view Russia as a location where relationships can be built, we still see the business setting as risky, mainly due to the political environment. Turkey and India are other rapidly developing markets that offer many opportunities for expansion. Over the next several years, we look for a growing presence in these dynamic markets. We believe the expansion of businesses into these areas offers strong potential for diversification and growth. Here, too, larger firms have distinct advantages. In some cases, they may have an existing client base in one or more of these countries, albeit for a limited set of products; by offering additional products, they can build on this base. Large firms may also have a physical presence or relationships in neighboring countries and, thus, familiarity with regulations, market demographics, and the like; this can make it easier to open branches in nearby countries. Finally, the largest firms deep pockets and resilience allows them to stay in new markets, even if they encounter difficulty initially.


During the late 1990s and in the early part of the 2000s, the financial services industry underwent rapid consolidation. Reasons for this trend include the easing of regulatory barriers, the search for profit sources, companies desire for more diverse product offerings, and the industrys inherent economies of scale. The more recent deterioration in capital levels due to turmoil in the credit markets prevented some of the big banks, such as Citigroup, from completing large acquisitions. However, banks with more solid capital levels, such as JPMorgan Chase, have made major acquisitions and may continue to look for potential acquisitions if capital levels permit. The easing of regulatory barriers began in the late 1980s, when rule changes by the Federal Reserve Board allowed banks to generate up to 5% of their revenues from securities underwriting. (The percentage was subsequently increased to 10%, and then to 25%.) This evolution was essentially completed with the passage of the Gramm-Leach-Bliley Act in November 1999. Broadly speaking, the law eliminated the prohibition against commercial banks owning brokerage firms, mandated by the Glass-Steagall Act of 1933, by allowing the three largest segments of the financial services industrycommercial banks, investment banks, and insurance companiesto enter into one anothers businesses. The reform did not cause an avalanche of mergerslargely because loopholes in previous laws already permitted much cross-industry activity. After moderate acquisition activity in 2005, there were several large deals in 2006 and early 2007, such as Capital One Financial Corp.s acquisition of North Fork Bancorp. Inc. in December 2006. Market turbulence in late 2007 nearly halted merger and acquisition (M&A) activity. However, the financial crisis in 2008 and 2009 led to the failure or fire sale of several large US financial institutions. These actions increased the concentration of the US banking system above pre-crisis levels. Four

banking behemoths (JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup), with assets of over $1.0 trillion each, now dominate the US financial system. Three of these US banks significantly grew their assets by acquiring weakened competitors during the crisis. In March 2008, JPMorgan Chase & Co. acquired Bear Stearns & Co. Inc.; in September, in the depths of the financial crisis, it acquired Washington Mutual, with government assistance. Bank of America Corp. expanded with the purchases of Countrywide Financial Corp. (July 2008) and Merrill Lynch & Co. Inc. (January 2009), while Wells Fargo purchased Wachovia Corp. (October 2008). The increase in concentration in terms of deposits since the start of the financial crisis is also remarkable. At December 31, 2011, the four largest banks in the US held 45% of total domestic US deposits, up sharply from 26% at March 31, 2007, the beginning of the financial crisis. Over the same period, the largest 10 banks in the US held 58% of deposits, up from 39%; and the 20 largest, 69%, up from 49%. We estimate market share based on statistics collected by the FDIC, the SEC, American Banker, and Highline Data (a data service for the banking industry). Recent acquisitions In February 2012, Capital One Financial Corp. completed the acquisition of ING Direct USA from ING Groep, making Capital One the sixth largest bank by deposits in the US. Capital One paid $6.2 billion in cash and $2.8 billion in stock. ING Groep received a 9.9% stake in Capital One as part of the deal. We think Capital One got a good price on a crown jewel as we believe that ING Groep sold the profitable business to repay loans to the Dutch government from its bailout in 2008. On May 1, 2012, Capital One acquired the US credit card business of HSBC Holdings. The HSBC US credit card portfolio included general purpose and private label cards with approximately $28.2 billion credit card receivables and $0.6 billion in other net assets. Capital One paid a $2.5 billion (or 8.68%) premium to par value of all receivables. The close of the purchase by Capital One essentially unseats American Express position as the fourth latest credit card lender in the US. We expect future small-scale acquisitions of lending portfolios or niche businesses to be more common than huge, transformational deals, as companies strive to add size and new product offerings to their organizations. The nature of the financial services industry offers advantages to larger companies, which may find it easier and less expensive to access capital. Large companies also are likely to have the resources to take advantage of growth opportunities in international markets. While the upheaval in the credit markets may change some of the dynamics of future deals, we believe companies will find it more important than ever to have a diversified business model.


For many of the credit card industrys strongest players, loan growth declined during the Great Recession. In 2009 and 2010, due to a tightening of credit standards, consumer interest in paying down debt, and cutbacks in cards issued, loan growth declined, year over LARGEST CREDIT CARD LOAN PORTFOLIOS year. Pre-recession, annual growth rates ranged between (Ranked by outstanding debt as of December 31, 2011) 5% and 8% reflecting industry maturation as growth CREDIT CARD DEBT rates were in the high-double-digit area as the industry ---------(MIL. $) --------blossomed in the 1990s. More recently, in 2011 and into ISSUER 12/31/10 12/31/11 the first quarter of 2012, credit card receivables growth Citigroup 159,104 151,478 rates returned to a range of 3%7% for the major B04: LARGEST JPMorgan Chase 128,391 121,699 consumer financefocused companies, while traditional CREDIT CARD Bank of America 141,250 117,035 banks continued to see balance declines. LOAN American Express 60,850 62,621 Capital One Financial PORTFOLIOS 52,526 58,591 We believe that there are several reasons for diverging Discover Financial Services 46,231 47,773 loan growth trends and loan growth appetite. First, the HSBC North America 33,583 30,913 consumer finance companies generally now have higher Wells Fargo 22,384 22,905 margins and relatively lower leverage than banks with U.S. Bancorp 16,808 17,366 more commercial lending and other traditional banking Barclays 10,235 12,038 Source: American Banker. businesses, and less risk from sovereign debt issues in

Europe. Also the industry made a calculated effort to improve leverage and reduce risk in order to conform to standards set by the Federal Reserve stress tests. Lastly, memories of severe credit challenges are now strong for both management teams and consumers. . We believe that there are several reasons for this dramatic slowdown in loan growth. First, some issuers focused mainly on improving the credit quality of their portfolios, instead of pursuing loan growth. Second, in the past, relatively low interest rates and strong housing markets enabled homeowners to pay off their higher interest-rate credit card balances. Third, competition from alternative lending products, such as home equity loans and lines of credit, reduced demand for credit card loans. That said, with home equity lines being reduced due to housing price declines, credit card balances could begin to build. In addition, credit card issuers have scaled back on balance transfers, which enable credit card users to switch companies in return for a low interest rate for a fixed period. Finally, the credit card industry consolidated considerably in the 1990s, and acquisition opportunities have dwindled in recent years. At the end of 1997, the top 10 credit card issuers accounted for about 60% of the US credit card market; in 2011, however, they accounted for about 80%. Since the mid-1990s until the present, consumer finance companies have progressed from lending for household items, such as furniture and large appliances, to financing swimming pools and cars and providing home equity loans. Lately, they have branched out even further and are lending in diverse segments such as financing for boats, motor homes, and personal aircraft. This expansion has increased the diversification of the product offerings, but has also left consumer finance companies exposed to the housing market downturn that has led to higher delinquencies on home equity loans, auto loans, and loans for other large purchases. Co-branding, sponsorships maintain strength Some credit card issuers have found a unique marketing niche in co-branding their products with major retailers and other entities, such as airlines. In a co-branding arrangement between a credit card company and a retailer, the retailers name and logo appear on the credit card. In such arrangements, credit card companies enjoy additional account and balance growth and the opportunity to market other products to a new set of customers. Retailers find these arrangements advantageous because they can expand their sales by encouraging credit use, while the card issuer handles the payment collection aspects. Retail establishments increased acceptance of credit cards and customers greater willingness to use them are major forces driving credit card volume growth. Whereas customers once reserved their credit cards mainly for costly purchases, such as furniture or major appliances, they now charge everything from groceries and gasoline, to movie tickets and other inexpensive items. Indeed, some companies, such as American Express, reward consumers with incentives (e.g., double points) to encourage daily use. We note that nondiscretionary charges such as those mentioned above are usually made on debit cards as opposed to charge cards. As a result, payment volume on debit cards has held up better than charge cards during weaker economic times. Issuers also have developed sponsor relationships with colleges, universities, and professional organizations. The lender provides the funds, typically embossing the logo or insignia of the endorsing organization on the card, while the organization provides the customer list. Card members thus are encouraged to use the card to show support for the endorsing organization, which may receive a small percentage of the sales proceeds charged with the card. In 2008, Capital One even announced the addition of a new personalized image feature for its customers. All Capital One consumer credit card customers now have the option to visit the Capital One website and upload their own photo imageswhether it be family, friends, pets, or a favorite pictureto be printed on their cards, at no cost. Reward programs increase credit card use The fastest growing segment is rewards. Many card issuers now offer reward programs through which purchasers accumulate points that they can redeem for various goods, such as travel benefits or free flights on major airlines. Issuers devised these programs to encourage loyalty among customers and to boost credit card usage for items that might otherwise have been paid for with cash or by check.

