Atlanticus Holdings Corp 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the fiscal year ended December 31, 2006
a Georgia Corporation
IRS Employer Identification No. 58-2336689
SEC File Number 0-25751
245 Perimeter Center Parkway, Suite 600
Atlanta, Georgia 30346
CompuCredits common stock, no par value per share, is registered pursuant to Section 12(g) of the Securities Exchange Act of 1934.
CompuCredit (1) is a well-known seasoned issuer, (2) is required to file reports pursuant to Section 13 or Section 15(d) of the Act, (3) has filed all reports required to be filed by Section 13 or 15(d) of the Act during the preceding 12 months and (4) has been subject to such filing requirements for the past 90 days.
CompuCredit believes that during the 2006 fiscal year, its executive officers, directors and 10% beneficial owners subject to Section 16(a) of the Securities Exchange Act of 1934 complied with all applicable filing requirements, except as set forth under the caption Section 16(a) Beneficial Ownership Reporting Compliance in CompuCredits Proxy Statement for the 2007 Annual Meeting of Shareholders.
CompuCredit is an accelerated filer and is not a shell company.
The aggregate market value of CompuCredits common stock (based upon the closing sales price quoted on the NASDAQ Global Select Market) held by nonaffiliates as of June 30, 2006 was $685.7 million. (For this purpose, directors and officers have been assumed to be affiliates and we have excluded 5,677,950 of loaned shares.)
As of February 22, 2007, 51,930,494 shares of common stock, no par value, of the registrant were outstanding. (This excludes 5,677,950 loaned shares to be returned.)
DOCUMENTS INCORPORATED BY REFERENCE
Portions of CompuCredits Proxy Statement for its 2007 Annual Meeting of Shareholders are incorporated by reference into Part III.
Table of Contents
Cautionary Notice Regarding Forward-Looking Statements
We make forward-looking statements in this Report and in other materials we file with the Securities and Exchange Commission (SEC) or otherwise make public. In this Report, both Item 1, Business, and Item 7, Managements Discussion and Analysis of Financial Conditions and Results of Operations, contain forward-looking statements. In addition, our senior management might make forward-looking statements orally to analysts, investors, the media and others. Statements with respect to our expected income, acquisitions and other growth opportunities, location openings and closings, loss exposure and loss provisions, delinquency and charge-off rates, securitizations and gains and losses from securitizations, the impact of actions by the Federal Deposit Insurance Corporation (FDIC), Federal Trade Commission (FTC) and other regulators on both us and the banks that issue credit cards on our behalf, account growth, the performance of investments that we have made, operating expenses, the impact from our utilization of the Market Expansion Platform (MEP), the impact of recent bankruptcy law changes, marketing plans, the profitability of our Auto Finance segment, the profitability of our Retail Micro-Loans segment, our entry into international markets, our ability to raise funds, our income in equity-method investees, growth in our ancillary and interchange revenues, our servicing income levels, gains and losses from investments in securities, experimentation with new products and other statements of our plans, beliefs or expectations are forward-looking statements. In some cases these statements are identifiable through the use of words such as anticipate, believe, estimate, expect, intend, plan, project, target, can, could, may, should, will, would and similar expressions. You are cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements we make are not guarantees of future performance and are subject to various assumptions, risks and other factors that could cause actual results to differ materially from those suggested by these forward-looking statements. These factors include, among others, those set forth in Part I, Item 1A, Risk Factors, in this Report and in the other documents that we file with the SEC. There also are other factors that we may not describe, generally because we currently do not perceive them to be material, that could cause actual results to differ materially from our expectations.
We expressly disclaim any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.
In this Report, except as the context suggests otherwise, the words Company, CompuCredit Corporation, CompuCredit, we, our, ours and us refer to CompuCredit and its subsidiaries and predecessors. CompuCredit owns Aspire®, CompuCredit®, Emerge®, Imagine®, Majestic®, Purpose®, Tribute® and other trademarks in the United States.
A general discussion of the business of CompuCredit Corporation follows. For additional information about our business, including specific descriptions of how we market and segment customers and other operational items, please visit our website at www.compucredit.com.
We are a provider of various credit and related financial services and products to or associated with the underserved (or sub-prime) consumer credit market, as well as to un-banked consumers. We serve this market principally through our marketing and solicitation of credit card accounts and other credit products and our servicing of various receivables underlying originated accounts and portfolio acquisitions. We operate primarily within one industry consisting of five reportable segments by which we manage our business. Our five reportable segments are: Credit Cards; Investments in Previously Charged-Off Receivables; Retail Micro-Loans; Auto Finance; and Other. We describe these segments below. (See, Note 3, Segment Reporting, to our consolidated financial statements included herein for segment-specific financial data.)
Credit Cards Segment. Our Credit Cards segment consists of our credit card lending and servicing activities, as conducted with respect to receivables underlying accounts that we originate and receivables underlying portfolios that we purchase. This reportable segment includes the activities associated with substantially all of our credit card products, including our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. We finance a substantial majority of our credit card activities through securitization of the receivables underlying the accounts we originate and portfolios we purchase. The leverage (i.e., the percentage on a dollar of receivables that lenders will lend, or the advance rate) that our securitization facilities provide against our credit card receivables is a critical factor in our ability to obtain the desired returns on equity for our shareholders. Revenues from the Credit Cards segment principally consist of: (1) the portion of fees and related income on non-securitized earning assets derived from our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range; (2) fees and related income on securitized earning assets, which are derived from our investments in our securitized originated and purchased portfolios; (3) the portion of servicing income that relates to credit card servicing; (4) income earned on cash and cash equivalents and investments in debt and equity securities; and (5) equity in the income of the Credit Cards segments equity-method investees. Our post-2002 credit card receivables acquisition activities include:
We decide whether to grow receivables levels through our origination efforts or to acquire other portfolios based upon several factors, including credit quality and financing costs. We assess credit quality using an analytical model that we believe predicts the likelihood of payment more accurately than traditional credit scoring models. For instance, we have identified factors (such as delinquencies, defaults and bankruptcies) that under some circumstances we weight differently than do other credit providers. Our analysis enables us to better identify consumers within the underserved market who are likely to be better credit risks than otherwise would be expected. Similarly, we apply our analytical model to entire portfolios in order to identify those that may be more valuable than the seller or other potential purchasers might recognize.
Customers at the lower end of the FICO scoring range intrinsically have higher loss rates than do customers at the higher end of the FICO scoring range. As a result, we price our products to reflect this greater risk, generally through more demanding terms than our customers would have to bear if their FICO scores were higher. For the products that we provide to customers with the lowest FICO scores, we also generally charge higher up-front, annual and other fees than customers would have to pay if their FICO scores were higher. Because of these higher fees, our products are subject to greater regulatory scrutiny. See Consumer and Debtor Protection Laws and RegulationsCredit Card Segment and Item 1A, Risk Factors.
As is customary in our industry, we finance most of our credit card receivables by selling them to a securitization vehicle, such as a trust, that in turn sells participation interests. The rates of return that purchasers require and the portion of the funding that the purchasers are willing to provide (as contrasted with the portion that we must provide), which is known as the advance rate, are our two most significant financial considerations. In 2001, the advance rates provided by purchasers of participation interests in our securitization facilities decreased significantly, thereby leading us to conclude that we could not earn our desired return on equity from growing our portfolio of credit card receivables that we had historically funded through securitization within our originated portfolio master trust. As a result, we reduced our marketing efforts during 2002 and 2003 and began to contemplate an orderly liquidation of the credit card receivables within our originated portfolio master trust. During this same time period, however, we were able to obtain attractive financing for acquisitions of portfolios and, hence, were able to complete three substantial portfolio acquisitions. Also during this time period, we began to focus on ways to diversify our business to better insulate us against adverse shifts in advance rates, which have the effects of increasing financing costs, increasing liquidity requirements and reducing returns on the equity we invest in credit card receivables. By way of example, we began in 2003 to grow our portfolio of credit card receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Even without initial leverage against this particular portfolio, we earned our desired return on equity.
In January 2004, we completed a financing arrangement with Merrill Lynch that provided us with significantly improved advance rates. As a result, we significantly increased our marketing and related efforts throughout 2004 and into 2005 to grow our receivables within the originated portfolio master trust. Advance rates and cost of funds under the Merrill Lynch facility continue to support the marketing and growth of our originated portfolio master trust receivables. Also, in March 2006, we completed a structured financing transaction that is secured by credit card receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. This debt facility is recourse only to the underlying credit card receivables that serve as security for the facility. In September 2006, we amended this facility to increase the maximum borrowings limit from $150.0 million to $350.0 million, improve the advance rates and pricing, and extend the maturity to March 2008.
Investments in Previously Charged-Off Receivables Segment. Our Investments in Previously Charged-Off Receivables segment consists of the operations of our debt collection subsidiary, Jefferson Capital Systems, LLC (Jefferson Capital). Through this subsidiary, as market conditions and other factors justify, we acquire and sell previously charged-off credit card receivables and apply our collection expertise to the receivables we from time-to-time own. Revenues in this segment are classified as fees and related income on non-securitized earning assets in our consolidated statements of operations.
In June 2005, Jefferson Capital sold a portfolio of charged-off credit card receivables having a face amount of approximately $2.9 billion to Encore Capital Group, Inc. (Encore), and agreed to sell Encore up to $3.25 billion in face amount of future charged-off credit card receivables at an established price over the next five years. As consideration for these transactions, Jefferson Capital received $143.0 million in cash. The purchase price included $76.0 million related to the sale of the portfolio of charged-off credit card receivables and $67.0 million of deferred revenue related to the sale of future receivable acquisitions. Pursuant to the agreement with Encore, Jefferson Capital is expected to purchase for delivery to Encore over the life of the agreement, certain previously charged-off receivables from trusts, the receivables of which are serviced by us, as well as certain previously charged-off receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Any shortfalls in delivery of minimum periodic dollar amounts of previously charged-off receivables to Encore could result in Jefferson Capital being required to return a portion of the purchase price related to the sale of future receivable acquisitions.
The market for buyers of previously charged-off receivables has become more competitive, in part because of the entry of new publicly held debt buyers into the market, although we continue to believe that investing in previously charged-off receivables is an attractive business activity for us in the current environment in narrow areas, including Chapter 13 bankruptcy purchases and purchases through Jefferson Capitals balance transfer program. Jefferson Capitals balance transfer program involves a credit card offering as an incentive to debtors to repay their previously charged-off debts. This program not only allows Jefferson Capital to realize enhanced liquidation curves in what is now a competitive pricing environment, but it also allows Jefferson Capital to partner with other debt buyers to help them enhance their own economics.
Retail Micro-Loans Segment. Our Retail Micro-Loans segment consists of a network of storefront locations that, depending on the location, provide one or more of the following products or services: (a) small-denomination, short-term, unsecured cash advances that are typically due on the customers next payday; (b) installment loan and other credit products; and (c) money transfer and other financial services. Our revenues in this segment principally consist of fees and/or interest earned on our cash advance, installment loan and other credit products, as well as various transactional fees earned on our money transfer and other financial services. Our Retail Micro-Loans segment marketed, originated, invested in, and/or serviced $613.4 million in micro-loans during 2006, which resulted in revenue of $103.9 million.
We established this segment during the second quarter of 2004 principally through the acquisition by one of our subsidiaries of substantially all of the assets of a sub-prime lender with over 300 retail storefronts operating under the names of First American Cash Advance and First Southern Cash Advance (collectively First American). We followed this acquisition during the third quarter of 2004 with the acquisition by one of our subsidiaries of substantially all of the assets of Venture Services of Kentucky, Inc. (Venture Services), which added another 166 retail storefronts, and we acquired another 39 storefronts in the State of Ohio in January 2005. During 2006, we began exploring strategic alternatives in the United Kingdom, and we initiated the process of opening several test stores in the greater London area. As of December 31, 2006 our retail micro-loan subsidiaries operated 475 storefront locations in 17 U.S. states and the United Kingdom.
In most of the states in which they historically have operated, our retail micro-loan subsidiaries have made cash advance and other micro-loans directly to customers. However, in four states (Arkansas, Florida, North Carolina and West Virginia), they previously acted only as a processing and servicing agent for a state-chartered, FDIC-insured bank that issued loans to the customers pursuant to the authority of the laws of the state in which
the bank was located and federal interstate banking laws, regulations and guidelines. During February 2006, we learned from our bank partner that the FDIC had effectively asked insured financial institutions to cease deferred presentment and installment micro-loan activities conducted through processing and servicing agents. In response to the FDICs actions, we converted all of our Florida and Arkansas operations to a direct lending model during 2006. However, in North Carolina and West Virginia, after initially pursuing conversion to a direct lending model, our subsidiaries decided to exit those states because they concluded that alternative lending products would not provide acceptable long-term returns for the business. Consequently, during the third quarter of 2006, our subsidiaries completed the process of closing 52 branch locations in North Carolina and 11 branch locations in West Virginia.
The FDICs February 2006 actions followed restrictive guidelines issued by the FDIC in March 2005, which originally caused us to accelerate our efforts to convert our mono-line micro-loan storefronts into neighborhood financial centers offering a wide array of financial products and services. The FDICs 2006 actions combined with the ongoing regulatory scrutiny of the retail micro-loan industry only reconfirmed the need for this strategic transition. In addition, we believe that a multi-product line strategy is important to increasing foot traffic within our storefronts, thereby maximizing the profit potential for each of the stores. Our current suite of products includes auto insurance, stored-value cards, credit cards, check cashing, money transfer, money order, bill payment, auto title loans and tax preparation service assistance. To support these multiple products, our Retail Micro-Loans segment completed the process of converting our entire network of branches to a common information technology platform during 2006. We have been pleased with the early results we have seen from the new product offerings, and we continue to roll out new products to our stores.
