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Credit Cards Can Thrive Despite New Regulations

Jeremy Glaser

Jeremy Glaser: I'm Jeremy Glaser, with Morningstar.com. Credit cards have been in focus recently as new legislation looks to clamp down some of the excesses of the credit card companies and there's been a lot of talk of consumers starting to de-leverage their personal balance sheets and pay off some of these high-interest loans.

Here to discuss the industry with me is analyst Michael Kon. Michael, thanks for joining me.

Michael Kon: Thank you, Jeremy.

Glaser: So, what have been some of the big themes that you've seen from the credit card companies in the last few months?

Kon: Well, the credit card companies are preparing themselves for a new regulatory reality and basically what that means is higher fees, higher interest rates. In addition to that credit card companies have to deal with high unemployment rates and a consumer that is under pressure, so they have to adjust their underwriting standards and their portfolios to deal with the economic environment.

Glaser: So, what does the default rate look like on these credit card portfolios?

Kon: Well, credit card default rates are reported on a monthly basis and in fact we've seen some encouraging signs of improvement over the past few months. Credit card delinquencies have been rising throughout '08 and early '09 but then around March and April we've seen a few companies reported declining delinquencies. Then American Express, at their analyst day, implied that we might have passed peak in credit card losses.

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Glaser: So it seems like consumers really are taking any extra cash they have lying around and paying down debt versus going out and buying another big-screen TV or something like that.

Kon: Well, there are two types of spending: there is non-discretionary spending and discretionary spending. Non-discretionary spending has been fairly resilient. The part that was badly hurt is discretionary spending. Some of the discretionary spending is not coming back. Some of it was driven by the boom in real estate markets: people felt affluent. There is a "wealth effect" attitude placed in certain markets and a lot of the spending is not coming back. But some of the discretionary spending will come back as unemployment declines and people will feel more comfortable with their finances.

Glaser: So, if you're thinking about investing in the sector, what are some of the options that you have?

Kon: Well, a lot of investors are trying to play it safe and avoid any companies that carry credit risk and the best plays out there are Visa and MasterCard. Those companies are the toll booth of the industry: they just collect a small fee whenever people use their credit or debit cards. My problem with Visa and MasterCard right now is just that the stock prices don't offer enough margins of safety to buy them. They're great companies, they're well managed, it's a terrific business model and their growth prospects are really promising but I think that most of that upside is already priced into the stock.

So that leaves us with companies that carry credit risk like American Express, Discover and credit card lenders like Capital One that doesn't have a network like American Express and Discover but has a banking operation in addition to the credit card business. Right now we have Discover rated as five stars, we think that the firm is undervalued. I think the market is completely ignoring the networks that Discover operates and the upside in those networks and offering their receivables, their lending business, at a discount and that's were most of the upside in Discover is.

Glaser: Thank you, Michael.

Kon: Thank you.

Glaser: I'm Jeremy Glaser, with Morningstar.com. Thanks for watching.