As saturation of the credit card market continues to rise, programs such as these are increasingly important. The ability to create a distinct product with unique benefits is paramount. Credit card issuers must differentiate themselves from competitors. This is particularly the case when consumers have more than a few cards at their disposal. These programs have proven so popular that companies such as Capital One and American Express have even expanded them to small and midsize businesses. Research has shown that these kinds of credit cards tend to be more sticky than others. (The term sticky denotes that the customers are more likely to remain with the issuer for a longer period; without these rewards, many customers leave after the original financial enticements run out or their debt is paid off.) During the 200809 credit crisis, it was shown that charge-offs from reward-oriented customers of credit card companies held up better than from their other customers. The main challenges to rewards accounts are the increasingly competitive environment and the relatively high costs that issuers are realizing in order to develop and maintain these programs. Given the 2009 credit card reform legislation, we expect credit card companies to charge their customers higher fees in order to maintain reward programs.


Improved technology has spurred much of the growth in transaction volume by facilitating faster, cheaper transactions. In fact, some retailers prefer credit or debit card transactions to checks. Credit and debit transactions provide electronic records of all purchases. Compared with cash transactions, they are generally less susceptible to miscalculations or other human errors. The downside, though, is that they are costlier to merchants than cash transactions due to interchange fees. The Durbin Amendment to the DoddFrank Act directs the Federal Reserve to regulate interchange fees. Many purchases, such as those made through catalog phone orders, are difficult to make without credit cards. Increased consumer shopping over the Internet has further multiplied transaction volumes. Financially astute consumers have discovered that paying for purchases after the credit card bill arrivestypically weeks after purchases were madelets them keep cash in the bank longer, earning more interest for themselves. The relative safety of using credit cards compared with cash and checks has boosted industry volume growth in recent years. Although credit cards are not immune to theft or fraud, issuers generally limit consumers liability for unauthorized use of their credit cards. Finally, the ability to travel without having to carry cash for all transactions makes credit cards particularly useful for vacation and business travelers; for the latter group, credit cards also aid in record keeping.


The consumer finance industry comprises companies that operate in many disparate businesses. The three major consumer finance companies have origins in the credit card industry. American Express, Capital One, and Discover all provide credit cards and other consumer-related products to their customers. American Express and Discover also operate their own payment networks that compete with large global payments companies Visa and MasterCard. Capital One is the most similar to a traditional bank of the three, although it is more focused on the direct-to-consumer approach (while primarily a credit card lender, it is a top deposit-taking institution in the US, it owns ING Direct, and has a substantial auto finance business). Discover is also developing its direct banking business (its biggest business is its credit card network and credit card lending; it has been growing student loans). The diversified consumer finance companies that originally defined the consumer finance industry were Texas-based Associates First Capital (bought out by Citigroup in 2000), Illinois-based Household International Inc. (purchased by HSBC in 2002 for $15 billion), and Beneficial Corporation (purchased by Household International in 1998 for about $8.6 billion). They primarily offered unsecured personal loans, home equity loans, private label and general purpose credit cards, and auto finance. Another major player was Greentree Financial, which made its mark in manufactured housing and motor home loans. Greentree was bought out by a major life insurer, Conseco, for about $7 billion in 1998; lack of extensive due

diligence on the acquisition lead to Consecos 2002 Chapter 11 bankruptcy (the third largest US bankruptcy at the time). The consumer finance industry came into its own as securitization gave access to capital to small companies that focused their efforts on market niches, rather than trying to meet the borrowing needs of all people. Numerous niche players focused on credit cards, home equity, and auto finance went public in the early 1990s. However, many of these companies behaved like cowboys in the Wild West or kids in the candy store with a $10 allowance. Access to capital was easy, non-banks were essentially unregulated, and the urge to grow lured many companies into growing too fast. Further, accounting rules were not prepared for the new business models. Many companies used gains on sale of securitized assets for current period earnings. However, history shows us that assumptions in securitizations were not so easy to predict. And there were surprises as home equity was originally considered safer than auto finance loans, yet in practice predicting prepayments added more risk than expected. Securitizations were structured as bankruptcy remote and were offbalance sheet, yet if a companys securitization experienced higher losses than expected, it could prevent the company from securitizing more assets. Companies generally securitized assets quarterly to fund new loan originations. If a company could no longer securitize, it could face a liquidity crisis and a quick demise. Consumer finance experienced its first bubble long before the bubble burst, but back then, the industry was relatively small and independent, and therefore did not cause global shocks to the system nor affect the stability of the global financial system. While many small monoline players have gone bankrupt, others were bought out by banks in search of growth. The strongest have emerged as not only survivors, but also as visionary industry leaders of tomorrows financial service and payment systems arena. The landscape of the consumer finance industry has changed dramatically from the mid-1990s. We define consumer finance companies as those included in the S&P Consumer Finance Index. The players that make up the largest piece of the index include, American Express, Capital One, and Discover Financial Services. They offer a wide variety of products and services, including various consumer lending products (primarily credit cards, automobile loans, home equity loans and, to a lesser extent, traditional banking products, insurance, debit cards, and securities and investment products). American Express and Discover run payment networks that compete primarily with Visa and MasterCard. The division between banks and consumer finance companies is no longer as clear as it once was. To add to the confusion major consumer finance companies have banking subsidiaries. Many of the niche businesses are now operated by major banks. This is a result of banks desire to grow in higher-margin businesses and their history of having better access to funds through deposits and other forms of capital. Thus, the consumer finance companies compete with major diversified banks, primarily Citigroup, J.P. Morgan, Wells Fargo, and Bank of America. For greater insight into peers in the diversified financials and bank sectors, essentially the financial conglomerates, see the Banking; Insurance: Life & Health; Insurance: Property-Casualty; and Investment Services issues of Industry Surveys.

According to Experian Automotive (Experian), a market research firm, the US auto loan market totaled $658 billion in outstanding loans as of year-end 2011. The market is competitive, with four different categories of players engaged in automotive financing: retail banks, finance companies specialized in auto finance, captives of original equipment manufacturers (OEMs), and credit unions. According to Experian, retail banks had the largest market share of auto loans, at 36.2% at the end of 2011, followed by finance companies (26.9% market share), captives (20.0%), and credit unions (16.9%). In terms of individual players, Ally Financial Inc., an auto financing company, had the largest market share (6.79%) of all vehicle loans in the industry in 2011. Wells Fargo was the largest player among retail banks in automotive financing and held the second largest market share (5.61%). Other major retail banks with significant auto financing assets were JP Morgan (4.72% market share), Capital One (3.97%), and Bank of

America (3.17%). Among captive finance companies, Toyota Financial Services was the largest player and ranked third among the top lenders in the auto industry. American Honda Finance and Ford Motor Credit were ranked fourth and sixth in the list of top auto lenders in 2011. Credit unions held the eighth position in the list of auto lenders in 2011.
TOP BANKS & THRIFTS BY AUTO LOANS (In millions of dollars, as of March 27, 2012)

2. Wells Fargo 3. JPMorgan Chase 4. Bank of America 5. Capital One Financial Corp. 6. U.S. Bancorp 7. Fifth Third Bancorp 8. TD Bank US Holding Co. 9. SunTrust Banks Inc. 10. BB&T Corp. 11. USAA Federal Savings Bank 12. Citizens Financial Group 13. BMW Bank of North America 14. Huntington Bancshares 15. PNC Financial Services Source: American Banker. 43,508 39,330 33,030 21,780 11,508 11,139 11,041 9,462 8,729 8,517 7,538 6,672 5,881 5,181



Following the recent economic crises, auto financers have focused on the risk profile of the borrowers and primarily extended loans to prime borrowers. According to Experian Automotive, the proportion of loans extended toward prime borrowers has continuously increased in the past three years: this group accounted for almost 64% (38.8% super prime and 25% prime) of auto loans in the fourth quarter of 2011, versus a bit over 60% (36.9% super prime and 23.9% prime) in the fourth quarter of 2009. As expected, the proportion of loans to deep subprime lenders dropped significantly, to 11.5% in the fourth quarter of 2011, from 15.3% in the fourth quarter of 2009.

46.8 5.3 5.3 3.4 16.0 5.4 13.3 13.7 7.6 7.8 22.4 8.6 99.7 14.5 3.2

Financing is available for the purchase of both new and used vehicles, which represent three times the number of new cars sold. The auto loan sector grew strongly in 2011, driven by a 10% growth in new car sales and 5.2% growth in used car sales. Automotive loan disbursements have a strong correlation with auto sales volumes, as nearly 70% of vehicle sales are financed, according to CNW Research. According to Reuters, Wells Fargo is the market leader in financing used cars, with around 7% market share at the end of 2011, followed by Ally Financial (4.25% share).

The student loan market in the US totaled approximately $867 billion at the end of the fourth quarter of 2011, according to Bloomberg. These loans are designed to help students pay for university tuition, books, and living expenses, and generally have lower rates of interest and deferred schedules of repayments. The market is broadly divided into two categories: Federal Loans, issued directly by the federal government, and Private Loans, issued by banks and other financial institutions. According to American Banker, federal lending controls the majority of the student loans with $848 billion of outstanding loans, as of September 30, 2011. While the federal government extended $117 billion in student loans in 2011, their private competitors could capture only around $9 billion. The dominance of federal loans over private loans can also be gauged by the size of the student loan portfolio of SLM Corp. (also known as Sallie Mae), the largest private lender of student loans in the US. The company had a student loan portfolio of $36 billion in 2011 out of a total market nearing $1 trillion. Private lending has historically been less attractive to students due to higher interest rates, less flexibility in repayment terms, and few consumer protections. US Senator Dick Durbin (D., Illinois) has recently been fighting to protect students through introducing student loan consumer protection bills to improve student knowledge and repayment flexibility. A second major concern is the floating nature of its interest rates, which can increase during the life of the loan depending on the fluctuation of prime lending rates and LIBOR rates. Moreover, the interest charged by private lenders varies according to the credit profile of borrowers. Finally, many lenders, such as Discover, may require the student to have someone, such as a parent, guarantee the loan. On the other hand, the interest rate charged by the federal government is fixed. The subsidized rate is currently set at 3.4%, but it reverts to 6.8% as of July 1, 2012 if Congress does not reinstate the subsidy. In addition to a fixed interest rate, there is a provision for flexible loan repayments during times of financial distress. Federal loans have more lenient terms than private loans: for example, federal loans are not

considered to be in default until the borrower misses payments for nine months. Default conditions for private loans depend on the lenders contract and can be as strict as only one missed payment. Federal vs. private student loans Federal loans won a significant share of the market from private lenders after July 2010, when the Federal Family Education Loan (FFEL) program was eliminated. Under the program, created in 1965, the federal government had started guaranteeing student loans provided by banks and nonprofit lenders. Until then, private lending controlled the student loan market as the direct lending by the federal government showed up as a total loss in the budget, despite recovery of the loan in future years. Later, in 1990, the direct lending by the federal government started gaining share, but remained subdued to private lending till 2010, when the FFEL was abolished and all the government guaranteed loans were made as direct loans. Following the decision by the US government, many US banks pulled out of the student lending business. According to American Banker, US Bancorp stopped accepting student loan applications as of March 2012. JPMorgan Chase also plans to limit student lending to existing customers from July 2012.