As evidenced by the FDICs actions, the regulatory environment surrounding our micro-loan activities is a dynamic one. Our Retail Micro-Loans segment management team continuously monitors federal and state legislative and regulatory initiatives affecting its product offerings, and we believe our retail micro-loan subsidiaries continue to have reasonable prospects to reap acceptable risk-adjusted returns on equity and growth for us through a multi-product-line strategy.
Auto Finance Segment. On April 1, 2005, we acquired Wells Fargo Financials Consumer Auto Receivables (or CAR) business unit, which comprised the entirety of our Auto Finance segment in 2005 and 2006. When we completed the acquisition, CAR had $128.9 million auto-finance-related receivables (at face, net of unearned discounts) and approximately 300 employees and operated in thirty-eight states through its twelve branches, three regional processing centers and national collection center at its Lake Mary, Florida headquarters.
Our CAR operations consist of a nationwide network of pre-qualified dealers in the Buy Here/Pay Here used car business from which auto loans are purchased at a discount or serviced for a fee. Revenues are generated on purchased loans through interest earned on the face value of the purchased installment agreements combined with discounts on these purchased loans. Interest income from discounts is generally earned over the life of the applicable loan. Additionally, CAR generates revenues from servicing loans on behalf of dealers for a portion of actual collections, providing custodial services and providing back-up servicing for similar quality securitized assets.
During 2005, our CAR segment received regulatory approval to expand business operations into four new states, and during 2006, CAR expanded business operations into three additional states, bringing the total number of states in which the business operates to forty-five, with approximately 1,200 active dealers, approximately 38,000 active accounts that the business owns and approximately 2,800 accounts for which the business provides servicing. During 2006, CAR released new financing products designed to complement the products it currently offers to this market. In addition to these initiatives, the business unit is in the process of forming strategic alliances with aftermarket product and service providers in an effort to cross-sell to existing customer bases.
On February 2, 2007, we acquired the assets of San Diego-based ACC Consumer Financial Services, LLC (ACC), which we expect to include within our Auto Finance segment operations in 2007 and beyond. ACC
currently services approximately $275 million in auto finance receivables, operates in 12 states with collection centers in San Diego, California and Denver, Colorado, and has approximately 170 employees. In conjunction with this purchase, we also acquired a $195 million auto loan portfolio from Patelco Credit Union. These assets were originated and serviced by ACC on behalf of Patelco. ACC serves a consumer niche that, from a credit quality perspective, is slightly above the niche served by CAR, which makes our acquisition of ACC quite complementary to our CAR operations.
Other Segment. Our Other segment consists of our stored-value (or debit) card operations and their associated fee income and servicing expenses and other start-up product offerings (including our merchant credit program, an Internet-based installment loan product, centralized decision engine development efforts and third-party consumer finance receivables origination and servicing activities) that do not individually meet the reportable business segment disclosure criteria. The activities within our Other segment are generally start-up in nature, and we expect to continue our testing and investments in these areas in keeping with our diversification strategy throughout 2006 and beyond.
Recent Developments. In September 2005, we entered into a Stock Purchase Agreement (the Agreement) with CardWorks, L.P., pursuant to which we would acquire CardWorks, Inc., a privately held issuer and third-party servicer of consumer credit cards through its subsidiaries Merrick Bank Corporation, a Utah industrial loan bank, and Cardholder Management Services, LLC. The CardWorks, Inc. acquisition was subject to customary closing conditions, including the receipt of regulatory approvals. On July 28, 2006, the FDIC announced a moratorium until January 31, 2007 on approving acquisitions of industrial loan banks, which made it impossible for us to obtain the necessary regulatory approvals prior to the October 2, 2006 contract expiration date. As a result, the Agreement expired on October 2, 2006. We subsequently withdrew our application to acquire Merrick Bank Corporation.
Future Plans. We expect to continue to expand and diversify our product offerings to our underserved and un-banked consumer market base by developing new products and services that we can provide to them and by acquiring other complementary sub-prime lenders and businesses throughout 2007. As noted above, on February 2, 2007, we acquired a $195.5 million portfolio of auto finance receivables and the ACC servicing platform under which the acquired receivables and others previously have been serviced. We believe the acquisition of this existing portfolio and business will provide us greater depth in the auto finance arena and provide significant room for expansion in the coming years.
How Do We Operate?
Credit Cards Segment. We market unsecured general-purpose Visa and MasterCard credit cards through our contractual relationships with third-party financial institutions. Our longest-standing relationship is with Columbus Bank & Trust Company (CB&T), a Georgia state chartered banking subsidiary of Synovus Financial Corporation. Our contractual arrangement with CB&T expires in March 2009. Under our CB&T agreement, CB&T, as the issuer, owns the credit card accounts, and we purchase receivables underlying the CB&T credit card accounts. Our other newer contractual relationships with third-party financial institutions work in a similar manner to our agreement with CB&T.
On a daily basis, we purchase the credit card receivables generated in the accounts originated by the banks issuing our credit cards. We in turn securitize a significant majority of the receivables (i.e., all of the Credit Card segments credit card receivables other than those receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range) each day by selling the receivables to trusts. When we sell the receivables, we receive cash proceeds and a retained interest in the trusts. The cash proceeds that we receive from investors when we sell receivables in our securitizations are less than the cash we use to initially purchase the credit card receivables. The retained interest we receive equals this difference and is a use of our cash. Our retained interests are subordinate to the other investors interests. The receivables that are sold in our securitizations generate future cash flows as cardholders remit payments, which include repayments of
principal, interest and various fees on their accounts. These payments are remitted to the securitization trusts and then disbursed in accordance with the securitization agreements. We receive all of the excess cash flows from the securitizations, which represent collections on the accounts in excess of the interest paid to the investors, servicing fees, credit losses and required amortization or other principal payments. We use the cash proceeds that we receive when we sell the receivables to help fund the new receivables generated in the accounts. We use cash flows generated from operations, as well as cash from the issuance of debt and equity, to fund our retained interests in the receivables generated in the accounts.
We also acquire distressed and other portfolios of sub-prime credit card receivables. We typically acquire these portfolios at a substantial discount due to the likelihood that a large percentage of the receivables will be charged off as the underlying debtors default. We use our credit models to predict the extent to which the underlying debtors will be able to repay us, which we factor into the price that we pay for the portfolio. Our profitability in these transactions hinges on whether the underlying debtors in the aggregate remit payments that exceed the price we paid for the portfolio. Portfolio acquisitions historically have been a significant component of our business.
See our consolidated financial statements included herein and our Liquidity and Capital Resources section of Managements Discussion and Analysis of Financial Conditions and Results of Operations for further details on our securitizations.
Retail Micro-Loans Segment. Our Retail Micro-Loans segment operates through a subsidiary, which serves as a holding company for the several separate subsidiaries required to support these operations. This business is conducted by subsidiaries that operate separately in each state. Each of these operating subsidiaries has a board of managers and management distinct from those of CompuCredit, has been capitalized at a level that we believe is appropriate for its business, conducts its operations independently of the other operating subsidiaries and on an arms-length basis with its parent and other CompuCredit-related entities, has its own books and records, and maintains its assets independently of the other operating companies and other CompuCredit-related entities except insofar as certain cash management and administrative functions that are or may be performed on a collective basis for the benefit of the operating subsidiaries. Each of these subsidiaries is operated as an independent entity in accordance with the laws of the state of its formation.
Auto Finance Segment. During 2005 and 2006, our Auto Finance segment consisted entirely of CAR, which operates through a subsidiary, which serves as a holding company for the separate subsidiaries required to support these operations. CAR is licensed and/or authorized to acquire assets in the forty-five states in which it presently operates. Each of the various CAR operating subsidiaries has a board of managers and management distinct from those of CompuCredit, has been capitalized at a level that we believe is appropriate for its business, conducts its operations independently of other operating subsidiaries and on an arms-length basis with CompuCredit and other CompuCredit-related entities, has its own books and records and maintains its assets independently of other operating companies and other Company-related entities, except insofar as certain cash management and administrative functions that are or may be performed on a collective basis for the benefit of the operating subsidiaries. Each of the CAR subsidiaries is operated as an independent entity in accordance with the laws of the state of its formation.
This business unit is principally dedicated to acquiring and servicing aged or newly originated receivables from buy here/pay here used car dealers, related finance companies and regional finance companies, as well as receivables that are being liquidated by banks, thrifts or consumer finance companies. These receivables are purchased at a discount to net present value, and typically have a remaining maturity of twenty to thirty months.
CAR is comprised of seventeen primary physical locations and approximately sixty sales resources. Three of the physical locations manage business developed by direct sales resources, while twelve locations act as standalone profit centers with dedicated sales resources. The business is divided into three divisions (East, Central and West) with sales operations centers located in Charlotte, North Carolina, Coppell, Texas and
Las Vegas, Nevada, respectively. Collections and customer service are centralized in an operations center that is based in Lake Mary, Florida. Executive and certain corporate functions are based in Peachtree City, Georgia. This operating unit maintains a dedicated funding facility sufficient to support present operations.
Our ACC operation, which we acquired on February 2, 2007, services auto loans that it has originated. In addition, our ACC operation is in the process of recommencing its origination of auto loans, a process that it discontinued in November 2006 in anticipation of winding up its business prior to agreeing to be acquired by us.
ACC services auto loans from facilities located in San Diego, California, and Denver, Colorado. It currently originates loans through franchised automobile dealers located in 12 states.
How Do We Collect and Evaluate Data?
Credit Cards Segment. Our general business model is predicated upon our ability to successfully predict the performance of sub-prime receivables, irrespective of whether the receivables arise from portfolio acquisitions or through other origination channels. In other words, we do not focus on the financial institution that originated the particular receivable, but, rather, on how it will perform. We believe our unique skill set is our ability to predict this behavior and to service the portfolio in a superior manner to ensure maximum performance. To this end, we have developed a proprietary information management system that supports our decision-making functions, including target marketing, solicitation, application processing, account management and collections activities. The information system takes advantage of a state-of-the-art data warehouse and ancillary data management systems that maintain information regarding a customer throughout the customers relationship with us. The systems purpose is to gather, store and analyze the data necessary to facilitate our target marketing and risk management decisions.
Our information system captures customer information gathered either from prior owners of our acquired receivables or in the target marketing and solicitation phases of an originated customer relationship and throughout the remainder of our relationship with the customer, including customer behavior patterns. By combining and storing such information, we have established an analytical database linking static historical data with dynamic actual customer performance. Our portal interfaces and business intelligence tools allow management to access and analyze the information management system on demand.
We believe that the information we collect in our information system, as well as the ability that we have to access, study and model this information, provides us with a more efficient and complete process to effectively price our products and our portfolio acquisitions. We believe that we have priced our products and acquisitions such that over time the income we earn from the receivables that are not charged off is sufficient to cover our marketing expenses, our servicing expenses, overhead expenses, our costs of funds and our losses from cardholders who fail to make their payments and are charged off.
In addition, over the past two years, we have made significant investments in the technology infrastructure supporting our information management system, such as a new data warehouse, enterprise-wide data management software, and a Voice-over-Internet Protocol (VoIP)-enabled telephony platform. Such investments are rapidly providing tangible returns in terms of cost efficiencies and higher productivity. These solutions also allow us to effectively enable the growth of our business through a flexible, scalable and secure infrastructure.
How Do We Obtain Our Customers?
Credit Cards Segment. As noted above, we view our customers the same regardless of whether we acquire them through traditional marketing activities or via portfolio purchases. For our credit card lending activities, we believe we have developed an effective model for predicting the behavior of sub-prime consumers, and this model works for credit card receivables generated through acquisition and through our other origination channels. We believe we can use this model to predict the behavior of sub-prime consumers with sub-prime-related products and asset classes other than credit cards. Since 1996, we have worked with national credit
bureaus to develop proprietary risk evaluation systems using credit bureau data. Our systems enable us to segment customers into narrower ranges within each FICO scoring range. The FICO scoring, developed by Fair, Isaac & Co., Inc., is the most commonly used credit risk score in the consumer credit industry. The purpose of the FICO score is to rank consumers relative to their probability of non-payment on a consumer loan. We believe that sub-segmenting our market within FICO scoring ranges enables us to better evaluate credit risk and to price our products effectively. Within each FICO scoring range, we evaluate potential customers using credit and marketing segmentation methods derived from a variety of data sources. We place potential customers into product offering segments based upon combinations of factors. We focus our marketing programs (direct mail, telemarketing, Internet, television, etc.) on those customer segments that appear to have high income potential when compared to other segments and demonstrate acceptable credit and bankruptcy risks. The key to our efforts is the use of our systems to evaluate credit risk more effectively than the use of FICO scores alone.
Similarly, our target marketing system is intended to provide the same competitive advantage when evaluating portfolios as when originating customers through our marketing campaigns. We believe that our ability to evaluate credit risk within FICO scoring ranges enables us to determine a portfolios overall credit risk more accurately than many portfolio sellers and potential purchasers. This risk evaluation expertise is designed to enable us to avoid portfolio purchases in which the final purchase premium or discount does not accurately reflect the credit risk of the portfolio. Conversely, we may bid more aggressively for portfolios in which the perceived credit risk, as reflected by the FICO scores, is significantly higher than our forecast of credit risk.
Retail Micro-Loans Segment. Our subsidiaries obtain new retail micro-loan customers through direct marketing on television and radio, as well through local advertising in appropriate markets. All new customers are required to have an active bank account and a regular source of income, of which they must provide positive evidence, prior to obtaining most micro-loan product offerings. Once approved, a customer signs a lending agreement detailing the terms of the loan and, depending upon the type of micro-loan product, may write a personal check to cover the amount of the loan plus a finance charge.
