One issue looms as Capital One's megadeal hits home stretch

Bloomberg

The Capital One-Discover merger saga, which has been underway for a year, is entering a key stretch, with the deadline to close the deal looming in May.

While the two banks and most industry experts are still optimistic that Capital One Financial will be able to clinch the blockbuster, $35 billion acquisition, questions about the combined company's market share in subprime credit card debt have raised flags about competition in the space.

According to a recent Capitol Forum report, Department of Justice staff has pointed to the companies' outsize position in the subprime card market as potentially harmful to competition in the sector. 

Even if the two banks wanted to significantly shave down their combined subprime exposure, which they haven't indicated, selling a massive chunk of low-FICO-score credit card debt would be easier said than done, said Dominick Gabriele, a managing director at Compass Point Research and Trading.

"The subprime lending and credit card [business] is fairly concentrated in general anyway," Gabriele said. "There are not going to be many players that dive into underwriting credit cards in the subprime space."

The DOJ outlined its conclusion in a draft of the report it will present to the regulators assessing the deal, according to anonymous sources cited in the Capitol Forum story. The transaction is still awaiting approval from the Federal Reserve and the Office of the Comptroller of the Currency. The DOJ can submit its recommendations to the agencies, but it can't veto the deal on its own authority.

There haven't been any public recommendations or requirements that the two banks sell off or trim down their subprime portfolios. The DOJ declined to comment.

Capital One and Discover Financial Services have a combined subprime credit card position of $66.5 billion, which makes up between some one-fourth and one-third of the total market, per analyst reports. About 30% of Capital One's credit cards belong to customers whose credit scores are in the subprime range, typically regarded as below a FICO score of 660, while about 20% of Discover's portfolio meets the same criteria.

Capital One said in an emailed statement that its deal with Discover "complies with the Bank Merger Act's legal requirements and we remain well-positioned to gain approval."

The market for subprime card portfolios

A subprime credit card portfolio is a tough sell right now, said Brian Riley, who leads payments and credit research at Javelin. 

"As far as the top card issuers, I don't see one that would be champing at the bit," Riley said. 

He said there isn't much for national banks and card issuers to gain from acquiring a chunk of the debt, and smaller regionals and fintechs don't have the funding to buy a major portfolio.

In a sea of companies unlikely to buy a subprime portfolio, Synchrony Financial is the most likely option, Gabriele said. The Stamford, Connecticut-based company, which primarily works in private label and co-branded cards, has brought up the possibility of entering the general purpose card market, he said. Synchrony would likely have enough capital to execute such a deal, as opposed to a smaller entity like Bread Financial Holdings, which is about one-fifth the size of Synchrony in total assets.

The volatility of subprime debt would make now a risky time to enter the sector, due to economic uncertainty, Gabriele added. Subprime loans typically become more costly when unemployment rates rise, as charge-offs increase, and consumer spending — with its related net interest income — decreases, he said.

In a normal environment, high-revolving credit card portfolios — those that keep balances on over time and generate steady net interest income — can trade above 100%, meaning the seller takes a gain, Gabriele said.

But Riley said the potential for a recession increases how steeply a subprime book would need to be discounted, which makes it more challenging for the seller as well.

"The core challenge [subprime credit card sellers] face is, at the first level, finding a buyer," Riley said. "The second is: How deeply would it get discounted, and will it be a material loss to do that? And the economy … really suggests you'd have to discount that headwind."

But subprime card deals aren't impossible. Earlier this year, Ally Financial got out of the credit card business through the sale of its $2.3 billion subprime portfolio to Cardworks, a fintech with a banking subsidiary that specializes in the sector. Ally had entered the card business in 2021, but struggled with credit quality in the new business. With the exit, the bank is pivoting back to its bread-and-butter auto loan operations.

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Analysts remain optimistic

Arguments surrounding subprime competition in connection with the Capital One-Discover deal aren't new. The proposed merger has faced controversy since it was announced last spring. 

Consumer groups, academics and New York Attorney General Letitia James have brought up the combination of the banks' massive portfolios of low-FICO-score borrowers as potentially damaging to competition. In October, James also asked the state for permission to subpoena Capital One as part of an antitrust probe.

Capital One and Discover saw their stock prices slide by as much as 7% and 12.5%, respectively, on Monday, following the Capitol Forum report about the DOJ staff's competition concerns. Still, the companies' share prices recovered the following day, and analysts were upbeat about the deal crossing the finish line.

The acquisition is a golden opportunity for Capital One, Gabriele said.

"It's not something that they're going to let slip between their fingers if they can help it," he said. "I would imagine that they would do whatever is necessary to have the deal close."

Riley said he thinks the combination of the two card companies will be good for the industry over the long term.

In a research note, Sanjay Sakhrani, an analyst at Keefe, Bruyette and Woods, expressed the view that the stock sell-offs were "overblown," especially since the DOJ hadn't formally publicized any concerns.

Ian Katz, managing director at Capital Alpha Partners, wrote in a note: "While it's logical that such a report would spook investors, we can't assume that it would doom the deal."

Truist Securities analyst Brian Foran said in another note a large subprime credit card market share would be "a very strange reason" to nix a deal. Many of Discover's subprime customers have higher credit scores at origination, and later get dinged by a delinquency, he added.

Last month, Capital One and Discover won shareholder approval for their deal. Now they're waiting on clearance from the OCC and the Fed, plus "customary closing conditions," to formally combine. The merger agreement's termination date is May 19.