In the early 1990s, the consumer finance industry was fragmented. The fragmentation and lure of high margins and easy financing led to rapid growth of niche businesses. The rapid growth and higher margins, as well as the liquidity crisis suffered by highly leveraged companies, led to consolidation. Today, large players generally dominate the industry. Scale advantages The nature of the financial services industry tends to favor large companies given the advantages of scale for efficiency, cost of capital, and access to capital. Larger companies, which typically offer many different products, leverage their distribution systems to get the most products to the greatest amount of people in the most efficient manner. It is also easier for them to advertise widely and generate name recognition. Access to low-cost financing can be a key advantage in the financial services business: larger firms can generally secure financing for their operations at a lower cost than their smaller competitors. Barriers to entry New heavy regulation, high competition, and ability to access capital provide barriers to entry for the consumer finance industry today. The consumer finance industry initially blossomed with low barriers to entry, namely, little regulation and easy access to capital through securitization in the 1990s. In addition, the Gramm-Leach-Bliley Act of 1999 eliminated the Glass-Steagall Act barriers and allowed investment banks, insurance companies, and commercial banks to enter each others businesses. However, more recent accounting changes for off balance sheet financing, significantly greater regulatory oversight, and consolidation now characterize a high barrier to entry industry. Competition Due to the commodity-like nature of most financial services products, competition is intense. Even unique companies face competition from companies that offer acceptable, if not exact, substitutes. In addition, because financial products cannot be copyrighted or patented, companies that successfully introduce new products soon face competition. That said, consumer finance providers engage in risk-based pricing to obtain attractive returns over the long term (rather than setting prices, or annual percentage rates and fees, so high that only the most desperate borrowers take the cards and, shortly thereafter, run up their balances to the maximum, then default). Pricing: The interest rates that customers pay According to, an aggregator of financial rate information, the national average credit card interest rate for standard cards as of April 5, 2012, was around 16%. Although short-term promotional rates can be as low as 0%, such teaser rates are less prevalent now than in years past due to tighter lending standards. According to the FDICs Quarterly Banking Profile, the cost of funds averaged 2.5% for credit card companies and 2.3% for consumer lenders from 2002 through the end of 2011. Annual percentage rates charged, in contrast, have varied widely (8%30%) by product and over the period.

Lending rates offered by consumer finance companies are usually competitive with those offered by banks, as the two often vie for the same customers. Because some consumer finance companies specialize in less lending segments than the typical bank, they may be more familiar with the associated risks and thus sometimes offer more attractive rates than banks. Before making a loan, consumer finance companies investigate the creditworthiness of the potential customer. The credit extension process tends to be highly automated. Many firms have proprietary credit scoring models that determine the creditworthiness of applicants. Companies work in conjunction with independent credit rating agencies, such as Equifax Inc., Experian Information Solutions Inc. (formerly TRW) or TransUnion LLC, which issue reports of borrowers credit histories and paying habits. Financial services companies use this informationalong with other data, such as employment history, income level, value of designated collateral, and current debt servicing requirementsto attempt to gauge an individual borrowers ability and willingness to repay a loan. Firms often employ credit analysts who can override decisions made by a companys scoring system after receiving further information from applicants. For instance, those with a shorter credit history (typically youth, new immigrants) or poor credit history (those who have been late payers, missed payments or have bankruptcy in their credit profile) tend to pay higher interest rates and fees than people with an established track record of timely debt payment. The interest rate charged is determined by factors that affect the loans riskiness: the loans duration, whether its rate is fixed or variable, whether the loan is secured or unsecured, the life of the item being financed, and the borrowers creditworthiness. Loan duration. Other things being equal, loans made on a short-term basis carry lower interest rates because lenders can more reliably gauge economic conditions and their impact on interest rates over a briefer time span. Long-term loans typically carry higher interest rates to cover the greater potential risks associated with the uncertainty of distant future economic events. Fixed- or variable-rate. The interest rate on a loan can be either fixed or variable. For a fixed-rate loan, the interest rate remains unchanged throughout a loans life. For a variable-rate loan, in contrast, the interest rate is adjusted over time as the lenders costs fluctuate. For lenders, fixed-rate loans are riskier and thus carry higher interest rates at the date of issue, because lenders cannot raise rates when their funding costs rise. Loans made at variable interest rates carry lower initial interest charges because they usually are linked to a base interest rate and, therefore, offer the lender protection from higher interest rates. Secured or unsecured. Whether a loan is secured or unsecured is another paramount factor in determining its risk. Secured loans typically hold a home or other tangible asset as collateral; a lien is placed on the property until the loan is repaid. Unsecured lending offers no such protection to the lender, and thus carries higher associated risk. From the lenders point of view, the difference between the two is the likelihood that the loan obligation will be satisfied through alternative means if the loan is not repaid. When a borrower defaults on a secured loan, the lender repossesses the asset, which may be sold to pay the loan obligation. Because of this collateral, secured loans are perceived as less risky and, therefore, carry lower associated interest rates. The greater risk inherent in unsecured loans means that borrowers pay higher interest rates. Using a credit card to make purchases or cash withdrawalstwo common forms of unsecured loansincurs some of the highest interest rates of all lending. Although temporary teaser rates can be as low as 0%, interest rates on credit card loans can be as high as 20% or more. The life of the item being financed. In the case of a secured loan, the financed items durability is another factor determining interest rates and loan terms. In general, the longer the projected life of the item, the further one can extend payments, and the lower the associated interest rate will be. Assets that are expected to have long life spans (homes, large appliances, or other durable goods) may qualify the borrower for lower interest rates, as the item probably will not need to be replaced within the duration of the loan. Conversely, lenders are not likely to make a 10-year loan on an item expected to last five years. Automobile loans, for example, typically extend no more than five or six years for new models and three or four years for used vehicles.

Customer credit rating. The borrowers creditworthinessbased on his or her financial profile and past record of making timely loan paymentswill affect the interest rate at which a lender is willing to lend money. A good credit history is attractive to financial services companies, which may offer such borrowers reduced interest rates. Borrowers income and debt levels also affect the interest rates they are charged. An individual whose debt levels are high as a percentage of income might have trouble repaying a loan. Attractive lending spreads Despite higher loss trends compared with banks, consumer finance companies tend to have wider spreads than banks, and credit card companies wider spreads than other consumer lenders. For instance, in 2011, bank credit cards enjoyed a yield on earning assets of 11.6% and net interest margin of 10.6%, compared to 5.6% and 4.6%, respectively, for consumer lenders, and 4.3% and 3.6% for all FDIC-insured institutions (see the FDICs Quarterly Banking Profile for more details). Commercial banks net interest margins are typically lower than consumer finance companies due to their wider variety of business and greater proportion of lower-risk secured lending. Although consumer finance companies generally enjoy greater latitude in pricing their products and services, there are limits. Although, some states, for example, have usury ceilings (a maximum allowable interest rate that financial institutions can charge). In most cases, however, this rate is higher than 20%. In cases where allowed rates do not adequately compensate for the risks involved, financial services companies can elect not to participatedeclining credit to individuals or not actively soliciting their business.

Diversified financial services companies with lending operations are similarly influenced by changing interest rates. Interest rates affect the profitability of diversified financial services and consumer finance companies by influencing the demand for credit, the cost of funds, and the amount of charge-offs. Lower interest rates cut borrowing costs, boosting demand for the industrys products. As interest rates fall, the cost of the funds that companies use to make loans also falls, and lending spreads tend to widen. Finally, low interest rates typically fuel economic (and thus job) growth, and lower unemployment rates often result in higher credit quality. When interest rates rise, the opposite occurs. The cost of borrowing goes up, so consumers may forgo purchases. The cost of funding loans also rises, putting pressure on spreads, and job growth slows, which may ultimately lead to credit quality problems. Securitization provides lower-cost funding Consumer finance companies are some of the biggest issuers of asset-backed securities. Beginning around 1994, securitization of finance receivables became a popular financing mechanism as it can offer lower cost funding than a companys own corporate credit would provide, as loans are pooled and used to secure debt. In these transactions, a lender typically pools various finance receivables, structures them as asset-backed securities, and sells them in the public securities market. The securitization and sale of certain loans, and the use of loans as collateral in asset-backed financing arrangements, are important sources of liquidity for financial services firms. Together with credit syndications and loan sales, securitizations help these companies manage exposures to a single borrower, industry, product type, or other concentration. Until the latter part of 2008, when the securitization markets virtually came to a standstill, most large financial services companies were active participants in the assetbacked securities market. As loan receivables are securitized, the companys onbalance-sheet funding needs are reduced by the value of loans securitized. The company often continues to service the accounts, for which it receives a fee. Funds received from securitizations sold in the public market are typically invested in money-market instruments and investment securities, which are available whenever the company needs to fund loan growth. During the revolving period of the securitization (generally 24 to 108 months), no principal payments are made to the security holders. Payments received on the accounts are used to pay interest to the holders and to purchase new loan receivables generated by the accounts so that the principal dollar amount remains unchanged. Once the revolving period ends, principal payments are allocated for distribution to holders.