Auto Finance Segment. Our CAR operations within this unit acquire existing retail installment contracts directly from dealers and small finance companies, while ACC, which we acquired on February 2, 2007, directly extends loans to consumers. The Auto Finance segment also enters agreements to service retail installment contracts. Relationships with dealers and small finance companies are developed and maintained through a direct sales force. Markets are analyzed through the acquisition of data from industry-related service providers, which provide information that indicates sufficient dealer and customer densities. Direct advertising campaigns also are conducted in specific target markets in conjunction with industry-focused advertising in established magazines and periodicals. This segment also sponsors and participates in most state and local auto dealer associations and is a sponsor in national organizations such as the NIADA and NABD.
What Other Services Do We Offer to Our Customers?
Credit Cards Segment. We offer fee-based products and services to our cardholder customers, including memberships, insurance products, subscription services and debt waiver. These fee-based products and services are offered throughout our relationship with a customer. Currently, our two most significant providers of fee-based products are LOTSolutions, which administers debt wavier products, and Assurant Solutions, which provides supplemental insurance products to our customers and administers debt wavier for certain customer segments. We provide marketing support and a billing platform for these third-party products. These third-party providers are fully responsible for the fulfillment of the products. Our responsibility is to ensure that enrollment and cancellation of the products purchased by our customers are properly processed and billed to the customers at the rates established.
The success of our fee-based business is a function of the number and variety of our fee-based product offerings, the marketing channels leveraged to sell fee-based products and the customers to whom we market these products. The profitability of our fee-based products and services is affected by new credit card account
growth, the response rates to product solicitations, the volume and frequency of the marketing programs and the operating expenses associated with the programs. Although a wide range of our customers purchase fee-based products and services, fee-based product and service sales generally are higher to new customers and tend to diminish throughout our relationship with our cardholders. As a result, we anticipate that during periods of low new account growth, our profitability from fee-based products and services will either grow at a reduced rate or decline.
How Do We Maintain the Accounts and Mitigate Our Risks?
Credit Cards Segment. For our credit card lending activities, we manage account activity using behavioral scoring, credit file data and our proprietary risk evaluation systems. These strategies include the management of transaction authorizations, account renewals, over-limit accounts and credit line modifications. We use an adaptive control system to translate our strategies into the account management processes. The system enables us to develop and test multiple strategies simultaneously, which allows us to continually refine our account management activities. We have incorporated our proprietary risk scores into the control system, in addition to standard behavior scores used widely in the industry, in order to segment, evaluate and manage the accounts. We believe that by combining external credit file data along with historical and current customer activity, we are able to better predict the true risk associated with current and delinquent accounts.
We monitor authorizations for all accounts. Customer credit availability is limited for transaction types that we believe present higher risks, such as foreign transactions, cash advances, etc. We manage credit lines to reward underserved customers who are performing well and to mitigate losses from delinquent customer segments. Accounts exhibiting favorable credit characteristics are periodically reviewed for credit line increases, and strategies are in place to reduce credit lines for customers demonstrating indicators of increased credit or bankruptcy risk. Data relating to account performance are captured and loaded into our proprietary database for ongoing analysis. We adjust account management strategies as necessary, based on the results of such analyses. Additionally, we use industry-standard fraud detection software to manage the portfolio. We route accounts to manual work queues and suspend charging privileges if the transaction-based fraud models indicate a high probability of fraudulent card use.
Auto Finance Segment. Accounts are managed in house by an experienced staff specifically trained in this segment of the industry. For our CAR operations, credit quality and loss mitigation are managed at the dealer portfolio level through the implementation of dealer-specific loss reserve accounts. In most instances, the reserve accounts are cross-collateralized across all business presented by any single dealer. Performance at the dealer portfolio level (by product type) is monitored to adjust pricing or the reserve account or to determine if the dealer is to be excluded from our account purchase program.
Specific purchase guidelines are applied within CAR based upon each product offering, and established delegated approval authorities exist to assist in the monitoring of transactions during the loan acquisition process. Dealers are subject to specific approval criteria, and individual accounts are typically verified for accuracy before, during and after the acquisition process. Dealer portfolios across the business segment are monitored and compared against expected collections and peer dealer performance. Monitoring of dealer pool vintages, delinquencies and loss ratios helps determine past performance and expected future results, which are used to adjust pricing and reserve requirements. Our CAR operations manage risk through diversifying their receivables among approximately 1,200 active dealers.
For our ACC operations, credit quality and loss mitigation initially are dependent upon our obtaining a first lien in the auto being financed. When a customer defaults and we repossess the auto, the sale of that auto at auction generally provides for the repayment of a substantial portion of the loan. However, it is unlikely to provide proceeds sufficient to repay the entire loan. As a result, for credit evaluation purposes, we consider a portion of these loans to be unsecured and evaluate the creditworthiness of the customers in that context.
How Do We Collect from Our Customers?
Credit Cards Segment. The goal of the collections process is to collect as much of the money that is owed to us in the most cost effective and customer friendly manner possible. To this end, we employ the traditional cross-section of letters and telephone calls to encourage payment. However, recognizing that our objective is to maximize the amount collected, we also will offer customers flexibility with respect to the application of payments in order to encourage larger or prompter payments. For instance, in certain cases we vary from our general payment application priority (i.e., of applying payments first to accrued finance charges, then to fees, and then to principal) by agreeing to apply payments first to principal and then to accrued finance charges and fees or by agreeing to forego finance charges in exchange for an appropriate payment. Application of payments in this manner also permits our collectors to assess real time the degree to which a customers payments over the life of an account have covered the principal credit extensions to the customer. This allows our collectors to readily identify our potential economic loss associated with the charge-off of a particular account (i.e., the excess of principal loaned to the customer over payments received back from the customer throughout the life of the account). With this information, our collectors work with our customers in a way intended to best protect us from economic loss on the cardholder relationship. Our selection of collection techniques, including, for example, whether we apply payments to finance charges or principal, impacts the statistical performance of our portfolios that we reflect under the Credit Cards Segment caption within Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations.
We consider managements experience in operating professional collection agencies, coupled with our proprietary systems, to be a competitive advantage in minimizing delinquencies and charge off losses. Our collectors employ various and evolving tools when working with a cardholder, and they routinely test and evaluate new tools in their drive toward improving our collections with the greatest degree of efficiency possible. These tools include programs under which we may reduce or eliminate a cardholders APR or waive a certain amount of accrued late fees, provided the cardholder makes a minimum number or amount of payments. In some instances, we may agree to match a customers payments, for example, with a commensurate reduction of accrued finance charges or waiver of accrued late fees. In other situations, we may actually settle with customers and adjust their accrued finance charges and accrued late fees, for example, based on their commitment and their follow through on their commitment to pay certain portions of the balances that they owe. Our collectors may also decrease a customers minimum payment under certain collection programs. Additionally, we employ re-aging techniques as discussed below. We also may occasionally use our marketing group to assist in determining various programs to assist in the collection process. Moreover, we willingly participate in the Consumer Credit Counseling Service (CCCS) program by waiving a certain percentage of a customers debt that is considered our fair share under the CCCS program. All of our programs are utilized based on the degree of economic success they achieve.
We constantly are monitoring and adapting our collection strategies, techniques, technology and training to optimize our efforts to reduce delinquencies and charge offs. We use our systems to develop these proprietary collection strategies and techniques, which we employ in our operations. We analyze the output from these systems to identify the strategies and techniques that we believe are most likely to result in curing a delinquent account in the most cost-effective manner, rather than treating all accounts the same based on the mere passage of time.
Our collection strategies include utilizing both internal and third-party collectors and creating a competitive process of rewarding the most effective and efficient group of collectors from within our system and among third-party agencies. We divide our portfolios into various groups that are statistically equivalent and provide these groups of accounts to our various internal and external collection resources. We compare the results of the internal and external collectors against one another to determine which techniques and which collection groups are producing the best results.
As in all aspects of our risk management strategies, we compare the results of each of the above strategies with other collection strategies and devote resources to those strategies that yield the best results. Results are
measured based on delinquency rates, expected losses and costs to collect. Existing strategies are then adjusted as suggested by these results. Management believes that maintaining the ongoing discipline of testing, measuring and adjusting collection strategies will result in minimized bad debt losses and operating expenses. We believe this on-going evaluation differs from the approach taken by the vast majority of credit grantors that implement collection strategies based on commonly accepted peer group practices.
We generally charge off credit card receivables when they become contractually 180 days past due or within 30 days of notification and confirmation of a customers bankruptcy or death. However, if a cardholder makes a payment greater than or equal to two minimum payments within a month of the charge off date, we may reconsider whether charge off status remains appropriate. Additionally, in some cases of death, receivables are not charged off if, with respect to the deceased customers account, there is a surviving, contractually liable individual or an estate large enough to pay the debt in full.
Our determination of whether an account is contractually past due is relevant to our delinquency and charge off data included under the Credit Cards Segment caption within Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations. Various factors are relevant in analyzing whether an account is contractually past due (i.e., whether an account has not satisfied its minimum payment due requirement), which for us is the trigger for moving receivables through our various delinquency buckets and ultimately to charge off status. We will consider a cardholders receivable to be delinquent if the cardholder fails to pay a minimum amount computed as a fixed percentage of his or her statement balance (3% or 4%, depending on the credit card product that he or she has). If, for any reason, we are required to revise our minimum payment requirements and practices, our delinquency and charge off data may be adversely affected.
Additionally, we use account re-aging as an account and customer management tool based on indicia or criteria that, in our judgment, evidence continued payment probability in an effort to increase the value of our account relationships. It is our policy to work cooperatively with customers demonstrating a willingness and ability to repay their indebtedness and who satisfy other criteria, but are unable to pay the entire past due amount. Generally, to qualify for re-aging, an account must have been opened for at least nine months and may not be re-aged more than once in a twelve-month period or twice in a five-year period. We also limit re-ages for cardholders in workout programs to once in a five-year period in addition to the periods stated above. The customer also must have made three consecutive minimum monthly payments or the equivalent cumulative amount in the last 90 days with the exception of CCCS customers who are required to make at least one qualifying payment within a month of CCCS proposal acceptance. In addition, if a re-aged account subsequently experiences payment defaults, it will again become contractually delinquent and will be charged off according to our regular charge off policy. The fact that the re-aging criteria may be met for a particular account does not require us to re-age that account, and the extent to which we re-age accounts that are eligible under the criteria will vary depending upon our view of prevailing economic conditions and other factors which may change from period to period. In addition, where circumstances warrant, we can make exceptions to these practices. The practice of re-aging an account may affect delinquencies and charge offs, potentially delaying or reducing such delinquencies and charge offs.
Retail Micro-Loans Segment. Generally, for our traditional cash advance micro-loan product, upon the establishment of a relationship with a customer, the store will schedule when the customer is expected to return to our retail location and repay the cash advance. Prior to that date, the store will attempt to contact the customer to confirm scheduling.
If a customer does not return to repay the cash advance, the store manager will either attempt to contact the customer to schedule another payment date through a promise to pay or deposit the personal check issued to us by the customer when he or she received his or her cash advance loan. Re-scheduling of payment dates is generally attempted first in order to improve customer relations and enhance overall collections.
If the store manager is unable to re-schedule a payment date, the customers check is deposited. If the check does not clear, either due to insufficient funds, a closed account or a stop-payment order, the branch employees
use additional collection efforts. These collection efforts typically include contacting the customer by phone or in person to obtain a promise to pay, sending collection letters to the customer or attempting to deposit the customers check if funds become available. If these collection efforts fail, the debt may be sold to either our own debt collections subsidiary or to a third party to attempt collection.
Auto Finance Segment. Accounts that CAR purchases from approved dealers initially are collected by the originating branch or service center location using a combination of traditional collection techniques. After a short period, accounts that have been loaded into our data processing system are centrally serviced to leverage auto dialer processing for early stage collections. The collection process includes contacting the customer by phone or mail, skip tracing and using starter interrupt devices to minimize delinquencies. Uncollectible accounts in our CAR operation generally are returned to the dealer under an agreement with the dealer to charge the balance on the account against the dealers reserve account. We generally do not repossess autos in our CAR operation as a result of the agreements that we have with the dealers. In our ACC operation, we customarily repossess autos following the default and sell those autos at national auctions. There almost always is a deficiency upon that sale, at which point we assess whether to pursue or, more often, not pursue that deficiency.
Consumer and Debtor Protection Laws and Regulations
Credit Cards Segment. Our business is regulated directly and indirectly under various federal and state consumer protection and other laws, rules and regulations, including the federal Truth-In-Lending Act, the federal Equal Credit Opportunity Act, the federal Fair Credit Reporting Act, the federal Fair Debt Collection Practices Act, the federal Gramm-Leach-Bliley Act and the federal Telemarketing and Consumer Fraud and Abuse Prevention Act. These statutes and their enabling regulations, among other things, impose disclosure requirements when a consumer credit loan is advertised, when the account is opened and when monthly billing statements are sent. In addition, various statutes limit the liability of credit cardholders for unauthorized use, prohibit discriminatory practices in extending credit, impose limitations on the types of charges that may be assessed and restrict the use of consumer credit reports and other account-related information. Some of our products are designed for customers at the lower end of the FICO scoring range. To offset the higher loss rates among these customers, these products generally have higher fees and more demanding terms than our other products. Because of the greater credit risks inherent in these customers and the fees and terms that the products have, these products, and the banks that issue them on our behalf, are subject to significant regulatory scrutiny. Were regulators, including the FDIC (which regulates the lenders that issue these products on our behalf) and the FTC, to object to these products, we could be required to modify or discontinue them.
Investments in Previously Charged-Off Receivables Segment. Our business is regulated directly and indirectly under various federal and state consumer protection and other laws, rules and regulations, including the federal Truth-In-Lending Act, the federal Equal Credit Opportunity Act, the federal Fair Credit Reporting Act, the federal Fair Debt Collection Practices Act, the federal Gramm-Leach-Bliley Act, the U.S. Bankruptcy Code and the federal Telemarketing and Consumer Fraud and Abuse Prevention Act. These statutes and their enabling regulations, among other things, establish specific regulations that debt collectors must follow when collecting consumer accounts and contain specific restrictions when communicating with customers, including the time, place and manner of the communications. In addition, some states require licensure prior to attempting collection efforts.
