Opinion: Discover Doesn’t Understand Lending 101

By John Kiernan, WalletHub Senior Editor

Have you seen this Discover commercial? The spot highlights two features of the company’s flagship “it” Card: no late fee and no Penalty APR. Such pricing might initially seem like a generous gesture on the part of Discover, the sixth largest card issuer by outstanding balances. But it’s actually a rookie mistake.

In fact, it’s a blunder that indicates a troublesome trajectory for Discover Financial Services (DFS) and could very well foreshadow looming danger for investors. Just take a second to consider who this type of “late-payment forgiveness” is likely to appeal to.

Is it people who always pay their bills on time each month (let alone in full)? No, late-fees and penalty APRs are of little concern to such consumers. What about folks with the capacity to ride out a recession while keeping their excellent credit – required for it Card approval – intact? Unlikely, considering they’re generally most interested in rewards.

No, the types of people most interested in late-payment forgiveness are among the most risky for a credit card company. This group is comprised of consumers who either have a history of missed payments or foresee some in their future, given looming financial difficulties that aren’t yet baked into their credit standing.

“It's called Adverse Selection and it happens when you've disproportionately attracted a riskier group of applicants and cardholders,” said credit expert John Ulzheimer, formerly of the Fair Isaac Corporation (FICO) and Equifax, Inc. (EFX). “The last thing you want to do is tell debtors that there's leeway with respect to payments being made on time. That's why you have cardholder agreements and promissory notes. The people who pay their bills on time won't be interested in this but the folks who know they pay late should love it.”

In other words, Discover’s underwriting and marketing brass have positioned the company’s credit card division to be among the first that would go under in the event of a financial downturn, which could come a lot sooner that many people think. And while Discover has been able to tread water to date, its marketing department continues to chum the waters amid reports of possible shark sightings, so to speak.

Consumers have racked up an astounding $288.5 billion in credit card debt since the Great Recession ended in 2010, according to CardHub data. That includes a staggering $71 billion in 2015 alone, with more debt being added to our tab in the final three months than in 2010 and 2011 combined. Meanwhile, the default rate has actually fallen from above 10% to below 3% in the past five years. But it can’t stay so low forever. The average dating back more than 30 years is 4.6%, after all.

This all spells trouble for Discover when the economy ultimately concludes its nearly-seven-year climb. The risky consumers it’s currently recruiting will be among the first victims of a downturn, potentially dragging the company down with them given its relatively high exposure to this demographic. And with that in mind, both investors and executives alike must remain cognizant of the likelihood that bailouts won’t be so forthcoming this time around.

Perhaps this is why Discover increased its provision for loan losses by 58% during the second half of 2015. At $1.55 billion as of Q4 2015, this emergency fund is roughly 69% higher than at the end of 2007, which is roughly when the Great Recession began. But will it be enough?

Well, to sum things up: Discover seems to have slept through lending 101, and the fundamental mistakes it’s currently making have to make you wonder what other issues may lay under the surface.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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