In June 2009, the Financial Accounting Standards Board (FASB) issued new standards aimed at changing the way banks account for securitizations and offbalance-sheet special-purpose entities through Statements 166 and 167. Both Statements were effective at the start of a companys first fiscal year beginning after 2009, or January 1, 2010. Statement 166 is a revision to Statement No. 140 and will require more information about the transfer of financial assets, including securitization transactions, with a particularly focus on whether companies have continuing exposure to the risks related to the transferred assets. Statement 167 is a revision to FASB Interpretation No. 46(R) and changes how a company determines when an entity that is not sufficiently capitalized or is not controlled through voting should be consolidated. Among the determinants of whether a company is required to consolidate an entity are the entitys purpose and design, and whether a company can direct these activities. In our view, the new standards have made analyzing consumer finance companies easier and financial statements reflective of the true trends of the business.

Companies that lend tend to have highly leveraged balance sheets. The degree of leverage within actual businesses varies and often is determined by the companies business and regulatory statutes. The equity-toassets ratio is one measure used to determine indebtedness. For example, at December 31, 2011, Capital One had common shareholders equity of $30 billion and total assets of $206 billion, for an equity-to-assets ratio of about 14.5%.

The US financial services industry is highly regulated. Their role is vital as countries around the world are tightly linked through financial services and electronic trading. Given that the business focuses on money (lending, investing, borrowing, or some combination thereof), heavy regulation is not surprising. What is surprising is that for many years the consumer finance industry was unregulated. In the wake of the 2007 09 financial crisis, the government focused on protecting the consumer through new legislation (including the Credit Card Act of 2009) and government agencies (the new Consumer Financial Protection Bureau), discussed in the Industry Trends and Current Environment sections of this Survey. In general, most financial regulations mandate various consumer protection and capital adequacy measures. Consumer protection measures are designed to safeguard consumers from predatory lending practices and fraud. Capital adequacy measures are designed to ensure the viability of the financial services industry under different economic scenarios. Given their diverse nature, consumer finance companies are subject to a wide range of regulations by numerous regulatory agencies; specific regulators vary based on the companys product offerings. Most are regulated by the Federal Reserve Board and the Consumer Financial Protection Bureau, while some of these companies subsidiaries are also insured by the Federal Deposit Insurance Corporation and, therefore, subject to the agencys regulatory capital requirements. State and local regulators, including state banking and insurance regulators, also oversee the industry, while companies with international operations must conform to regulations in their host countries. Companies with non-US operations are also subject to the rules of foreign jurisdictions; this includes all the major players (American Express, Capital One, and Discover Financial Services). In addition, they must adhere to federal privacy laws governing the collection and use of customer information by financial institutions. Other regulations concern telemarketing, money laundering, and terrorism. Specific regulatory information can be found in a companys annual reports, 10-Ks and 10-Qs. Consumer protection laws. The most important US laws and their main provisions are as follows: The Truth in Lending Act of 1968: requires extensive disclosure of the terms on which credit is granted The Fair Credit Reporting Act of 1970: regulates use by creditors of consumer credit reports and credit prescreening practices, and requires certain disclosures when a credit application is rejected The Fair Credit Billing Act of 1974: regulates how billing inquiries are handled and specifies certain billing requirements


The Equal Credit Opportunity Act of 1974: generally prohibits discrimination in the granting and handling of credit The Electronic Funds Transfer Act of 1978: also known as Regulation E, regulates disclosures and settlement of transactions for electronic funds transfers, including those at ATMs The Fair Credit and Charge Card Disclosure Act of 1988: mandates certain disclosures on credit and charge card applications.

Banking laws. Because many consumer finance companies operate as bank holding companies, they are also subject to regulation by various federal bank regulatory agencies, specifically the Bank Holding Company Act of 1956 (BHCA). The BHCA prohibits bank holding companies from directly or indirectly acquiring or controlling more than 5% of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve. The BHCA generally prohibited bank holding companies from engaging in nonbanking activities, subject to certain exceptions, though many of these restrictions were relaxed with the passage of the Gramm-Leach-Bliley Act.


The practice of lending money sometimes results in extra costs to lenders, as when a customer stops repaying a loan. Naturally, lenders try to limit these types of losses. When the worst happens, however, these companies take other steps. As with any other cost of doing business, consumer finance companies attempt to minimize their loan losses, while at the same time take on enough risk that they can grow their loan portfolio. Individual companies may set limits on what they perceive as acceptable levels of losses, depending on the type and duration of loans they make and the interest rates they charge. Delinquencies, charge-offs, and default Default occurs when the borrower has stopped servicing a debt obligation for a certain number of months. The point at which default occurs is generally determined by credit managers once they have exhausted all methods of collecting on the obligation. Delinquencies and charge-offs are generally higher during periods of adverse or recessionary economic conditions. These conditions may include rising unemployment, declining home values, and inflationary pressures, all of which can affect a borrowers ability to repay loans. At such times, financial services companies may limit the number and amount of loans they are willing to make. The ways they can do this include placing stricter standards on credit availability or charging higher interest rates to compensate for greater perceived risk. In general, financial services companies that offer financing for a broad range of products will experience a historical average delinquency rate of around 2%, based on the FDICs Quarterly Banking Profile. However, the range varies widely based on the type of product and demographic and credit profile of the targeted customer. For instance, the credit card delinquency ratio for 30-89 days past due was 1.6% in the fourth quarter of 2011, down from a near-term peak of 3.1% and a historical peak (back to 1984) of 3.4% in the third quarter of 1991, and the lowest rate seen since 1990. The delinquency ratio has historically fluctuated within the 2%3% range. The net charge-off ratio in the fourth quarter of 2011 was 4.4%, a significant improvement from the peak of 13.2% in the first quarter of 2010 and the previous record of 7.7% in the first quarter of 2002. A more typical level for the net charge-off ratio tends to be in the area of 3%4%. Loan-loss provisions Like banks, consumer finance companies must set aside funds, called reserves, for loan losses, in case customers do not repay their loans. Loan loss provisions appear on a firms income statement, where they represent a charge taken against earnings to cover potential loan defaults. Provisions are based on managements assessment of current and expected lending conditions. The provision flows into the reserve for loan losses, which appears on the balance sheet as a contra account to loans. The reserve reconciliation is provided in the 10-Qs and 10-Ks and can usually be easily tracked. The reserve conciliation starts with ending reserves, adds provisions, subtracts charge-offs, adds recoveries, and ends with ending period reserves.

Unpaid loans are generally grouped according to the time that has elapsed since payment was to have been received: zero to 30 days; 30 to 90 days; or more than 90 days. After 30 days, loans are first categorized as delinquent; after 90 days, they are deemed uncollectible and are charged off. Charged-off loans are removed from the balance sheet and subtracted from the reserve for loan losses. Types of bankruptcy Bankruptcies generally cause lenders immediately to charge off a customers loan, since repayment is considered unlikely. Types of bankruptcy are described below. Individual consumers typically file under Chapter 7 or Chapter 13. Chapter 11 is typically used for business bankruptcies and restructuring. Chapter 7. This bankruptcy filing is essentially a liquidation. It lets a debtor retain certain exempt property, while a trustee liquidates the debtors remaining assets. The proceeds are distributed according to priorities set by the bankruptcy court. Chapter 11. This filing, known as a reorganization, lets individuals reorganize their financial obligations, such as state or federal taxes, over an extended period of time. Chapter 13. This filing, generally referred to as the wage-earner chapter, is designed for individuals with regular income who wish to repay their debts but who are currently unable to do so. Under the supervision of the bankruptcy court, such individuals carry out a repayment plan in which their obligations to creditors are paid over an extended period. Funding sources and margins The mix of yields earned on assets and the rates paid for funding are of utmost importance to financial services firms. Like all firms, financial services companies try to maximize their profit from each salein this case, from each loan. They must seek the best available interest rates for funding, and also lend at the highest possible interest rates, and stay competitive. To be successful, a financial services company must have access to funds at competitive interest rates, terms, and conditions. To obtain such funds, most firms turn to the global capital markets, by issuing commercial paper, medium-term notes, long-term debt, asset-backed securities, or equity (such as common or preferred stock). To a lesser extent, they also may offer customers limited deposit services.

Credit costs are typically the largest cost for a consumer finance companies, followed by marketing, advertising, and distribution costs, and employee compensation. Other costs such as technology and occupancy/rent are meaningful, but a lesser factor for earnings. Marketing and distribution Because competition among lenders is usually intense, the costs of soliciting new business and retaining existing customers can be substantial. Response rates tend to be low, and competitors often try to lure customers away. For example, in 2011, Capital One spent $1.3 billion (up 40% year-over-year) on marketing. A companys marketing and advertising efforts often are geared toward the specific market segments where it has expertise or where it offers the most products and services at the most competitive prices. In this manner, a firm can maximize available resources in hopes of attracting the greatest number of customers. Distribution channels often include media, direct mail, telemarketing, branch networks, event marketing, and retail relationships. Media. Companies promote their brands and products through advertising on their own websites, television, social networking websites, and more. Establishing a national brand name and trust is helpful to attracting customers. We note that consumers that seek credit are often more likely to be having credit difficulties, making the Internet a less productive way to source customers than it is for retailers.