Retail Micro-Loans Segment. These businesses are regulated directly and indirectly under various federal and state consumer protection and other laws, rules and regulations, including the federal Truth-In-Lending Act, the federal Equal Credit Opportunity Act, the federal Fair Credit Reporting Act, the federal Fair Debt Collection Practices Act, the federal Gramm-Leach-Bliley Act and the federal Telemarketing and Consumer Fraud and Abuse Prevention Act. These statutes and their enabling regulations, among other things, impose disclosure requirements when a consumer loan or cash advance is advertised and when the account is opened. In addition, various state statutes limit the interest rates and fees that may be charged, prohibit discriminatory practices in extending credit, impose limitations on the number and form of transactions and restrict the use of consumer
credit reports and other account-related information. Many of the states in which these businesses operate have various licensing requirements and impose certain financial or other conditions in connection with their licensing requirements.
Auto Finance Segment. This segment is regulated directly and indirectly under various federal and state consumer protection and other laws, rules and regulations, including the federal Truth-In-Lending Act, the federal Equal Credit Opportunity Act, the federal Fair Credit Reporting Act, the federal Fair Debt Collection Practices Act, the federal Gramm-Leach-Bliley Act and the federal Telemarketing and Consumer Fraud and Abuse Prevention Act. These statutes and their enabling regulations, among other things, impose disclosure requirements. In addition, various state statutes limit the interest rates and fees that may be charged, limit the types of interest computations (e.g., interest bearing or pre-computed) and refunding processes that are permitted, prohibit discriminatory practices in extending credit, impose limitations on fees and other ancillary products and restrict the use of consumer credit reports and other account-related information. Many of the states in which this business segment operates have various licensing requirements and impose certain financial or other conditions in connection with these licensing requirements.
Credit Cards Segment. We face substantial competition, the intensity of which varies depending upon economic and liquidity cycles, from other consumer lenders. Our credit card business competes with national, regional and local bankcard issuers, other general-purpose credit card issuers and retail credit card issuers. Large credit card issuers, including but not limited to JP Morgan Chase, Bank of America, CitiBank, and Capital One, may compete with us for customers in a variety of ways, including but not limited to interest rates and fees. Many of these competitors are substantially larger than we are, have significantly greater financial resources than we do and have significantly lower costs of funds than we have. In addition, most of our largest competitors are banks and do not have to rely on third parties to issue their credit cards. Customers choose credit card issuers largely on the basis of price, including interest rates and fees, credit limit and other product features. Customer loyalty is often limited in this area. As such, we may lose entire accounts or account balances to competing credit card issuers.
Our competitors are continually introducing new strategies to attract customers and increase their market share via techniques such as advertising, target marketing, balance transfers and price competition. In response to competition, some issuers of credit cards have lowered interest rates and offered incentives to retain existing customers and attract new ones. These competitive practices, as well as competition that may develop in the future, could harm our ability to obtain customers and maintain profitability.
Investments in Previously Charged-Off Receivables Segment. The consumer debt collection industry is highly competitive and fragmented. We compete with a wide range of other purchasers of charged-off consumer receivables, including third-party collection agencies, other financial service companies and credit originators that manage their own consumer receivables.
Some of our competitors are larger and more established and may have substantially greater financial, technological, personnel and other resources than we have, including greater access to capital markets. We believe that no individual competitor or group of competitors has a dominant presence in the market. Competitive pressures affect the availability and pricing of receivables portfolios, as well as the availability and cost of qualified debt collectors.
We face bidding competition in our acquisition of charged-off consumer receivables portfolios. Some of our current competitors, and possible new competitors, may have more effective pricing and collection models, greater adaptability to changing market needs and more established relationships in our industry than we have. Moreover, our competitors may elect to pay prices for portfolios that we determine are not reasonable and, in that event, our volume of portfolio purchases may be diminished.
We believe that our managements experience and expertise in identifying, evaluating, pricing and acquiring consumer receivable portfolios and managing collections coupled with our strategic alliances with third-party servicers give us a competitive advantage. However, we cannot be assured that we will be able to compete successfully against current or future competitors or that competition will not increase in the future. Because our Investments in Previously Charged-Off Receivables segment serves in some respects as a hedge for the sale of charged-off credit card receivables by our Credit Cards segment, the adverse effects of competition for our Investments in Previously Charged-Off Receivables segment typically would serve to benefit the operating results of our Credit Cards segment.
Retail Micro-Loans Segment. Competition for our Retail Micro-Loans segment originates from numerous sources. Our Retail Micro-Loans segment subsidiaries compete with traditional financial institutions that offer similar products such as overdraft protection and cash advances, as well as with other micro-loan companies that offer substantially similar products and pricing models to ours. Key competitors, in addition to traditional financial institutions, include Advance America, Check n Go and Check into Cash, among others, who have multiple store operations located throughout the United States.
Differentiation among micro-loan providers is often relegated to location of branches, customer service, convenience and confidentiality. Due to the low barriers to entry within the market in terms of both cost and regulatory safe harbors within certain states, the micro-loan industry is in a period of significant growth, with multiple local chains and single unit operators often operating within the same market. The competition created by these operations could restrict our businesses ability to effectively earn adequate returns or grow at desired rates in certain markets.
Auto Finance Segment. Competition within the auto finance sector is very widespread and fragmented and includes captive finance companies from all of the major manufacturers. Our CAR operations target a customer base and dealer profile that often times are not capable of accessing indirect lending from major financial institutions or captive finance companies. We compete mainly with a handful of national companies focused on this credit segment (e.g., Credit Acceptance Corp., WestLake Financial, Mid-Atlantic Finance and Western Funding) and a large number of smaller, regional based private companies with a narrow geographic focus. Individual dealers with access to capital may also compete in this segment through the purchase of receivables from peer dealers in their markets.
As of December 31, 2006, we had approximately 3,600 employees principally located in Florida, Georgia, Minnesota, Nevada, North Carolina and Utah. Predominantly associated with the acquisitions within and operations of our Retail Micro-Loans and Auto Finance segments, we have employees located in Alabama, Arizona, Arkansas, Colorado, Florida, Kentucky, Louisiana, Mississippi, Nevada, North Carolina, Ohio, Oklahoma, South Carolina, Tennessee, Texas, Virginia and Wisconsin. Additionally, we have a limited number of employees in India and the United Kingdom. No collective bargaining agreement exists for any of our employees. We consider our relations with our employees to be good.
Trademarks, Trade Names and Service Marks
CompuCredit and our subsidiaries have registered and continue to register, when appropriate, various trademarks, trade names and service marks used in connection with our businesses and for private-label marketing of certain of our products. We consider these trademarks and service marks to be readily identifiable with, and valuable to, our business. This Annual Report on Form 10-K also contains trade names and trademarks of other companies that are the property of their respective owners.
CompuCredit is incorporated in Georgia. Our principal executive offices are located at 245 Perimeter Center Parkway, Suite 600, Atlanta, Georgia 30346, and the telephone number at that address is (770) 206-6200. Our Internet address is www.compucredit.com. We make available free of charge on our Internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
Certain corporate governance materials, including our Board committee charters and our Code of Business Conduct and Ethics, are posted on our website under the heading Investor Relations. From time to time, the corporate governance materials on our website may be updated as necessary to comply with rules issued by the SEC or NASDAQ, or as desirable to further the continued effective and efficient governance our company.
An investment in our common stock or other securities involves a number of risks. You should carefully consider each of the risks described below before deciding to invest in our common stock. If any of the following risks develops into actual events, our business, financial condition or results of operations could be negatively affected, the market price of our common stock or other securities could decline and you may lose all or part of your investment.
Our Cash Flows Are Dependent Upon the Cash Flows Received on the Receivables Underlying Our Securitizations and From Our Other Credit Products.
The collectibility of the receivables underlying our securitizations and those that we hold and do not securitize is a function of many factors including the criteria used to select who is issued credit, the pricing of the credit products, the lengths of the relationships, general economic conditions, the rate at which customers repay their accounts or become delinquent and the rate at which cardholders use their cards. To the extent we have over estimated collectibility, in all likelihood we have over estimated our financial performance. Some of these concerns are discussed more fully below.
We may not successfully evaluate the creditworthiness of our customers and may not price our credit products so as to remain profitable. The creditworthiness of our target market generally is considered sub-prime based on guidance issued by the agencies that regulate the banking industry. Thus, our customers generally have a higher frequency of delinquencies, higher risk of nonpayment and, ultimately, higher credit losses than consumers who are served by more traditional providers of consumer credit. Some of the consumers included in our target market are consumers who are dependent upon finance companies, consumers with only retail store credit cards and/or lacking general purpose credit cards, consumers who are establishing or expanding their credit and consumers who may have had a delinquency, a default or, in some instances, a bankruptcy in their credit histories, but have, in our view, demonstrated recovery. We price our credit products taking into account the perceived risk level of our target customers. If our estimates are incorrect, customer default rates will be higher, we will receive less cash from our securitizations and other credit products, which will result in a decrease in the value of our retained interests (which are based on expected future cash flows) and our loans and fees receivable, and we will experience reduced levels of net income.
An economic slowdown could increase credit losses and/or decrease our growth. Because our business is directly related to consumer spending, any period of economic slowdown or recession could make it more difficult for us to add or retain accounts or account balances. In addition, during periods of economic slowdown or recession, we expect to experience an increase in rates of delinquencies and frequency and severity of credit losses. Our actual rates of delinquencies and frequency and severity of credit losses may be higher under adverse economic conditions than those experienced in the consumer finance industry generally because of our focus on the sub-prime market. Changes in credit use, payment patterns and the rate of defaults by account holders may result from a variety of unpredictable social, economic and geographic factors. Social factors include, among other things, changes in consumer confidence levels, the publics perception of the use of credit and changing attitudes about incurring debt and the stigma of personal bankruptcy. Economic factors include, among other things, the rates of inflation, the unemployment rates and the relative interest rates offered for various types of loans. Moreover, adverse changes in economic conditions in states where account holders are located, including as a result of severe weather, could have a direct impact on the timing and amount of payments on our credit card accounts.
Because a significant portion of our reported income is based on managements estimates of the future performance of securitized receivables, differences between actual and expected performance of the receivables may cause fluctuations in net income. Income from the sale of receivables in securitization transactions and income from retained interests in receivables securitized have constituted, and are likely to continue to constitute, a significant portion of our income. Portions of this income are based on managements
estimates of cash flows we expect to receive from the interests that we retain when we securitize receivables. Differences between actual and expected performance of the receivables will occur and may cause fluctuations in our net income. The expected cash flows are based on managements estimates of interest rates, default rates, payment rates, cardholder purchases, costs of funds paid to investors in the securitizations, servicing costs, discount rates and required amortization payments. These estimates are based on a variety of factors, many of which are not within our control. As a result, these estimates will differ from actual performance.
Increases in expected losses and delinquencies may prevent us from continuing to securitize receivables in the future on similar terms or otherwise obtaining favorable financing for non-securitized receivables. Greater than expected delinquencies and losses also could impact our ability to complete other securitization or financing transactions on acceptable terms or at all, thereby decreasing our liquidity and forcing us to either decrease or stop our growth or rely on alternative, and potentially more expensive, funding sources if even available.
Increased utilization of existing credit lines by cardholders would require us to establish additional securitization and financing facilities or curtail credit lines. Our existing commitments to extend credit to cardholders exceed our available securitization and financing facilities. If all of our cardholders were to use their entire lines of credit at the same time, we would not have sufficient capacity to fund card use. However, in that event, we could either reduce our cardholders available credit lines or establish additional securitization and financing facilities. This would subject us to several of the other risks that we have described in this section.
Increases beyond expected losses and delinquencies may cause us to incur losses on our retained interests and losses on our loans and fees receivable. If the actual amounts of delinquencies and losses that occur in our securitized receivables or our on-balance-sheet receivables are greater than expected, the value of our retained interests in the securitization transactions and our loans and fee receivable, net on our consolidated balance sheet will decrease. Since we derive substantial income from our retained interests and loans and fees receivables, higher than expected rates of delinquency and loss could cause our net income to be lower than expected. In addition, under the terms of our securitizations agreements, levels of loss and delinquency could result in us being required to repay our securitization investors earlier than expected, reducing funds available to us for future growth. Similarly with respect to financing agreements secured by our on-balance-sheet receivables, levels of loss and delinquency could result in our being required to repay our lenders earlier than expected, thereby reducing funds available to us for future growth
Our portfolio of receivables is not diversified and originates from customers whose creditworthiness is considered sub-prime. We obtain the receivables that we securitize and retain on our balance sheet in one of two wayswe either originate the receivables or purchase pools of receivables from other issuers. In either case, substantially all of our receivables originate from sub-prime borrowers. Our reliance on sub-prime receivables has in the past (and may in the future) negatively impacted our performance. For example, in 2001, we suffered a substantial loss after we increased the discount rate that we use in valuing our retained interests to reflect the higher rate of return required by securitization investors in sub-prime markets. These losses might have been mitigated had our portfolios consisted of higher-grade receivables in addition to our sub-prime receivables. Because our portfolios are undiversified, negative market forces have the potential to cause a widespread adverse impact. We have no immediate plans to issue or acquire significant receivables that are higher in the credit spectrum.
Seasonal consumer spending may result in fluctuations in our net income. Our quarterly income may substantially fluctuate as a result of seasonal consumer spending. In particular, our credit card customers may charge more and carry higher balances during the year-end holiday season and during the late summer vacation and back-to-school period, resulting in corresponding increases in the receivables we manage and subsequently securitize or finance during those periods.
Increases in interest rates will increase our cost of funds and may reduce the payment performance of our customers. Increases in interest rates will increase our cost of funds, which could significantly affect our results of operations and financial condition. Our credit card accounts have variable interest rates. Significant increases in these variable interest rates may reduce the payment performance of our customers.
