Is Ally's leap into subprime credit cards worth the risk?

Ally Financial’s $2.65 billion bet on the subprime credit card business is drawing skepticism from Wall Street, with investors raising concerns about the strategy and timing of the auto lender’s decision to embrace riskier unsecured consumer loans.

Detroit-based Ally announced an agreement Tuesday to acquire the parent company of Merrick Bank, which provides high-priced revolving credit to consumers who typically do not qualify for mainstream plastic.

It is a lucrative business. CardWorks, the Woodbury, N.Y.-based parent company, recorded $277 million in pretax income last year on assets of less than $5 billion. Merrick Bank’s return on assets in the first nine months of last year was more than four times higher than the average across the U.S. banking industry.

But Ally’s stock price plunged Wednesday by more than 11%. And analysts had tough questions for Ally executives about the deal during a conference call.

One source of doubt is the differing credit profiles of the two companies’ customer bases. At Merrick Bank, the average customer credit score is around 630. Meanwhile, only about 10% of Ally’s auto loan customers have credit scores of 620 or below, according to regulatory filings.

Ally executives said that the acquisition will enable the auto lender, which also offers deposit products through a digital bank, to provide an expanded product set to its existing customers. Over time, Ally will likely offer a credit card for consumers with higher credit scores than those who would typically apply for a card from Merrick Bank, they said.

“I think there is a lot of overlap,” argued Ally Chief Financial Officer Jennifer LaClair. “And I think the needs across the customer base are quite similar.”

Ally has tried to expand into credit card lending before, though without much success. Last July, the company pulled the plug on a three-year-old card partnership with TD Bank. That card provided cash rewards of 1% to 2% under a deal with TD that limited both Ally’s risk and its ability to record profits.

Ally CEO Jeffrey Brown said Wednesday that the subprime credit card acquisition represents an entirely different approach.

“Control over credit matters a lot,” he said. “This is really now being able to control and drive the product and drive the risk appetite ourselves. So we think about this in a very, very different light than the relationship we used to have.”

Of course, subprime card lending is a riskier, more volatile business than making secured auto loans to consumers with solid credit histories. A disconnect between what Ally shareholders thought they were purchasing and what the new acquisition revealed about Ally’s plans could help explain the sharp sell-off on Wednesday.

Investors may also have been spooked by the timing of the deal, since many observers believe the current boom in U.S. consumer credit is in a late stage. The subprime credit card business typically takes a bigger hit during recessions than the prime card market does. Ally expects the acquisition to close in the third quarter of this year.

Sanjay Sakhrani, an analyst at Keefe, Bruyette & Woods, is among the observers who were surprised by Ally’s decision to enter the subprime card business at this point in the credit cycle. “I would say that the investment community in general has been very nervous about the fact that the good times have lasted for so long,” he said.

But Sakhrani noted that investors have typically given better valuations to companies that have higher risk profiles. He wrote in a research note Wednesday that shares in Ally are cheap while reiterating his recommendation that investors buy the stock.

Ally executives expressed confidence in the ability of the acquired company’s team to weather credit cycles. “Risk-adjusted returns have been consistent over time, including during the economic downturn,” Brown said.

Also participating in the conference call was Don Berman, the chairman and CEO of CardWorks. Berman, who owns 70% of the privately held company’s stock, plans to join Ally’s board of directors and become a member of Ally's executive management team after the deal closes.

He argued that CardWorks was able to remain profitable during the last economic downturn because of its discipline. “It’s knowing when to be assertive in the market and when not to be,” Berman said.

Merrick Bank offers an unsecured credit card that currently includes an annual fee of up to $72 and an account setup fee of up to $75. Consumer advocates argue that this kind of pricing obscures the true cost of credit, since fees are not included in the annual percentage rate. Merrick Bank charges APRs of 18.95% to 29.2% on purchases with its unsecured card.

In addition to credit cards, Merrick Bank offers loans on purchases of boats, recreational vehicles and horse trailers. Last year, credit card loans represented 72% of the parent company’s $4.7 billion in assets, while recreational lending accounted for 15%.

Ally used to make loans for purchases of RVs, but the company announced in August 2018 that it was exiting that business, explaining that the move would allow employees to put more energy and resources into the firm’s core businesses.