Direct mail. Direct mail involves the prescreening of credit rating databases for individuals with favorable credit criteria; they are mailed offers of lending products such as home equity loans or credit cards. These mass mailings are inexpensive, but they also have a low success rate. Although direct mail is generally cheap, the volume is enormous, resulting in considerable outlays for postage and delivery charges. Telemarketing. These techniques often use the same financial criteria as direct mail in locating potential clients, but the process involves a representative calling the prospect directly. Telemarketing campaigns tend to be more expensive than direct mail campaigns. They are also more successful, and often can be used to reach existing customers to cross-sell ancillary products, such as insurance. Branch networks. Branch networks usually cover a geographic region, such as the Southeast or the Midwest, with offices located in high-traffic areas. This enables firms to leverage marketing and production efforts. At branch offices, walk-in customers may meet with financial representatives to find out about lending products or other offerings. This brick-and-mortar approach to business is costly, but also highly effective. Customers entering branch offices are already looking to borrow money, and the face-to-face contact makes it easier for financial representatives to close the deal. Branch networks are more common among banks than consumer finance companies as consumer finance companies and card networks have taken a more national approach. Event marketing and event sponsorships. Event marketing typically involves setting up booths, at sporting events or other well-attended activities, where product offerings are made. This kind of marketing has a fairly high success rate, reflecting the combination of face-to-face contact with customers and the use of promotional tie-ins, such as T-shirts and hats, which encourage people to apply for credit. Event sponsorship of a sport, concert, or other entertainment can also help reinforce a companys brand name. Retail outlets. Retail outlets often let financial services companies provide brochures or applications to customers, who may seek financial assistance in purchasing the items they want. This practice is common among electronics and appliance retailers, which sell high-cost consumer durable goods. This method is also helpful to the retailer, since sales of high-priced items could be limited if financing were not available. Compensation Costs Compensation costs, after interest expense, are the most significant expense item at most consumer finance companies. These expenses include salaries, bonuses, profit sharing, payroll taxes, and benefits paid to or incurred for various employees. Large credit card issuers, such as Capital One, often employ thousands of part-time telemarketers to promote their products to customers, numerous credit underwriters to approve credit, and collection specialists to help speed up payments from late-paying customers and to help limit credit card loan defaults. Technology Costs Given the industrys increasing reliance on technology, especially for computer-driven credit scoring and evaluation, it is not surprising that technology-related costs are often a sizable part of a firms expenses.


The following measures can be used to gauge the health of companies in the consumer finance industry. Like traditional banks, consumer finance companies record interest income and fees from lending products, establish reserves for potential credit losses, and generally compete aggressively with each other. However, they tend to be slightly less diverse and focus on relatively higher margin and, in some cases, higher-risk businesses. For companies with securities, insurance, or commercial banking operations, consult the Industry Surveys on those subjects for specific ratios and statistics affecting those lines of business. Interest rates. Interest rates are a key macroeconomic indicator of the financial services industrys overall performance. Because rates affect the ultimate cost of items to be financed, they may increase or diminish the demand for financial services companies products.




Declining interest rates tend to stimulate economic activity and the demand for borrowing. Rising interest rates tend to make loan payments less affordable, reduce loan demand, and generally result in higher delinquencies and charge-offs, weakening financial services firms profits. Analysts watch short- and long-term interest rates closely. They also monitor the relationship between those rates, which can be graphed and is referred to as the yield curve. The chart plots interest rates and their maturities.
YIELD CURVE (In percent)
5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1 .5 1 .0 0.5 0.0

H02 Yield curve







201 0

201 1

201 2

Short-term rates generally are represented by the federal funds rate and the discount rate. The Federal Reserve Board (the Fed), whose policy takes into account current economic conditions, influences the federal funds rate and directly controls the discount rate. For example, strong economic growth and/or employment activity, which can generate shortages in labor and goods and therefore cause higher inflation, may cause the Fed to raise its target for the federal funds rate, which, in turn, affects other interest rates.

Market forces determine long-term rates, commonly represented by the yield on the 10-year Treasury note. However, they are subject to the same factors as short-term rates: strong economic and employment conditions, by fueling inflation, can make them rise. Because they are subject to market forces rather than to regulation, long-term interest rates react more swiftly than short-term rates to daily economic developments. Thus, they can be viewed as a leading indicator for future interest rate levels and economic activity.
Source: Federal Reserve Board.

1 0-year T-note

3-month T-bill

When long-term rates decline but short-term rates do not, the difference between the two diminishes, and the yield curve begins to flatten. A flat yield curve is undesirable for the industry because it reduces the difference between the rates lenders must pay to borrow funds and what they can charge their customers. By reducing the spread, it cuts into their profit margins. To anticipate the direction of interest rates, the analyst should evaluate the levels of domestic economic growth and inflation. Interest rates tend to rise when economic growth is strong, because healthy demand for borrowing makes lenders less willing to compromise on credit rates. A strong economy often means higher employment and consumer confidence levels; however, strong economic growth also may put upward pressure on inflation, as goods and services may be in short supply. Higher inflation limits individuals purchasing power. US interest rates continue to be well below their historical levels. As of April 2012, the 10-year yield stood at 2.01%, while the three-month yield was 0.09%, resulting in a spread of 192 basis points. This compares to the average for 2010 of 307 basis points, and is similar to the 227 basis point average spread in 2008, but above the 15 basis point spread in 2007. Net interest income is usually about half the revenues of a major bank, and is dependent on interest rate spreads, growth of interest-earning assets, and level of nonperforming loans. Unemployment rate. Reported each month by the Bureau of Labor Statistics (part of the US Department of Labor), this is an important measure of employment and unemployment across the nation. Changes in the unemployment rate are meaningful to financial services companies as predictive measures of potential inflation (and hence of possibly rising interest rates) due to a tight labor market, or as an indicator of conceivably higher charge-offs and delinquencies due to rising unemployment. As of March 2012, 8.2% of the US labor force was unemployed (seasonally adjusted); this compares to peak unemployment rates of 10.0% in October 2009 and 10.8% in November 1982.




Disposable personal income. Reported each month by the Bureau of Economic Analysis (part of the US Department of Commerce), disposable personal income is a measure of inflation-adjusted income minus taxes. Changes in disposable personal income are important to financial services companies because they influence consumer spending and borrowing. Healthy rises in disposable personal income indicate a higher capacity to borrow and spend. Real disposable CONSUMER CONFIDENCE INDEX personal income growth has not fully (1985=100) recovered from the great recession: it was 2.8% in 2007, 1.3% in 2008, 1.1% in 2009, 1 60 1.8% in 2010, and 1.3% in 2011, according to 1 40 the Bureau of Economic Analysis. ConsConf:
1 20 1 00 80 60 40 20 2000 01 02 03 04 05 06 07 08 09 1 0 1 1 201 2


Consumer confidence index. The consumer confidence index reflects US consumers views on current and future business and economic trends and how they expect to be affected by those trends. It is compiled monthly by the Conference Board, a private research organization, which polls 5,000 representative US households to gauge consumer sentiment. The survey has two components. One set of questions is concerned with consumers appraisals of present conditions, the other with expectations for the future. The consumer confidence index combines responses to those questions. Factors that influence the index include individuals perceptions of employment availability and of their current and projected income levels. Historically, the level of consumer confidence has been a good predictor of future borrowing and spending habits. Peoples expectations of future economic, employment, and income levels affect their ability to repay borrowed money and can be key in making purchase decisions. Consumer borrowing often moves in tandem with job growth and can be influenced by the direction of interest rates (lower rates may stimulate borrowing). Consumer credit. The Fed reports consumer installment and revolving credit outstanding monthly. As of February 2012, consumer credit outstanding in the United States totaled $2.52 trillion (seasonally adjusted), up from $2.42 trillion a year earlier. Delinquency trends. Delinquency statistics are collected by the Federal Reserve Board, the Federal Deposit Insurance Corporation, and other regulators.

Source: The Conference Board.

TOTAL CONSUMER INSTALLMENT CREDIT (In billions of dollars, outstanding at end of month)
3,000 2,500 2,000 1 ,500 1 ,000 500 0 1 997 98 99 00 01 02 03 04 05 06 07 08 09 1 0 Revolving
Source: Federal Reserve Board.


1 201 1 2


CONSUMER CREDIT AT FINANCE COMPANIES (In billions of dollars, outstanding at end of month)
700 600 500 400 300 200 1 00 0 2000 2002 2004 2006 2008 201 0 201 2


Source: Federal Reserve Board.



Bankruptcy trends. The number of US bankruptcy filings increases when consumers try to spend beyond their means. When a borrower declares bankruptcy, the lending company is forced to write off the loan as a loss. In addition, bankruptcy implies

that an individuals ability to borrow is limited. The number of US bankruptcy filings is calculated quarterly by the Administrative Office of the US Courts and disseminated by the American Bankruptcy Institute.