Due to the lack of historical experience with Internet customers, we may not be able to successfully target these customers or evaluate their creditworthiness. There is less historical experience with respect to the credit risk and performance of customers acquired over the Internet. As part of our growth strategy, we are expanding our origination of accounts over the Internet; however, we may not be able to successfully target and evaluate the creditworthiness of these potential customers. Therefore, we may encounter difficulties managing the expected delinquencies and losses and appropriately pricing our products.
We Are Substantially Dependent Upon Securitizations and Other Borrowed Funds to Fund the Receivables That We Originate or Purchase.
All of our securitization and financing facilities are of finite duration (and ultimately will need to be extended or replaced) and contain conditions that must be fulfilled in order for funding to be available. Although our primary credit card receivables securitization facility with Merrill Lynch alleviates for the foreseeable future our principal exposure to advance rate fluctuations, in the event that future advance rates (i.e., the percentage on a dollar of receivables that lenders will lend us) for securitizations our financing facilities are reduced, investors in securitizations or financing facilities lenders require a greater rate of return, we fail to meet the requirements for continued funding or securitizations and financing arrangements otherwise become unavailable to us, we may not be able to maintain or grow our base of receivables or it may be more expensive for us to do so. In addition, because of advance rate limitations, we retain subordinate interests in our securitizations, the retained interests, that must be funded through profitable operations, equity raised from third parties or funds borrowed elsewhere. The cost and availability of equity and borrowed funds is dependent upon our financial performance, the performance of our industry generally and general economic and market conditions, and at times equity and borrowed funds have been both expensive and difficult to obtain. Some of these concerns are discussed more fully below.
Our growth is dependent on our ability to add new securitization and financing facilities. We finance our receivables through securitizations and financing facilities. To the extent we grow our receivables significantly, our cash requirements are likely to exceed the amount of cash we generate from operations, thus requiring us to add new securitization or financing facilities. Our historic and projected performance impact whether, on what terms and at what cost we can sell interests in our securitizations or obtain financing from lenders. If additional securitization and financing facilities are not available on terms we consider acceptable, or if existing securitization and financing facilities are not renewed on terms as favorable as we have now or are not renewed at all, we may not be able to grow.
As our securitization and financing facilities mature, they will be required to accumulate cash that therefore will not be available to us for reinvestment or other purposes. Repayment for our securitization facilities begins as early as one year prior to their maturity dates. Once repayment begins and until the facility is paid, payments from customers on receivables are accumulated to repay the investors and are no longer reinvested in new receivables. When a securitization facility matures, the underlying trust continues to own the receivables and effectively the maturing facility maintains its priority in its right to payments following collections on the underlying receivables until it is repaid in full. As a result, new purchases need to be funded using debt, equity or a replacement facility subordinate to the maturing facilitys interest in the underlying receivables. Although this subordination historically has not made it more difficult to obtain replacement facilities, it may do so in the future. If our securitization facilities begin to accumulate cash and we also are unable to obtain additional sources of liquidity, such as debt, equity or new securitization facilities that are structurally subordinate to the facilities accumulating cash, we may be forced to prohibit new purchases in some or all of our accounts in order to significantly reduce our need for any additional cash.
The documents under which the securitization facilities are established provide that, upon the occurrence of certain adverse events known as early redemption events, the timing of payments to the investors could be accelerated. Early redemption events include portfolio performance triggers, the termination of the affinity agreement with CB&T, breach of certain representations, warranties and covenants, insolvency or receivership, servicer defaults, and may include the occurrence of an early redemption event with respect to another securitization transaction. In the Merrill Lynch facility, an early redemption event also may be triggered based on a total consolidated equity test or a change of control in CompuCredit. If an early redemption event occurs, principal payments would be made to investors to reduce their interests in our securitizations. As investors interests in our securitizations decrease, our liquidity would be negatively impacted and our financial results may suffer. We would need to obtain alternative sources of funding, and there is no certainty that we would be able to do so. Similar triggers exist with respect to the financing facilities for our loans and fees receivable retained on our balance sheet, the refunding of which could be made more difficult or impossible at terms acceptable to us if we hit such triggers.
We may be unable to obtain capital from third parties needed to fund our existing securitizations and loans and fees receivable or may be forced to rely on more expensive funding sources. We need equity or debt capital to fund our retained interests in our securitizations and the difference between our loans and fees receivable and the amount that lenders will advance or lend to us against those receivables. Investors should be aware of our dependence on third parties for funding and our exposure to increases in costs for that funding. External factors, including the general economy, impact our ability to obtain funds. For instance, in 2001, we needed additional liquidity to fund our operations and the growth in our retained interests, and we had a difficult time obtaining the needed cash. If in the future we need to raise cash by issuing additional debt or equity or by selling a portion of our retained interests, there is no certainty that we will be able to do so or that we will be able to do so on favorable terms. Our ability to raise cash will depend on factors such as our performance and creditworthiness, the performance of our industry, the performance of issuers of other non-credit card-based asset backed securities and the general economy.
The timing and volume of securitizations and originations with respect to our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range may cause significant fluctuations in quarterly income. Fluctuations in the timing or the volume of receivables securitized will cause fluctuations in our quarterly income. Factors that affect the timing or volume of our securitizations include the growth in our receivables, market conditions and the approval by all parties of the terms of the securitization. Given the significant and variable growth rates that we have experienced for our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and given the appreciably shorter vintage life cycles for these offerings relative to our more traditional credit card offerings, we have experienced, and in the future expect to experience, significant volatility of quarterly earnings from these offerings based on the varying volumes of marketing spending and account origination in the quarters preceding peak vintage charge-off periods.
The performance of our competitors may impact the costs of our securitizations and financing facilities. Investors in our securitizations and financing facilities compare us to other sub-prime credit card issuers and, to some degree, our performance is tied to many of the factors that impact their performance. Generally speaking, investors in our securitizations also invest in our competitors securitizations, and lenders against our receivables also lend against our competitors receivables. These investors and lenders broadly invest in or lend against receivables, and when they evaluate their investments and lending arrangements, they typically do so on the basis of overall industry performance. Thus, when our competitors perform poorly, we typically experience negative investor and lender sentiment, and the investors in our securitizations and lenders against our receivables require greater returns, particularly with respect to subordinated interests in our securitizations. In 2001, for instance, investors demanded unprecedented returns.
In the event that investors require higher returns and we sell our retained interests in securitizations at that time, the total return to the buyer may be greater than the discount rate we are using to value the retained interests
in our financial statements. This would result in a loss for us at the time of the sale as the total proceeds from the sale would be less than the carrying amount of the retained interests in our financial statements. We also might increase the discount rate used to value all of our other retained interests, which also would result in further losses. Conversely, if we sold our retained interests for a total return to the investor that was less than our current discount rate, we would record income from the sale, and we would potentially decrease the rate used to value all of our other retained interests, which would result in additional income.
We may be required to pay to investors in our securitizations an amount equal to the amount of securitized receivables if representations and warranties made to us by sellers of the receivables are inaccurate. The representations and warranties made to us by sellers of receivables we have purchased may be inaccurate. We rely on these representations and warranties when we securitize these purchased receivables. In securitization transactions, we make representations and warranties to investors and, generally speaking, if there is a breach of our representations and warranties, then under the terms of the applicable investment agreement we could be required to pay the investors the amount of the non-compliant receivables. Thus, our reliance on a representation or warranty of a receivables seller, which proves to be false and causes a breach of one of our representations or warranties, could subject us to a potentially costly liability.
Our Financial Performance Is, in Part, a Function of the Aggregate Amount of Receivables That Are Outstanding.
The aggregate amount of outstanding receivables is a function of many factors including purchase rates, payment rates, interest rates, seasonality, general economic conditions, competition from other credit card issuers and other sources of consumer financing, access to funding as noted above and the success of our marketing efforts. To the extent that we have over estimated the size or growth of our receivables, in all likelihood we have over estimated our future financial performance.
Intense competition for customers may cause us to lose receivables to competitors. We may lose receivables to competitors that offer lower interest rates and fees or other more attractive terms or features. We believe that customers choose credit card issuers and other lenders largely on the basis of interest rates, fees, credit limits and other product features. For this reason, customer loyalty is often limited. Our future growth depends largely upon the success of our marketing programs and strategies. Our credit card business competes with national, regional and local bank and other credit card issuers, including issuers of American Express®, Discover® ,Visa® and MasterCard® credit cards. Our other businesses have substantial competitors as well. Some of these competitors already may use or may begin using many of the programs and strategies that we have used to attract new accounts. In addition, many of our competitors are substantially larger than we are and have greater financial resources. Further, the Gramm-Leach-Bliley Act of 1999, which permits the affiliation of commercial banks, insurance companies and securities firms, may increase the level of competition in the financial services market, including the credit card business.
We may be unable to sustain and manage our growth. We may experience fluctuations in net income or sustain net losses if we are not able to sustain or effectively manage our growth. Growth is a product of a combination of factors, many of which are not in our control. Factors include:
Our decisions regarding marketing can have a significant impact on our growth. We can increase or decrease the size of our outstanding receivables balances by increasing or decreasing our marketing efforts. Marketing is expensive, and during periods when we have less liquidity than we like or when prospects for continued liquidity in the future do not look promising, we may decide to limit our marketing and thereby our growth. We decreased our marketing during 2003, although we increased our marketing in 2004 through 2006 because of our improved access to capital.
Our operating expenses and our ability to effectively service our accounts are dependent on our ability to estimate the future size and general growth rate of the portfolio. One of our servicing agreements causes us to make additional payments if we overestimate the size or growth of our business. These additional payments compensate the servicer for increased staffing expenses it incurs in anticipation of our growth. If we grow more slowly than anticipated, we still may have higher servicing expenses than we actually need, thus reducing our net income.
We Operate in a Heavily Regulated Industry.
Changes in bankruptcy, privacy or other consumer protection laws, or to the prevailing interpretation thereof, may expose us to litigation, adversely affect our ability to collect account balances in connection with our traditional credit card business, our debt collection subsidiarys charged-off receivables operations, auto finance and micro-loan activities, or otherwise adversely affect our operations. Similarly, regulatory changes could adversely affect our ability or willingness to market credit cards and other products and services to our customers. The accounting rules that govern our business are exceedingly complex, difficult to apply and in a state of flux. As a result, how we value our receivables and otherwise account for our business (including whether we consolidate our securitizations) is subject to change depending upon the interpretation of, and changes in, those rules. Some of these issues are discussed more fully below.
Reviews and enforcement actions by regulatory authorities under banking and consumer protection laws and regulations may result in changes to our business practices, may make collection of account balances more difficult or may expose us to the risk of fines, restitution and litigation. Our operations and the operations of the issuing banks through which we originate credit products are subject to the jurisdiction of federal, state and local government authorities, including the SEC, the FDIC, the Office of the Comptroller of the Currency, the FTC, state regulators having jurisdiction over financial institutions and debt origination and collection and state attorneys general. Our business practices, including the terms of our products and our marketing, servicing and collection practices, are subject to both periodic and special reviews by these regulatory and enforcement authorities. These reviews can range from the investigations of specific consumer complaints or concerns to broader inquiries into our practices generally. If as part of these reviews the regulatory authorities conclude that we are not complying with applicable law, they could request or impose a wide range of remedies including requiring changes in advertising and collection practices, changes in the terms of our products (such as decreases in interest rates or fees), the imposition of fines or penalties, or the paying of restitution or the taking of other remedial action with respect to affected customers. They also could require us to stop offering some of our products, either nationally or in selected states. To the extent that these remedies are imposed on the issuing banks through which we originate credit products, we generally are responsible for the remedies as a result of our indemnification obligations with those banks. Furthermore, negative publicity relating to any specific inquiry or investigation could hurt our ability to conduct business with various industry participants or to attract new accounts and could negatively affect our stock price, which would adversely affect our ability to raise additional capital and raise our costs of doing business.
As discussed in more detail below, in March 2006, one of our subsidiaries stopped processing and servicing micro-loans in North Carolina in settlement of a review by the North Carolina Attorney General, and also in 2006, we terminated our processing and servicing of micro-loans for third-party banks in three other states in response to a position taken in February 2006 with respect to banks generally by the FDIC.
In June 2006, we entered into an assurance agreement with the New York Attorney General in order to resolve an inquiry into our marketing and other materials and our servicing and collection practices, principally as a result of New York Personal Property Law Section 413. Pursuant to this agreement, we agreed to pay a $0.5 million civil penalty to the State of New York and to refund certain fees to New York cardholders, which resulted in cash payments of under $2.0 million and a charge against a $5.0 million liability that we accrued for this purpose. In addition, we assured the New York Attorney General that we would not engage in certain marketing, billing, servicing and collection practices, a number of which we previously had discontinued.
Also in June 2006, the FDIC commenced an investigation of the policies, practices and procedures used in connection with our longest standing third-party credit card originating financial institution relationship. In December 2006, the FTC commenced a related investigation. In general, the investigations focus upon whether marketing and other materials contained misrepresentations regarding, among other things, fees and credit limits and whether servicing and collection practices were conducted in accordance with applicable law. We have provided substantial information to both the FDIC and FTC, and we continue to respond to their requests. The FDIC and FTC have proposed limitations on certain marketing, servicing and collection practices, reimbursement of various types of fees to affected customers and the payment of fines. The matters under investigation involve a significant amount of fees and a substantial number of accounts, and it is premature to determine the outcomes of these investigations or their effects on our financial condition, results of operations or business position and consolidated financial statements. However, we believe that our marketing and other materials and servicing and collection practices comply with applicable law, and we intend to vigorously contest the limitations and other proposals of the FDIC and FTC.
If any additional deficiencies or violations of law or regulations are identified by us or asserted by any regulator, or if the FDIC, FTC or any other regulator requires us to change any of our practices, there can be no assurance that the correction of such deficiencies or violations, or the making of such changes, would not have a material adverse effect on our financial condition, results of operations or business. In addition, whether or not we modify our practices when a regulatory or enforcement authority requests or requires that we do so, there is a risk that we or other industry participants may be named as defendants in litigation involving alleged violations of federal and state laws and regulations, including consumer protection laws. Any failure to comply with legal requirements by us or the issuing banks through which we originate credit products in connection with the issuance of those products, or by us or our agents as the servicer of our accounts, could significantly impair our ability to collect the full amount of the account balances. The institution of any litigation of this nature, or any judgment against us or any other industry participant in any litigation of this nature, could adversely affect our business and financial condition in a variety of ways.
Increases in required minimum payment levels could impact our business adversely. Recently, regulators of credit card issuers have requested or required that issuers increase their minimum monthly payment requirements to prevent so-called negative amortization, in which the monthly minimum payment is not sufficient to reduce the outstanding balance even if new purchases are not made. This can be caused by, among other things, the imposition of over-limit, late and other fees. We request a minimum payment from our credit cardholders equal to the greater of 3% or 4% (depending upon the credit card product) of their outstanding balance or an amount that is sufficient to cover over-limit, late and other fees a minimum payment level that is designed to prevent negative amortization. However, we have followed a more consumer-friendly practice of not treating cardholders as delinquent (with commensurate adverse credit agency reporting) provided they make a minimum payment of only 3% or 4% (depending on the credit card product) of their outstanding balance (i.e., exclusive of the requested over-limit, late and other fees). Because of this practice, as of December 31, 2006, approximately 3.8% of our accounts (representing approximately 5.9% of our receivables) were experiencing
negative amortization; this compares with 4.0% of accounts and 6.1% of our receivables experiencing negative amortization as of September 30, 2006 and 3.8% of accounts and 5.7% of our receivables experiencing negative amortization as of June 30, 2006. In response to comments about minimum payments and negative amortization received from the FDIC in the course of its routine examinations of the banks that issue credit cards on our behalf, during the second quarter of this year we began a review of our practices in this area. As a result of this review, commencing during the third and fourth quarters of 2006, we discontinued billing finance charges and fees on credit card accounts once they become over 90 days delinquent. In addition, we are reviewing alternative minimum payment, fee and other credit terms designed to prevent negative amortization. We have not, however, made any assessment of the impact of any changes on our business, although changes could adversely impact our delinquency and charge off statistics and the amounts ultimately collected from cardholders.
Adverse regulatory action with respect to issuing banks could adversely impact our business. It is possible that a regulatory position or action taken with respect to any of the issuing banks through which we originate credit products or for whom we service receivables, might result in the banks inability or unwillingness to originate credit products on our behalf or in partnership with us. For instance, in February 2006 the FDIC effectively asked insured financial institutions not to issue cash advance and installment micro-loans through third-party servicers. As a result of this request, the issuing bank for which we provided services in four states stopped making new loans. In the future, regulators may find other aspects of the products that we originate or service objectionable, including, for instance, the terms of the credit offerings (particularly for our high fee products), the manner in which we market them or our servicing and collection practices. We are entirely dependent in our issuing relationships with these institutions, and their regulators could at any time limit their ability to issue some or all products on our behalf, or that we service on their behalf, or to modify those products significantly. Any significant interruption of those relationships would result in our being unable to originate new receivables and other credit products, which would have a materially adverse impact on our business.
Changes to consumer protection laws or changes in their interpretation may impede collection efforts or otherwise adversely impact our business practices. Federal and state consumer protection laws regulate the creation and enforcement of consumer credit card receivables and other loans. As an originator and servicer of sub-prime receivables, we typically charge higher interest rates and fees than lenders serving consumers with higher credit scores. Sub-prime lenders are commonly the target of legislation (and revised legislative interpretations) intended to prohibit or curtail these and other industry-standard practices as well as non-standard practices. For instance, Congress recently enacted legislation that regulates loans to military personnel through imposing interest rate and other limitations and requiring new disclosures, all as regulated by the Department of Defense. Among others, changes in the consumer protection laws could result in the following:
Accordingly, our business is always subject to changes in the regulatory environment. Changes or additions to the consumer protection laws and related regulations, or to the prevailing interpretations thereof, could invalidate or call into question a number of our existing products, services and business practices, including our credit card origination, charged-off receivable collection, auto finance and micro-loan activities. Any material regulatory developments could adversely impact our results from operations.
Changes in bankruptcy laws may have an adverse impact on our performance. Effective October 17, 2005, the federal bankruptcy code was amended in several respects. One of the changes made it substantially more difficult for individuals to obtain a complete release from their debts through a bankruptcy filing. As a result, immediately prior to the effective date of the amendments there was a substantial increase in bankruptcy filings by individuals. While much of the impact of this particular law change appears to have been simply to accelerate the bankruptcy filings by individuals who otherwise would have filed in due course and while this particular law may have ongoing future benefits to us through potential reductions in future bankruptcy filings, other future bankruptcy law changes could potentially have a materially adverse effect on our business.
The Retail Micro-Loans segment of our business operates in an increasingly hostile regulatory environment. Most states have specific laws regulating micro-loan activities and practices. (One form of these activities is sometimes referred to as payday lending.) Moreover, during the last few years, legislation has been adopted in some states that prohibits or severely restricts micro-loan cash advance services. For example, in 2004, a new law became effective in Georgia that effectively prohibits certain micro-loan practices in the state. Several other state legislatures have introduced bills to restrict or prohibit cash advance micro-loans by limiting the amount of the advance and or reducing the allowable fees. In addition, Mississippi and Arizona have sunset provisions in their laws permitting micro-loans that require renewal of the laws by the state legislatures at periodic intervals. Although states provide the primary regulatory framework under which we conduct our micro-loan services, certain federal laws also impact our business. In March 2005 the FDIC issued guidance limiting the frequency of borrower usage of cash advance micro-loans offered by FDIC-supervised institutions and the period a customer may have cash advance micro-loans outstanding from any lender to three months during the previous 12-month period. Subsequently, in February 2006, the FDIC effectively asked FDIC-insured financial institutions to cease cash advance and installment micro-loan activities conducted through a processing and servicing agent such as us. Moreover, future laws or regulations (at the state, federal or local level) prohibiting micro-loan services or making them unprofitable could be passed at any time or existing micro-loan laws could expire or be amended, any of which could have a material adverse effect on our business, results of operations and financial condition.
Additionally, state attorneys general, banking regulators and others continue to scrutinize the micro-loan industry and may take actions that could require us to cease or suspend operations in their respective states. For example, one of our subsidiaries agreed with the Attorney General of the State of North Carolina in March 2006 to stop servicing micro-loans for third-party banks, a practice that we also terminated in three other affected states based on the February 2006 FDIC action cited above. Also, a group of plaintiffs brought a series of putative class action lawsuits in North Carolina claiming, among other things, that the cash advance micro-loan activities of the defendants violate numerous North Carolina consumer protection laws. The lawsuits seek various remedies including treble damages. One of these lawsuits is pending against CompuCredit and five of our subsidiaries. If these cases are determined adversely to us, there could be significant consequences to us, including the payment of monetary damages. In the future, we also might voluntarily (or with the encouragement of a regulator) withdraw particular products from particular states, which could have a similar effect.
Negative publicity may impair acceptance of our products. Critics of sub-prime credit and micro-loan providers have in the past focused on marketing practices that they claim encourage consumers to borrow more money than they should, as well as on pricing practices that they claim are either confusing or result in prices that are too high. Consumer groups, Internet chat sites and media reports frequently characterize sub-prime lenders as predatory or abusive toward consumers and may misinform consumers regarding their rights. If these negative characterizations and misinformation become widely accepted by consumers, demand for our products and
services could be adversely impacted. Increased criticism of the industry or criticism of us in the future could hurt customer acceptance of our products or lead to changes in the law or regulatory environment, either of which would significantly harm our business.
We Recently Entered Into and Have Subsequently Expanded Our Automobile Lending Activities, and These Activities Involve Risks in Addition to Those We Historically Have Faced.
In 2005, we acquired Wells Fargo Financials CAR business unit. We are operating these assets in forty-five states through twelve branches, three regional processing centers and one national collection center based in Lake Mary, Florida under the name CAR Financial Services, Inc. On February 2, 2007, we acquired the business of ACC, also an automobile lender. Automobile lending is a new business for us, and we expect to expand further in this business over time. As a new business, we may not be able to integrate or manage the business effectively. In addition, automobile lending exposes us to a range of risks to which we previously have not been exposed, including the regulatory scheme that governs installment loans and those attendant to relying upon automobiles and their liquidation value as collateral. In addition, the CAR Financial Services business acquires loans on a wholesale basis from used car dealers, for which we will be relying upon the legal compliance and credit determinations by those dealers.
Our automobile lending business is dependent upon referrals from dealers. Currently we provide automobile loans only to or through new and used car dealers. Providers of automobile financing have traditionally competed based on the interest rate charged, the quality of credit accepted and the flexibility of loan terms offered. In order to be successful, we not only will need to be competitive in these areas, but also will need to establish and maintain good relations with dealers and provide them with a level of service greater than what they can obtain from our competitors. This is particularly true with our newly acquired ACC business, which stopped originating loans in November 2006 and is in the process of reestablishing its relationships with dealers.
The financial performance of our automobile loan portfolio is in part dependent upon the liquidation of repossessed automobiles. Our newly acquired ACC business regularly repossesses automobiles and sells repossessed automobiles at wholesale auction markets located throughout the United States. Auction proceeds from these sales and other recoveries rarely are sufficient to cover the outstanding balances of the contracts; where we experience these shortfalls, we will experience credit losses. Decreased auction proceeds resulting from depressed prices at which used automobiles may be sold in periods of economic slowdown or recession will result in higher credit losses for us. Furthermore, depressed prices for automobiles also may result from significant liquidations of rental fleet inventories and from increased volumes of trade-ins due to promotional programs offered by new vehicle manufacturers. Additionally, higher gasoline prices may decrease the auction value of certain types of vehicles, such as SUVs.
Repossession of Automobiles Entails the Risk of Litigation and Other Claims. Although we contract with reputable repossession firms to repossess automobiles on defaulted loans, it is not uncommon for consumers to assert that we were not entitled to repossess an automobile or that the repossession was not conducted in accordance with applicable law. These claims increase the cost of our collection efforts and, if correct, can result in awards against us.
We Routinely Explore Various Opportunities to Grow Our Business, to Make Investments and to Purchase and Sell Assets.
We routinely consider acquisitions of, or investments in, portfolios and other businesses as well as the sale of portfolios and portions of our business. There are a number of risks attendant to any acquisition, including the possibility that we will overvalue the assets to be purchased, that we will not be able to successfully integrate the acquired business or assets and that we will not be able to produce the expected level of profitability from the acquired business or assets. Similarly, there are a number of risks attendant to sales, including the possibility that we will undervalue the assets to be sold. As a result, the impact of any acquisition or sale on our future performance may not be as favorable as expected and actually may be adverse.
Portfolio purchases may cause fluctuations in reported credit card managed receivables data, which may reduce the usefulness of historical credit card managed loan data in evaluating our business. Our reported managed credit card receivables data may fluctuate substantially from quarter to quarter as a result of recent and future credit card portfolio acquisitions. As of December 31, 2006, credit card portfolio acquisitions account for 21.1% of our total credit card managed receivables portfolio based on our ownership percentages.
Receivables included in purchased portfolios are likely to have been originated using credit criteria different from our criteria. As a result, some of these receivables have a different credit quality than receivables we originated. Receivables included in any particular purchased portfolio may have significantly different delinquency rates and charge off rates than the receivables previously originated and purchased by us. These receivables also may earn different interest rates and fees as compared to other similar receivables in our receivables portfolio. These variables could cause our reported managed receivables data to fluctuate substantially in future periods making the evaluation of our business more difficult.
Any acquisition or investment that we make, will involve risks different from and in addition to the risks to which our business is currently exposed. These include the risks that we will not be able to successfully integrate and operate new businesses, that we will have to incur substantial indebtedness and increase our leverage in order to pay for the acquisitions, that we will be exposed to, and have to comply with, different regulatory regimes and that we will not be able to apply our traditional analytical framework (which is what we expect to be able to do) in a successful and value-enhancing manner.
Other Risks of Our Business
Unless we obtain a bank charter, we cannot issue credit cards other than through agreements with banks. Because we do not have a bank charter, we currently cannot issue credit cards other than through agreements with banks. Previously we applied for permission to acquire a bank and our application was denied. Unless we obtain a bank or credit card bank charter, we will continue to rely upon banking relationships to provide for the issuance of credit cards to our customers. Even if we obtain a bank charter, there may be restrictions on the types of credit that it may extend. Our longest standing issuing agreement is with CB&T and is scheduled to expire on March 31, 2009. If we are unable to execute a new agreement with CB&T or our other issuing banks at the expirations of our current agreements with them, or if our existing or new agreements with our issuing banks were terminated or otherwise disrupted, there is a risk that we would not be able to enter into agreements with an alternate provider on terms that we consider favorable or in a timely manner without disruption of our business.
We may not be able to purchase charged-off receivables at sufficiently favorable prices or terms for our debt collection operations to be successful. The charged-off receivables that are acquired and serviced by Jefferson Capital, our debt collection subsidiary, or sold to third parties pursuant to forward flow contracts have been deemed uncollectible and written off by the originators. Jefferson Capital seeks to purchase charged-off receivables portfolios only if it expects projected collections or prices received for sales of such charged-off receivables to exceed its acquisition and servicing costs. Accordingly, factors causing the acquisition price of targeted portfolios to increase could reduce the ratio of collections (or sales prices received) to acquisitions costs for a given portfolio, and thereby negatively affect Jefferson Capitals profitability. The availability of charged-off receivables portfolios at favorable prices and on favorable terms depends on a number of factors, including the continuation of the current growth and charge off trends in consumer receivables, our ability to develop and maintain long-term relationships with key charged-off receivable sellers, our ability to obtain adequate data to appropriately evaluate the collectibility of portfolios and competitive factors affecting potential purchasers and sellers of charged-off receivables, including pricing pressures, which may increase the cost to us of acquiring portfolios of charged-off receivables and reduce our return on such portfolios.