This section discusses how to evaluate a financial services company. Although companies in this industry have different businesses mixes, certain quantitative factors can be used to compare all industry participants: revenue growth, profit margins, and return on equity. In contrast, loan growth, net interest margin, and credit quality measures pertain most specifically to those companies that provide loans. We recommend evaluating business mix, applicable quantitative measures from the list below, and valuation. MAJOR CARD COMPANIES' REVENUE SOURCES2011

Other commisions and fees 8% Travel commisions and fees 7% Net card fees 7%

Other CARD 7%


Net interest

An analysis of a diversified financial services company begins with an assessment of the companys lines of businessthe key factor differentiating the diverse companies in this group. Lines of business The consumer finance category includes a variety of different business models, most of which have roots in the credit card industry. Therefore, an analysis of any company in this industry segment must begin with an evaluation of what the company does, its products, and how it generates revenues. Companies with multiple business lines typically report revenue and profit contributions from different segments in their annual reports. For example, Capital One has diverse business lines including consumer banking (retail deposits, mortgage, and auto finance), credit card, direct brokerage, and commercial banking. Meanwhile, American Express and Discover Financial Services compete partially with financial services providers (primarily other consumer finance companies and banks), but also the major network services providers Visa and MasterCard; these companies are technically part of the Information Technology sector of the Global Industry Classification Standard (GICS). Quantitative measures After identifying a companys activities, the analyst should then assess its prospects for growth and profitability. Although companies in this segment operate different types of businesses, many similar quantitative measures can be used to compare industry participants. Key measures of financial performance are loan growth, net interest margin, return on managed receivables, credit

Discount revenues 56%


Loan fee income 5%

Transaction processing revenue 3%

Other Income 3%

Fees products 6% Discount and interchange revenues 1 5%

Net interest income 68%


Net interchange fees 8% Service charges and other customer related fees 1 2%

Other income 2%

Net interest income 78% Source: Company reports.



quality, and efficiency ratios. The two main drivers of a lenders earnings are net interest income and noninterest income. When evaluating a consumer finance companys loan portfolio, it is important to look at it on a managed basis, which reflects the impact of the securitized loans that the company still services. Managed metrics are adjusted for the impact of securitizations, thus providing a more complete picture of a companys operating performance. They include receivables (i.e., loans) that have been securitized and, therefore, are not on the originators balance sheet, but are being managed by the originator. Revenue growth. A key sign of health for any business is revenue growth. It is important to compare a firms revenue growth with its historic growth rate and with that of its competitors. Is growth accelerating or decelerating? Is the company outperforming others in its markets, and, if so, why? Determining what is behind the growth trends, such as acquisitions or new products, can provide insight into prospects for future growth. Note that with a lender, faster growth is not always better. Loan growth. To predict loan growth, it is important to understand the mix of a companys lending business. Given that loans are the biggest component of interest-earning assets, it is easy to see the relationship between loan growth and earnings growth. While some companies with higher risk profiles might outgrow those with higher credit standards in certain periods, the group with stricter lending standards is inherently less risky and more likely to succeed over the long term. A lender that is growing too fast can loose control of credit quality and ultimately put itself out of business. Net interest income. Net interest income is driven by loan growth. Net interest income represents income on total interest-earning assets, less the interest expense on total interest-bearing liabilities. Fee income (non-interest income). Fee income is driven by loan growth, add-on products, and/or credit quality (late payment fees or other penalties). Net interest margin. Net interest margin (net interest income divided by average interest-earning assets) indicates how much new profit can be expected from a given level of loan growth. For companies that have significant lending operationsbanks, savings and loans, or consumer finance companiesthis is a key profitability measure. Net interest margin trends are affected due to factors such as funding costs and business mix. Net interest margin may not fully reflect the risks that a company is taking, therefore, some analysts look at risk-adjusted net interest margin that accounts for net credit losses. Return on assets. For historical comparisons, it is best to use return on managed assets. Managed assets include a companys securitized loan portfolio; historically they were considered off-balance sheet assets. Return on equity (ROE). ROE (net income divided by average shareholders equity) is a telling indicator of financial performance. It measures how efficiently a company uses shareholders capital, or how much bang it gives shareholders for their buck. Not surprisingly, the ROEs of financial firms vary widely. Although ROE is a very useful tool for evaluating performance, it is not a perfect measure, as it is affected by leverage. All else being equal, the higher a companys level of debt as a percentage of its capital structure/the greater use of leverage, the greater the ROE. Credit quality. Occasionally the individuals to whom financial services companies lend do not repay it. Therefore, lenders set aside reserves to offset the impact of future potential credit losses. Evaluating a firms credit qualityits ability to withstand loan losses over the course of several quarters or years is a key differentiating aspect among peers. Delinquency ratio. The delinquency ratio is calculated by dividing loans delinquent by end of period (managed) receivables. This represents the percentage of loans in a companys portfolio that are delinquent. Typically, a loan is termed delinquent if the payment is not received within 30 days of its due date. Charge-off ratio. Delinquent loans are typically determined uncollectible after no payment after 180 days and are considered losses and written off the balance sheet. You can calculate the net charge-off

ratio or write-off rate by dividing charge-offs minus loan recoveries on balances previously charged off over average receivables in the period. Reserve ratio. Comparing a companys reserves for loan losses to total receivables can help determine whether it is adequately prepared for an unexpected deterioration in credit quality. We recommend assessing if a companys quarterly loan loss provisions are covering charge offs; is the reserve level rising or falling and whether reserves are growing at a similar rate as loans.

Efficiency ratios. Efficiency is measured by dividing expenses by revenues. Efficiencies typically improve as a firm grows in size, reflecting economies of scale. Companies generally strive to keep the growth rate of expenses below that of revenues. Pretax and net margins. Whether a company makes loans or not, you can evaluate the pretax margin and net margin. The ratios are typically calculated by dividing either the pretax income or net income by total net revenues. Companies with commodity-like, undifferentiated products tend to have lower pretax and net profit margins than companies that provide customers with proprietary products and value-added services. Funding sources. An examination of funding sources will reveal the relevant importance of a companys deposit taking and securitization activities. When a company securitizes pools of assets, it recognizes certain gains on its income statement. These sums recognized are based on assumptions made by the company about the loss trends and prepayment rates of the securitized assets. If the performance of the pool of assets diverges significantly from the companys expectations, the company may have to restate earnings or take a significant charge. In addition, securitization income can make a considerable contribution to net income. That said, the current securitization market is weak as the credit markets remain relatively illiquid. Valuation The last step in analyzing a diversified financial services company consists of trying to determine whether its stock price reflects its true value. What price might the business garner in a private transaction? The valuation of a financial services company should reflect myriad factors, such as the quality of management, future business prospects, earnings volatility, and earnings history, to name a few. Price-to-earnings ratio (P/E). Among valuation methods, the P/E ratio is the most commonly used yardstick for consumer finance companies. All else being equal, companies that have superior earnings growth prospects will command higher P/E ratios. Analysts compare a firms P/E ratio with the P/Es of its peers and with the P/E ratio of the broader market. The P/E ratios of diversified financial services companies vary widely. However, most financial services companies typically trade at a discount to the overall market because of the cyclical, interest-ratesensitive nature of their business. One useful technique is to estimate normalized earnings per share, and apply a multiple to it, based on longer-term historical trends. Normalized earnings per share can be estimated by forecasting the revenues based on an assumption of a moderate growth economic environment, with loan loss provisions that just cover net charge-offs, and expenses that are free of legacy legal and credit-related costs. Price-totangible book value. Tangible book value is basically book value less preferred shares and goodwill. Alternatively, book value can be calculated by taking total assets, minus goodwill and intangibles, minus total liabilities, minus preferred stock, all divided by shares outstanding. A key indicator of investors perception of future value of a company is if the company trades above 1X its tangible book value per share and how that compares to peers. Differences in valuation can be explained by asset quality trends, growth, geographical mix, and/or quality of management. A financial services company that is deemed to have more solid credit quality and growth potential will generally trade at a relatively higher price/tangible book value than weaker peers. This measure can be used when a company is in distress and when earnings are volatile. Purchase price-to-managed receivables. This measurement is typically used for mergers and acquisitions analysis.




Affinity cardA credit card sponsored by an organization (such as a nonprofit group or a university) and a card-issuing financial institution. Asset-backed commercial paperA short-term investment vehicle with a maturity that is typically between 90 and 180 days. The security itself is usually issued by a bank or other financial institution. The notes are backed by physical assets such as trade receivables, and are generally used for short-term financing needs. BankruptcyLegal proceeding initiated when an individual or organization is unable to pay outstanding debts. Under US law, bankruptcy may be involuntary (when creditors petition to have a debtor judged insolvent) or voluntary (when the debtor brings the petition). In each case, the goal is to achieve an orderly and objective settlement of obligations. Basis pointUnit measuring movements in interest rates or margins; it equals one one-hundredth of one percent (0.01%). Thus, 100 basis points equal one percentage point. Captive finance companyA company (usually a wholly owned subsidiary) that finances consumer purchases from a parent company, such as Ford Motor Credit Co. Collateralized debt obligation (CDO)A type of asset-backed security and structured credit product. CDOs hold a portfolio of fixed-income assets and divide the credit risk among different tranches (i.e., classes of bonds). CreditAn amount of money that a financial institution extends, which the customer may borrow. Credit bureauAn agency that tracks consumers credit history, which it relays to credit grantors for a fee, including credit lines applied for and received, and timeliness of payment. Data are maintained by several hundred credit bureaus that use three automated systems: Equifax, Experian, and TransUnion. Credit cardA plastic card issued by a bank, savings and loan, retailer, oil company, or other credit grantor that allows the consumer to obtain goods or services on credit, for which interest is charged. Most bank credit cards let consumers use their cards to obtain cash advances. Credit limitThe maximum balance that a credit card customer is allowed to carry. Credit ratingA formal evaluation of an individuals credit history and ability to repay obligations. Debit cardA bank card that allows depositors to pay for the cost of goods and services directly from their checking accounts, electronically. Debit cards often combine the convenience of an automated teller machine (ATM) card with the benefits of an American Express, Visa, or MasterCard credit card. Debt consolidationManaging consumer debts by combining them in a single loan from a financial institution. Usually results in a lower monthly payment extending over a longer period than the original loans, possibly at a higher interest rate. DelinquencyA credit card payment that is past due, typically by 30 or more days. FICO scoreA widely used measure developed by Fair Isaac & Co. to predict the likelihood that credit users will pay their bills; attempts to condense a borrowers credit history into a single number between 300 and 850. ForbearanceA period when a creditor permits a debtor to temporarily suspend or reduce payment. Interest rate sensitivityThe degree to which interest rate fluctuations affect an interest-earning asset or interest-bearing liability whose interest rates are adjustable within one year or less, according to maturity or contractual terms. Rate adjustments usually reflect changes in prevailing short-term money rates.