Additionally, sellers of charged-off receivables generally make numerous attempts to recover on their non-performing receivables, often using a combination of their in-house collection and legal departments as well as third-party collection agencies. Charged-off receivables are difficult to collect, and we may not be successful
in collecting amounts sufficient to cover the costs associated with purchasing the receivables and funding our Jefferson Capital operations.
The analytical model we use to project credit quality may prove to be inaccurate. We assess credit quality using an analytical model that we believe predicts the likelihood of payment more accurately than traditional credit scoring models. For instance, we have identified factors (such as delinquencies, defaults and bankruptcies) that under some circumstances we weight differently than do other credit providers. We believe our analysis enables us to better identify consumers within the underserved market who are likely to be better credit risks than otherwise would be expected. Similarly, we apply our analytical model to entire portfolios in order to identify those that may be more valuable than the seller or other potential purchasers might recognize. There can be no assurance, however, that we will be able to achieve the collections forecasted by our analytical model. If any of our assumptions underlying our model proves materially inaccurate or changes unexpectedly, we may not be able to achieve our expected levels of collection, and our revenues will be reduced, which would result in a reduction of our earnings.
Because we outsource account-processing functions that are integral to our business, any disruption or termination of that outsourcing relationship could harm our business. We outsource account and payment processing pursuant to agreements with CB&T and its affiliates. In 2006, we paid CB&T and its affiliates $36.5 million for these services. If these agreements were not renewed or were terminated or the services provided to us otherwise disrupted, we would have to obtain these services from an alternative provider, such as First Data Resources, Inc., which currently provides only limited account and payment processing for us. There is a risk that we would not be able to enter into a similar agreement with an alternate provider on terms that we consider favorable or in a timely manner without disruption of our business.
If we obtain a bank charter, any changes in applicable state or federal laws could adversely affect our business. From time-to-time we have explored the possibility of acquiring a bank or credit card bank. If we obtain a bank or credit card bank charter, we will be subject to the various state and federal regulations generally applicable to similar institutions, including restrictions on the ability of the banking subsidiary to pay dividends to us. We are unable to predict the effect of any future changes of applicable state and federal laws or regulations, but such changes could adversely affect the banks business and operations.
If we ever consolidate the entities that hold our receivables, the changes to our financial statements are likely to be significant. When we securitize receivables, they are owned by special purpose entities that are not consolidated with us for financial reporting purposes. The rules governing whether these entities are consolidated are complex and evolving. These rules at some point could be changed or interpreted in a manner that requires us to consolidate these entities. In addition, we might at some point modify how we securitize receivables, or propose modifications to existing securitization facilities, such that the consolidation of these entities could be required. If this occurred, we would include the receivables as assets on our balance sheet and also would include a loan loss reserve. Similarly, we no longer would include the corresponding retained interests as assets. There also would be significant changes to our statements of operations and cash flows. The net effect of consolidation would be dependent upon the amount and nature of the receivables at the time they were consolidated, and although it is difficult to predict the net effect of consolidation, it is likely to be material.
Internet security breaches could damage our reputation and business. Internet security breaches could damage our reputation and business. As part of our growth strategy, we may expand our origination of credit card accounts over the Internet. The secure transmission of confidential information over the Internet is essential to maintaining consumer confidence in our products and services offered online. Advances in computer capabilities, new discoveries or other developments could result in a compromise or breach of the technology used by us to protect customer application and transaction data transmitted over the Internet. Security breaches could damage our reputation and expose us to a risk of loss or litigation. Moreover, consumers generally are concerned with security and privacy on the Internet, and any publicized security problems could inhibit the growth of the Internet as a means of conducting commercial transactions. Our ability to solicit new account holders over the Internet would be severely impeded if consumers become unwilling to transmit confidential information online.
Investments that we make in the securities of others may be more risky and volatile than similar assets owned by us. From time-to-time we purchase debt and securities of others, principally those issued by asset-backed securitization trusts (e.g., notes secured or backed by pools of assets) that represent sub-prime credit risks of individuals. These securities in many cases are junior, including below investment grade, traunches of securities issued by the trusts. The assets underlying these securities are not originated by us and, accordingly, may not meet the underwriting standards that we follow in originating receivables. Further, we do not have direct control over the management of the underlying assets and, similarly, they may not be managed as effectively as we would manage similar assets. As a result, the securities in which we invest may carry higher risks, including risks of higher delinquencies and charge offs, risks of covenant violations and risks of value impairment due to the claims of more senior securities issued by the trusts, than similar assets originated and owned by us. These higher risks can cause much greater valuation volatility for these securities than we typically have experienced and would expect to experience on our holdings of securities underlying the trusts that we service. And although these securities generally are traded in an active secondary market, valuation volatility also can be expected to result from liquidity needs that we might have in the future, including any need that we may have for quick liquidity or to meet margin requirements related to our investments in these securities should their prices decline. In turn, this could result in steep and immediate impairments in the values of the securities as presented within our financial statements and could cause our financial position and results of operations to deteriorate, possibly materially. At December 31, 2006, we had investments in the debt and similar securities of others of $141.7 million.
Risks Relating to an Investment in Our Common Stock
The price of our common stock may fluctuate significantly, and this may make it difficult for you to resell your shares of our common stock when you want or at prices you find attractive. The price of our common stock on the NASDAQ Global Market constantly changes. We expect that the market price of our common stock will continue to fluctuate. The market price of our common stock may fluctuate in response to numerous factors, many of which are beyond our control. These factors include the following:
In addition, the stock markets from time to time experience extreme price and volume fluctuations that may be unrelated or disproportionate to the operating performance of companies. These broad fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance.
Future sales of our common stock or equity-related securities in the public market, including sales of our common stock pursuant to share lending agreements or in short sales transactions by purchasers of convertible notes securities, could adversely affect the trading price of our common stock and our ability to raise funds in new stock offerings. Sales of significant amounts of our common stock or equity-related securities in the public market, including sales pursuant to share lending agreements, or the perception that such sales will occur, could adversely affect prevailing trading prices of our common stock and could impair our ability to raise capital through future offerings of equity or equity-related securities. No prediction can be made as to the effect, if any, that future sales of shares of common stock or the availability of shares of common stock for future sale, including sales of our common stock in short sales transactions by purchasers of the notes, will have on the trading price of our common stock.
We have the ability to issue preferred shares without shareholder approval. Our common shares may be subordinate to classes of preferred shares issued in the future in the payment of dividends and other distributions made with respect to common shares, including distributions upon liquidation or dissolution. Our articles of incorporation permit our board of directors to issue preferred shares without first obtaining shareholder approval. If we issued preferred shares, these additional securities may have dividend or liquidation preferences senior to the common shares. If we issue convertible preferred shares, a subsequent conversion may dilute the current common shareholders interest.
Our executive officers, directors and parties related to them, in the aggregate, control a majority of our voting stock and may have the ability to control matters requiring shareholder approval. Our executive officers, directors and parties related to them own a large enough stake in us to have an influence on, if not control of, the matters presented to shareholders. As a result, these shareholders may have the ability to control matters requiring shareholder approval, including the election and removal of directors, the approval of significant corporate transactions, such as any reclassification, reorganization, merger, consolidation or sale of all or substantially all of our assets and the control of our management and affairs. Accordingly, this concentration of ownership may have the effect of delaying, deferring or preventing a change of control of us, impede a merger, consolidation, takeover or other business combination involving us or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us, which in turn could have an adverse effect on the market price of our common stock.
Note Regarding Risk Factors
The risk factors presented above are all of the ones that we currently consider material. However, they are not the only ones facing our company. Additional risks not presently known to us, or which we currently consider immaterial, may also adversely affect us. There may be risks that a particular investor views differently from us, and our analysis might be wrong. If any of the risks that we face actually occur, our business, financial condition and operating results could be materially adversely affected and could differ materially from any possible results suggested by any forward-looking statements that we have made or might make. In such case, the trading price of our common stock could decline, and you could lose part or all of your investment. We expressly disclaim any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.
Our principal executive offices, comprising approximately 194,000 square feet, and our operations centers and collection facilities for our Credit Cards segment, comprising approximately 284,000 square feet, are located in leased premises in: Atlanta, Georgia; St. Cloud, Minnesota; North Wilkesboro, North Carolina; and Salt Lake
City, Utah. Our Investments in Previously Charged-Off Receivables segment principally operates out of the St. Cloud, Minnesota facility. Our Retail Micro-Loans segment is headquartered in Peachtree City, Georgia with approximately 19,000 square feet of leased space; its storefront locations in the various states in which they operate average approximately 1,550 square feet per store of leased space. Our Auto Finance segment principally operates out of Lake Mary, Florida in approximately 16,000 square feet of leased space, with additional operation centers in North Carolina, Nevada and Texas and branch locations in various states. We believe that our facilities are suitable to our business and that we will be able to lease or purchase such additional facilities as our needs require. During 2006, we signed an additional lease for approximately 400,000 square feet in Atlanta, Georgia, which in mid-2007 will serve as our principal executive offices and will replace most of our Atlanta-based operations centers and collection facilities. We currently are exploring sublease options related to our pre-existing Atlanta office leases.
We are involved in various legal proceedings that are incidental to the conduct of our business. In one of these legal proceedings, CompuCredit Corporation and five of our subsidiaries are defendants in a purported class action lawsuit entitled Knox, et al. vs. First Southern Cash Advance, et al, No 5 CV 0445, filed in the Superior Court of New Hanover County, North Carolina, on February 8, 2005. The plaintiffs allege that in conducting a so-called payday lending business, certain of our Retail Micro-Loans segment subsidiaries violated various laws governing consumer finance, lending, check cashing, trade practices and loan brokering. The plaintiffs further allege that CompuCredit is the alter ego of our subsidiaries and is liable for their actions. The plaintiffs are seeking damages of up to $75,000 per class member. We are vigorously defending this lawsuit. These claims are similar to those that have been asserted against several other market participants in transactions involving small balance, short-term loans made to consumers in North Carolina. As of December 31, 2006 we have not recorded any accruals related to this lawsuit.
No matters were submitted to a vote of security holders during the quarter ended December 31, 2006.
Our common stock is traded on the NASDAQ Global Select Market under the symbol CCRT. The following table sets forth, for the periods indicated, the high and low sales prices per share of our common stock as reported on the NASDAQ Global Select Market. As of February 22, 2007, there were approximately 74 holders of our common stock, not including persons whose stock is held in nominee or street name accounts through brokers, banks and intermediaries.
The closing price of our common stock on the NASDAQ Global Select Market on February 22, 2006 was $34.93.
We have never declared or paid cash dividends on our common stock and do not anticipate paying a cash dividend on our common stock in the foreseeable future. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity, Funding and Capital Resources.
We have determined that we are a well-known seasoned issuera determination that we made based on our closing stock price on February 6, 2007 and our having 19,313,616 non-affiliate shares outstanding on that date, excluding 5,677,950 of loaned shares.
In May 2006, our Board of Directors authorized a new program to repurchase up to an additional 10 million shares of our outstanding common stock. Under the plan, we can repurchase shares of our common stock from time to time, through June 30, 2008, either on the open market or through privately negotiated transactions in compliance with SEC guidelines. In August 2006 our pre-existing plan expired and as of December 31, 2006, we were authorized to purchase 10 million shares under the new plan. During 2006, we did not purchase any shares under either the pre-existing or our new plan. At our discretion, we may use acquired shares in treasury to satisfy option exercises and restricted stock grants. We will continue to evaluate our stock price relative to other investment opportunities and, to the extent we believe that the repurchase of our stock represents an appropriate return of capital, we will repurchase additional shares of our stock.
Equity Compensation Plan Information
We maintain the 1998 Stock Option Plan, the 2000 Stock Option Plan, the 2003 Stock Option Plan (collectively, the Option Plans), pursuant to which we may grant options to purchase shares of common stock to eligible persons. We also maintain the 2004 Restricted Stock Plan (the Restricted Stock Plan, together with the Option Plans, the Plans), pursuant to which we may grant shares of restricted stock to eligible persons. The following table provides information about option awards under the Plans as of the end of 2006.
The following graph compares the cumulative total shareholder return on our common stock from December 31, 2001 through December 31, 2006, with the cumulative return for the Russell 2000 Index and the NASDAQ Other Finance Index over the same period, assuming the investment of $100 on December 31, 2001, and reinvestment of all dividends. We have not paid dividends since our initial public offering.
The following tables set forth, for the periods indicated, selected consolidated financial and other data. You should read the selected consolidated financial and other data below in conjunction with our consolidated financial statements and the related notes and with Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, included within this Form 10-K. With the exception of the selected credit card data, we have derived the following selected financial data from our audited consolidated financial statements for the years ended December 31, 2006, 2005, 2004, 2003 and 2002.
We securitize a substantial majority of our credit card receivables in transactions that are treated as sales under GAAP. In these securitizations, we receive cash, retain an interest in the receivables that are securitized, retain the rights to receive cash in the future and retain the rights and obligations to service the accounts. As such, we remove the securitized receivables from our consolidated balance sheet. The performance of the underlying credit card receivables, however, will affect the future cash flows we actually receive. Various financial, operating and statistical data for the credit card receivables underlying the securitization structures for which we act as servicer are presented in the Credit Cards Segment discussion within Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations.
The following tables contain unaudited quarterly results for the years ended December 31, 2006 and 2005.