Managed receivablesThe total amount of receivables (i.e., credit card, mortgage, or other forms of loans), including both securitized receivables and receivables on a companys balance sheet. Net charge-offThe portion of a loan that a financial services company is unlikely to collect and writes off as a bad debt expense; can be reduced by recoveries of payments for loans previously charged off. Net interest incomeTotal interest revenues less total interest expenses. Net interest marginA measure of the profitability of a lending business, calculated as net interest income divided by average earning assets. Does not consider risks incurred. Private label credit cardA credit card issued under the name of a merchant, such as a department store. Merchants issue private label cards, carrying their brand names, mainly to reinforce brand loyalty and to encourage spending. Return on assets (ROA)An indicator of operating efficiency, ROA is calculated by dividing net operating income by total average assets. Return on equity (ROE)A performance ratio, calculated as net operating income divided by total average equity. Risk-adjusted marginOperational measure that considers how much risk a company has taken on. Calculated as riskadjusted revenue (net interest income plus noninterest income, less net charge-offs) divided by average managed receivables. Secured loanA note that, upon default, provides for pledged or mortgaged property or other collateral to be applied toward the payment of the debt. SecuritizationThe process of pooling assets together and converting them into packages of securities collateralized by those assets. Asset-backed securities are sold into the secondary market as a funding source, but generally a piece is held by the issuer and following January 1, 2010 the entire portfolio of sold and unsold pieces are reflected on the issuers balance sheet. Subprime borrowerA classification of borrowers with a deficient credit history. Although certain lenders define subprime using different measures, the most widely-used form defines a subprime borrower as one with a FICO score below 620. Unsecured loanA credit agreement not backed by the pledge of specific collateral. The lenders only security is the credit users signature and personal financial situation as demonstrated through the credit application. WorkoutWhen a lender agrees to accept less than is owed on a debt as full payment; may include forbearance.




PERIODICALS ABA Banking Journal Monthly journal of the American Bankers Association; covers regulatory developments and compliance issues. American Banker Daily; news on a broad range of legislative, product, and financial developments affecting financial services companies. The Conference Board/ NFOs Consumer Confidence Survey Monthly; reports consumer confidence index levels. Federal Reserve Bulletin Monthly; provides data and articles on financial and economic developments. National Mortgage News Weekly newspaper serving the mortgage industry, including mortgage bankers, commercial bankers, savings institutions, brokerage firms, insurance companies, and government enterprises. Provides news and analysis of the trends shaping the mortgage industry, including coverage of commercial lending, mortgage servicing, technology & ecommerce, default management, nonconforming lending, latest M&A developments, and exclusive industry rankings. The Nilson Report Bimonthly; covers consumer payment systems worldwide. GOVERNMENT AGENCIES Federal Deposit Insurance Corporation (FDIC) Independent deposit insurance agency created by Congress to maintain stability and public confidence in the US banking system by identifying, monitoring, and addressing risks to insured depository institutions. Federal Reserve System, Board of Governors Founded by Congress in 1913, the Federal Reserve: supervises and regulates banks; maintains the stability of the financial system; conducts US monetary policy; and provides certain financial services to the US government, the public, financial institutions, and foreign official institutions. US Bureau of Labor Statistics (BLS) Principal fact-finding arm of the federal government in the broad fields of labor, economics, and statistics. Among its major programs are the consumer price index (CPI), the producer price index (PPI), the employment cost index, and the national compensation survey. OTHER American Bankruptcy Institute (ABI) Founded in 1982, the ABI is a multidisciplinary, nonpartisan organization dedicated to research and education on insolvency matters; it is the largest such organization in the world. Membership includes more than 5,800 attorneys, bankers, judges, professors, turnaround specialists, accountants, and other bankruptcy professionals. It publishes information for both insolvency practitioners and the public. Cardweb.Com Inc. Online publisher of information about all types of payment cards, including credit, debit, smart, prepaid, automated teller machine (ATM), loyalty, and phone cards. The organization is the offspring and online extension of RAM Research Group, a research firm covering the payment card industry, and serves hundreds of institutional clients in more than 30 countries.





Operating Revenues (Million $)
Ticker Company Yr. End DEC DEC DEC NOV SEP DEC DEC # MAR 2011 32,282.0 18,525.0 A 1,540.6 8,543.5 869.3 521.3 D 6,678.0 540.2 2010 30,242.0 18,939.0 1,293.3 A 8,241.2 733.0 431.1 D 6,868.4 491.4 134,194.0 F 111,465.0 D 115,475.0 F 2009 26,519.0 15,885.2 A 1,120.4 A 6,094.0 597.5 A 366.0 D 6,190.1 D 438.7 150,450.0 F 104,159.0 D 115,632.0 F 2008 31,920.0 17,650.1 1,030.8 A 6,093.4 D 457.4 333.5 D 8,134.8 388.2 2007 31,634.0 D 19,001.2 D 929.4 6,434.3 372.2 388.5 D 10,531.7 346.0 2011 4,899.0 3,253.0 136.0 2,226.7 122.2 70.9 600.0 100.7 1,446.0 10,955.0 18,976.0 CONSUMER FINANCE AXP [] AMERICAN EXPRESS CO COF [] CAPITAL ONE FINANCIAL CORP CSH CASH AMERICA INTL INC DFS [] DISCOVER FINANCIAL SVCS INC EZPW EZCORP INC -CL A FCFS SLM WRLD FIRST CASH FINANCIAL SVCS [] SLM CORP WORLD ACCEPTANCE CORP/DE

Net Income (Million $)

2010 4,057.0 3,050.0 115.5 764.8 97.3 54.3 597.5 91.2 2009 2,137.0 986.6 96.7 1,276.2 68.5 41.9 481.8 73.7 2008 2,871.0 84.5 81.1 1,062.9 52.4 38.1 -212.6 60.7 2007 4,048.0 2,591.7 79.3 588.6 37.9 32.7 (896.4) 53.0 2011 153,337.0 206,019.0 1,674.2 68,783.9 756.5 357.1 193,345.0 735.0 2,129,046.0 1,873,878.0 2,265,792.0

Total Assets (Million $)

2010 147,042.0 197,503.0 1,427.2 60,785.0 606.4 342.4 205,307.0 666.4 2,264,909.0 1,913,902.0 2,117,605.0 2009 124,088.0 169,646.4 1,269.7 46,021.0 492.5 256.3 169,985.3 593.1 2,223,299.0 1,856,646.0 2,031,989.0 2008 126,074.0 165,913.5 1,186.5 39,892.4 308.7 265.3 168,768.4 531.3 1,817,943.0 1,938,470.0 2,175,052.0 2007 149,830.0 150,590.4 904.6 37,376.1 251.2 291.5 155,565.0 486.1 1,715,746.0 2,187,631.0 1,562,147.0


DEC 129,913.0 F DEC 102,587.0 D DEC 110,838.0 F

113,106.0 F 119,190.0 F 104,605.0 D 157,333.0 A 101,491.0 A,F 116,353.0 F

(2,238.0) 6,276.0 4,008.0 14,982.0 10,622.0 -1,161.0 -32,094.0 3,617.0 17,370.0 11,652.0 3,699.0 15,365.0


6,911.0 5,098.7 844.7 234.8

6,263.0 4,991.6 A 921.9 168.1

3,589.8 4,067.6 902.9 A NA

3,650.0 1,906.0 282.4 52.1

2,966.0 1,846.0 98.8 42.2

2,353.0 1,462.5 -137.8 37.2

804.0 -253.9 -425.3 17.3

(1,076.1) 1,085.9 (34.0) NA

34,760.0 10,693.0 2,313.6 425.9

33,408.0 8,837.0 1,075.3 285.8

32,281.0 7,470.3 918.9 123.3

34,981.0 6,475.8 1,079.8 97.2

4,390.1 6,260.0 1,547.3 NA

Note: Data as originally reported. CAGR-Compound annual growth rate. S&P 1500 index group. []Company included in the S&P 500. Company included in the S&P MidCap 400. Company included in the S&P SmallCap 600. #Of the following calendar year. **Not calculated; data for base year or end year not available. A - This year's data reflect an acquisition or merger. B - This year's data reflect a major merger resulting in the formation of a new company. C - This year's data reflect an accounting change. D - Data exclude discontinued operations. E - Includes excise taxes. F - Includes other (nonoperating) income. G - Includes sale of leased depts. H - Some or all data are not available, due to a fiscal year change.

Return on Revenues (%)

Ticker Company Yr. End DEC DEC DEC NOV SEP DEC DEC # MAR 2011 15.2 17.6 8.8 26.1 14.1 13.6 9.0 18.6 2010 13.4 16.1 8.9 9.3 13.3 12.6 8.7 18.6 2009 8.1 6.2 8.6 20.9 11.5 11.4 7.8 16.8 2008 9.0 0.5 7.9 17.4 11.5 11.4 NM 15.6 2007 12.8 13.6 8.5 9.1 10.2 8.4 NM 15.3 2011 3.3 1.6 8.8 3.4 17.9 20.3 0.3 NA CONSUMER FINANCE AXP [] AMERICAN EXPRESS CO COF [] CAPITAL ONE FINANCIAL CORP CSH CASH AMERICA INTL INC DFS [] DISCOVER FINANCIAL SVCS INC EZPW EZCORP INC -CL A FCFS SLM WRLD FIRST CASH FINANCIAL SVCS [] SLM CORP WORLD ACCEPTANCE CORP/DE

Return on Assets (%)

2010 3.0 1.7 8.6 1.3 17.7 18.1 0.3 14.5 2009 1.5 0.3 7.9 2.8 17.1 16.0 0.2 13.1 2008 2.1 0.0 7.8 2.8 18.7 13.7 NM 11.9 2007 2.9 1.7 9.4 1.8 16.9 12.5 NM 11.8 2011 28.0 11.6 16.0 30.3 20.6 23.1 12.8 NA

Return on Equity (%)

2010 26.5 11.5 15.7 9.8 20.8 21.3 12.6 22.1 2009 14.0 1.7 15.4 18.5 19.9 22.8 9.3 21.9 2008 25.1 0.2 15.1 18.5 21.4 21.4 NM 23.1 2007 37.6 10.5 16.9 10.4 19.6 16.8 NM 23.6



1.1 10.7 17.1

NM 9.5 15.0

4.2 NM 10.1 34.0 28.7 NM 15.8

3.5 NM 3.6 12.8 NM NM 10.3

12.6 2.3 13.2 NM 26.7 NM NA

0.0 0.6 0.8 10.7 19.5 16.7 14.6

NM 0.6 0.8 9.0 22.6 9.9 20.6

NM NM 0.4 7.0 21.0 NM 33.7

0.1 NM 0.2 4.1 NM NM NA

0.9 0.2 1.1 NM 19.1 NM NA

0.0 6.4 10.7 14.2 34.4 40.3 24.9

NM 6.7 10.3 12.3 42.4 83.0 48.0

NM NM 6.3 10.6 53.9 NM NA

1.8 NM 2.3 7.8 NM NM NA

10.8 3.1 12.9 NM 40.3 NM NA


Note: Data as originally reported. S&P 1500 index group. []Company included in the S&P 500. Company included in the S&P MidCap 400. Company included in the S&P SmallCap 600. #Of the following calendar year.




Price / Earnings Ratio (High-Low)

Ticker Company Yr. End DEC DEC DEC NOV SEP DEC DEC # MAR 2011 13 814 716 23 15 11 10 5 8 5 10 13 10 8 2010 15 711 16 15 18 13 10 11 5 8 10 5 11 9 5 2009 27 43 11 712 16 18 86 8 4 2 7 8 4 2 2008 21 7 NM - NM 18 8 93 15 8 16 6 NM - NM 12 4 2007 19 13 18 26 19 15 7 11 12 11 CONSUMER FINANCE AXP [] AMERICAN EXPRESS CO COF [] CAPITAL ONE FINANCIAL CORP CSH CASH AMERICA INTL INC DFS [] DISCOVER FINANCIAL SVCS INC EZPW EZCORP INC -CL A FCFS SLM WRLD FIRST CASH FINANCIAL SVCS [] SLM CORP WORLD ACCEPTANCE CORP/DE

Dividend Payout Ratio (%)

2011 18 3 3 5 0 0 27 0 2010 21 3 4 7 0 0 0 0 2009 46 53 4 5 0 0 0 0 2008 29 NM 5 11 0 0 NM 0 2007 17 2 5 5 0 0 NM 0 2011 1.7 0.6 0.4 1.1 0.0 0.0 2.7 0.0 1.3 0.4 0.2 0.7 0.0 0.0 1.8 0.0

Dividend Yield (High-Low, %)

2010 2.0 0.6 0.5 0.7 0.0 0.0 0.0 0.0 1.5 0.4 0.3 0.4 0.0 0.0 0.0 0.0 2009 7.4 6.7 1.2 2.5 0.0 0.0 0.0 0.0 1.7 1.2 0.4 0.7 0.0 0.0 0.0 0.0 2008 4.4 6.4 0.7 3.6 0.0 0.0 0.0 0.0 1.4 2.4 0.3 1.2 0.0 0.0 0.0 0.0 2007 1.2 0.2 0.5 0.4 0.0 0.0 1.3 0.0 0.9 0.1 0.3 0.2 0.0 0.0 0.4 0.0

25 - 13 NM - NM 16 8



NM - NM 14 6 11 6

NM - NM 14 8 12 9 16 14 13 39

NM - NM NM - NM 21 7 29 - 13 23 - 10 NM - NM NA - NA

81 - 18 NM - NM 59 - 23 86 - 42 NM - NM NM - NM NA - NA

16 77 12 -

12 39 9

400 1 18 12 4 0 0

NM 0 5 12 4 0 0

NM NM 24 14 5 NM NA

400 NM 177 10 NM NM NA

72 296 32 NA 7 NM NA

0.8 0.1 2.9 0.9 0.3 0.0 0.0 -

0.3 0.1 1.7 0.6 0.2 0.0 0.0

0.4 0.0 0.6 0.8 0.3 0.0 0.0 -

0.2 0.0 0.4 0.5 0.2 0.0 0.0

1.6 1.0 3.5 1.0 0.5 0.0 NA -

0.2 0.1 1.1 0.5 0.2 0.0 NA

22.4 36.7 7.7 0.2 0.5 0.0 NA -

5.0 3.7 3.0 0.1 0.2 0.0 NA

5.9 7.5 3.6 NA 0.6 0.0 NA -

4.4 3.8 2.7 NA 0.2 0.0 NA


NA - NA 28 - 12 NM - NM NA - NA

Note: Data as originally reported. S&P 1500 index group. []Company included in the S&P 500. Company included in the S&P MidCap 400. Company included in the S&P SmallCap 600. #Of the following calendar year.

Earnings per Share ($)

Ticker Company Yr. End DEC DEC DEC NOV SEP DEC DEC # MAR 2011 4.11 7.08 4.59 4.06 2.45 2.31 1.13 6.59 2010 3.37 6.74 3.90 1.23 1.98 1.79 1.08 5.76 2009 1.55 0.99 3.26 2.42 1.45 1.42 0.71 4.52 2008 2.49 0.14 2.77 2.22 1.27 1.29 (0.69) 3.74 2007 3.45 6.64 2.68 1.23 0.92 1.04 (2.26) 3.11 CONSUMER FINANCE AXP [] AMERICAN EXPRESS CO COF [] CAPITAL ONE FINANCIAL CORP CSH CASH AMERICA INTL INC DFS [] DISCOVER FINANCIAL SVCS INC EZPW EZCORP INC -CL A FCFS SLM WRLD FIRST CASH FINANCIAL SVCS [] SLM CORP WORLD ACCEPTANCE CORP/DE

Tangible Book Value per Share ($)

2011 12.43 33.62 10.44 14.75 9.43 8.14 8.18 27.44 2010 10.54 26.73 7.51 11.04 7.84 7.11 7.45 27.41 2009 9.53 26.56 5.31 12.57 6.15 4.76 5.62 22.38 2008 7.61 27.28 1.54 11.37 5.90 2.71 4.35 17.01 2007 8.05 27.89 5.74 10.98 4.76 4.19 5.05 13.45 2011 53.80 56.26 62.33 27.92 38.66 52.18 17.11 74.48 41.30 35.94 36.65 18.31 25.30 29.71 10.91 50.12 2010 49.19 47.73 42.35 19.45 28.75 32.06 13.96 55.24 -

Share Price (High-Low, $)

2009 36.60 34.03 30.00 12.11 10.07 19.82 9.85 31.56 42.25 42.90 35.38 17.35 17.72 22.89 12.43 37.42 9.71 7.80 11.60 4.73 9.50 11.26 3.11 10.31 2008 52.63 63.50 48.86 19.87 19.25 20.00 25.05 45.99 16.55 23.28 21.50 6.59 10.00 7.54 4.19 13.44 2007 65.89 83.84 47.71 32.17 17.59 26.15 58.00 49.10 50.37 44.40 29.84 14.81 10.06 14.00 18.68 26.40



0.01 3.69 4.50

(0.37) 3.70 3.98

(0.29) 0.56 (7.60) (64.20) 2.25 0.86 1.04 (1.95) (5.05) 0.43

3.35 7.30 4.51 (1.27) 8.05 (0.41) NA

11.98 48.88 31.05 4.85 33.02 3.49 6.83

11.18 43.00 26.02 2.87 30.54 (0.15) 3.95

8.80 39.23 22.50 2.82 21.42 (2.03) 0.91

7.14 44.07 19.27 0.06 9.56 (3.23) (1.18)

11.54 99.52 18.77 NA 18.79 (2.39) NA

15.31 51.50 48.36 -

4.92 21.40 27.85

19.86 50.70 48.20 -

10.91 31.10 35.16

19.10 75.85 47.47 -

2.53 9.70 14.96

45.08 298.90 50.63 -

10.01 30.50 19.69

54.21 - 40.61 562.80 - 288.00 53.25 - 40.15 NA 227.18 50.00 NA NA 95.30 18.50 NA


103.45 - 67.51 384.99 - 219.33 58.88 - 30.25 65.00 - 24.94

97.19 - 64.90 269.88 - 191.00 41.47 - 15.62 65.10 - 41.13

89.69 - 41.78 259.00 - 117.06 17.09 3.65 NA NA

89.84 - 43.54 320.30 - 113.05 21.30 2.31 NA NA

Note: Data as originally reported. S&P 1500 index group. []Company included in the S&P 500. Company included in the S&P MidCap 400. Company included in the S&P SmallCap 600. #Of the following calendar year. J-This amount includes intangibles that cannot be identified.

The analysis and opinion set forth in this publication are provided by Standard & Poors Equity Research Services and are prepared separately from any other analytic activity of Standard & Poors. In this regard, Standard & Poors Equity Research Services has no access to nonpublic information received by other units of Standard & Poors. The accuracy and completeness of information obtained from third-party sources, and the opinions based on such information, are not guaranteed.