Selected Quarterly Financial Data
The following discussion should be read in conjunction with Item 6, Selected Financial Data, and our consolidated financial statements and the related notes included therein where certain terms have been defined.
This Managements Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements. We have based these forward-looking statements on our current plans, expectations and beliefs about future events. There are risks that our actual experience will differ materially from the expectations and beliefs reflected in the forward-looking statements in this section. See Cautionary Notice Regarding Forward-Looking Statements.
We are a provider of various credit and related financial services and products to or associated with the underserved, or sub-prime, consumer credit market, and to un-banked consumers. We serve these markets principally through our marketing and solicitation of credit card accounts and our servicing of various credit card receivables underlying both originated and acquired accounts. Because only financial institutions can issue general-purpose credit cards, we contract with third-party financial institutions pursuant to which the financial institutions issue general purpose Visa and MasterCard credit cards and we purchase the receivables relating to such accounts on a daily basis. We market to cardholders other fee-based products, including credit monitoring/identity theft, health discount programs, shopping discount programs, debt waiver and life insurance. Our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range are now a significant source of growth and profitability for us. At December 31, 2006, the gross face amount of credit card receivables underlying these product offerings was $732.0 million.
Our product and service offerings also include small-balance, short-term cash advance loans (generally less than $500 for less than 30 days and to which we refer as micro-loans), installment loans and stored-value cards marketed through various channels, including retail branch locations, direct marketing, telemarketing and the Internet. We also originate auto loans through franchised auto dealers, purchase and/or service auto loans from or for a pre-qualified network of dealers in the Buy Here/Pay Here used car business, and originate, purchase and/or service motorcycle, all-terrain vehicle, personal watercraft and similar loans through, from or for pre-qualified networks of dealers in these products. Lastly, our licensed debt collections subsidiary purchases and collects previously charged-off receivables from us, the trusts that we service and third parties.
Our business experienced several significant changes in 2006:
Throughout 2007 and beyond, our shareholders should expect us to continue to evaluate and pursue additional credit card receivables portfolios and other business activities and asset classes that are complementary to our historic sub-prime credit card business. For instance, in February 2007, we acquired the business of ACC, an originator and servicer of auto loans generated by franchised auto dealers, and a related portfolio of auto loans.
We also expect to continue growing our traditional originated portfolio and our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. However, these operations are heavily regulated and over time there will be changes to how we conduct our operations. For example, in response to comments about minimum payments and negative amortization received from the FDIC in the course of its examinations of the banks that issue credit cards on our behalf, during the third and fourth quarters of 2006 we discontinued billing finance charges and fees on credit card accounts that become over 90 days delinquent. This change had adverse effects on our third and fourth quarter net interest margins and other income ratios associated with our securitized managed receivables, and we expect it to have an adverse net effect on our net interest margin and other income ratios associated with our securitized managed receivables during the first quarter of 2007. Thereafter, however, we expect this change to positively impact our net interest margin and other income ratios associated with our securitized managed receivables because we no longer will experience any charge offs of finance charges and fees no longer billed on these delinquent accounts.
Also, in June 2006, we entered into an assurance agreement with the New York Attorney General in order to resolve his investigation into our marketing and other materials and our servicing and collection practices. Pursuant to this agreement, we agreed to pay a $0.5 million civil penalty to the State of New York and to refund certain fees to New York cardholders primarily in recognition that New York has a unique statute (New York Personal Property Law Section 413) relating to, among other things, the opening of credit card accounts.
Moreover, in June 2006, the FDIC commenced an investigation of the policies, practices and procedures used in connection with our longest standing third-party credit card originating financial institution relationship. In December 2006, the FTC commenced a related investigation. In general, the investigations focus upon whether marketing and other materials contained misrepresentations regarding, among other things, fees and credit limits and whether servicing and collection practices were conducted in accordance with applicable law. We have provided substantial information to both the FDIC and FTC, and we continue to respond to their requests. The FDIC and FTC have proposed limitations on certain marketing, servicing and collection practices, reimbursement of various types of fees to affected customers and the payment of fines. The matters under investigation involve a significant amount of fees and a substantial number of accounts, and it is premature to determine the outcomes of these investigations or their effects on our financial condition, results of operations or business position and consolidated financial statements. However, we believe that our marketing and other materials and servicing and collection practices comply with applicable law, and we intend to vigorously contest the limitations and other proposals of the FDIC and FTC.
We remain focused on making good economic decisions that will result in high returns on equity to our shareholders over a long-term horizon. While our decisions may make economic sense, they may also result in volatile earnings under GAAP as a result of the accounting requirements for securitizations under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, (Statement No. 140). To the extent that we grow our overall portfolio of credit card receivables (through origination, acquisition or other new channels) and then securitize these assets, we will have securitization gains or losses, which may be material. (This occurred, for example, in the third quarter of 2004 and in the first and third quarters of 2005.) For further discussion of our historic results and the impact of securitization accounting on our results, see the Results of Operations and Liquidity, Funding and Capital Resources sections below, as well as our consolidated financial statements and the notes thereto included herein.
RESULTS OF OPERATIONS
Year Ended December 31, 2006, Compared to Year Ended December 31, 2005
Total interest income. Total interest income consists primarily of finance charges and late fees earned on loans and fees receivable that we have not securitized in off-balance-sheet securitization transactionsprincipally receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and our Auto Finance segment. The $172.5 million increase when comparing 2006 to 2005 is primarily due to growth in credit card receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, as well as the fact that we did not complete our CAR acquisition within the Auto Finance segment until after the close of the first quarter of 2005. This new business line contributed $49.7 million to total interest income in 2006 compared to $36.7 million in 2005. Also included within total interest income (under the other category) is the interest income that we earned on our various investments in debt securities, including interest earned on bonds distributed to us from our equity-method investees, and on our subordinated, certificated interest in the Embarcadero Trust. Principal amortization has caused reductions in interest income levels associated with some of our bonds and the Embarcadero Trust interest. Nevertheless, our other interest income levels have increased year over year as interest paid on our investments in debt securities (typically in bonds issued by other third party asset-backed securitizations) has increased with our additional investments in these securities.
We expect continued growth in receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and within our Auto Finance segment. Unless we securitize these receivables in off-balance-sheet arrangements, this expected growth should translate into continued growth in our total interest income.
Interest Expense. Interest expense increased $18.5 million when compared to the prior year, principally due to interest expense associated with our issuance of an aggregate $550.0 million in Convertible Senior Notes in May and November of 2005, interest expense related to our March 2006 structured financing associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and a full year of interest costs during 2006 associated with our April 2005 CAR acquisition and its working capital-related debt. This increase would have been greater had we not incurred $11.0 million of interest expense in the second quarter of 2005 associated with a final settlement of an obligation to a lender that financed our original equity investment in CSG, an equity-method investee.
Fees and related income on non-securitized earning assets. The following table details (in thousands) the components of fees and related income on non-securitized earning assets for 2006, 2005 and 2004:
The $118.9 million increase in fees and related income on non-securitized earning assets during 2006 was largely attributable to:
These increases were partially offset by:
Because of the September 2005 securitization of the Fingerhut receivables, income associated with the Fingerhut receivables through the date of their de-securitization late in the fourth quarter of 2006 is primarily represented within fees and related income on securitized earning assets (as income from retained interests in credit card receivables) and as part of servicing income on our consolidated statements of operations. Because the portfolio of Fingerhut receivables is liquidating at a rapid rate, the income generated from this portfolio is much lower in 2006 than it has been in prior years. Because the debt facilities underlying the Fingerhut securitization had been amortizing at a more rapid rate than the rate of liquidation of the Fingerhut receivables, we de-securitized the Fingerhut receivables late in the fourth quarter of 2006. The income subsequent to this de-securitization is reflected above but was not meaningful when compared to the income earned in the prior year. As the portfolio now consists of under $20.0 million in receivables, we do not expect significant income to result from this portfolio in future periods.
The other category above includes unrealized gains and losses in both 2006 and 2005 associated with our investments in debt and equity securities that we classify as trading securities. It also includes 2005 gains on put options that we wrote on our stock and fees associated with our stored-value card, merchant credit, on-line micro-loan and third-party consumer finance receivable operations, none of which currently represents a significant activity for us. We expect to see continued income growth within the other category, as well as within our retail micro-loans fees and fees on non-securitized credit card receivables categories, throughout 2007 and beyond. We have these expectations in part because we significantly increased our purchases of debt and equity securities classified as trading securities during the third quarter of 2006. We expect future activity levels with respect to these securities commensurate with or even greater than 2006 levels, and we expect greater future volatility in realized and unrealized gains and losses taken into account with respect to these securities based on evolving future market conditions.
Provision for loan losses. Our provision for loan losses increased $371.9 million during 2006. This increase corresponds with our significant year-over-year growth in on-balance-sheet loans and fees receivable principally related to our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and our second quarter 2005 CAR acquisition.
Our provision for loan losses covers aggregate loss exposures on (1) principal receivable balances, (2) finance charges and late fees receivable underlying income amounts included within our total interest income category, and (3) other fees receivable. Although we do not expect to see any significant near-term degradation in
the credit quality of our on-balance-sheet loans and fees receivable, and while current delinquency and credit loss trends for these receivables generally look neutral to favorable on a vintage basis and with reference to our expectations, we do expect our provision for loan losses to increase in future quarters based on expected loans and fees receivable growth.
The percentage of our allowance for uncollectible loans and fees receivable to gross period-end loans and fees receivable at December 31, 2006 (22.6%) is higher than it was at September 30, 2006 (19.7%) and at December 31, 2005 (18.9%). Additionally, our provision for loan losses as a percentage of average gross loans and fees receivable in the fourth quarter of 2006 (18.8%) is higher than it was in the third quarter of 2006 (17.0%) and in the fourth quarter of 2005 (11.2%). The generally increasing trends between the third and fourth quarters as well as between 2005 and 2006 are explained principally by the following:
The following factors offset the trends noted within the above percentages:
Fees and related income on securitized earning assets. Fees and related income on securitized earning assets include (1) securitization gains and (2) income from retained interests in credit card receivables securitized and (3) returned-check, cash advance and other fees associated with our securitized credit card receivables, each of which is detailed (in thousands) in the following table for the years ended December 31, 2006, 2005 and 2004.
The $72.5 million increase in total fees and related income on securitized earning assets during 2006 reflects the following positive trends:
partially offset, however, by:
In our Credit Cards segment discussion below, we provide further details concerning delinquency and credit quality trends, which affect the level of our income from retained interests in credit card receivables securitized and fees on securitized receivables.
Servicing income. Servicing income decreased $52.3 million during 2006 due to receivables liquidations within our securitized purchased portfolios. Absent one or more significant credit card portfolio acquisitions, it is likely that servicing income will be lower than in the recent past as growth in servicing revenues associated with our serviced receivables within our originated portfolio master trust is unlikely to outpace decreases in servicing revenues associated with net liquidations of the securitized acquired portfolios.
Moreover, in February 2006, the FDIC effectively asked FDIC-insured financial institutions to cease cash advance and installment micro-loan activities conducted through processing and servicing agents such as our Retail Micro-Loans segment subsidiaries. We were conducting these retail micro-loan activities in four states and earned $5.9 million in servicing income from them during 2006, compared to $23.2 million in 2005. Because we have ceased these servicing operations, we expect no further servicing income associated with our Retail Micro-Loans segment. We converted the Retail Micro-Loans segments operations in two of the four affected states to a direct lending model, and we expect some of this lost servicing incomealbeit at substantially diminished amountsto be replaced by lending fees, which are reported within fees and related income on non-securitized earning assets.
Ancillary and interchange revenues. Ancillary and interchange revenues increased $14.4 million during 2006 primarily due to growth in both categories as a result of our origination of new credit card accounts, including those receivables that have been sold to our originated portfolio master trust and those associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. We typically experience higher ancillary revenues and higher purchasing volumes and associated interchange fees for newer cardholders than for more mature cardholders. As a result, we expect further growth in our ancillary and interchange revenues principally from our current emphasis on new account originations.
Equity in income of equity-method investees. Equity in income of equity-method investees increased $61.3 million during 2006 due to (1) improvements in the performance of receivables associated with our investment in our Transistor (33.3%) equity-method investee and our 47.5%-owned equity-method investee, (2) refinements in the assumptions used by our 47.5% owned equity-method investee within its Statement No. 140 model (as mentioned in Note 12, Off-Balance-Sheet Arrangements, to our consolidated financial statements included herein), (3) the late 2005 resumption of income within our then 50%-owned equity-method investee, CSG, which resulted from resumed cash flows from its underlying securitization trust after an extended several month blackout period, (4) our July 2006 purchase of an additional 11.25% interest in CSG, which increased our ownership interest to 61.25% and increased our income allocation (net of premium amortization) from this equity-method investee, and (5) a $36.2 million gain (of which our allocated share was $12.1 million) recognized by Transistor upon its September 2006 sale of its receivables pursuant to a Statement No. 140 transfer in exchange for a subordinated interest in a trust. We expect our equity-method investees to continue to contribute significantly to our equity in income of equity-method investees in successive quarters, albeit at levels that will diminish over time as we liquidate the receivables balances associated with these equity-method investees.
Total other operating expense. Total other operating expense increased by $99.2 million between 2005 and 2006 due principally to:
While we incur certain base levels of fixed costs associated with the infrastructure that we have built to support our growth and diversification into new products and services, the majority of our operating costs are highly variable based on the levels of receivables that we service (both for our own account and for others) and the pace and breadth of our search for, acquisition of and introduction of new business lines, products and services. We expect to continue growing and diversifying our business in 2007, and while certain unique expenses undertaken in 2006 may not be repeated and while we continue to derive cost reductions through our outsourcing and other cost-control efforts, we do expect to see continued growth in our total other operating expense levels (on a year-over-year and quarter-over-quarter comparative basis) based on growth that we plan to undertake. For example, we anticipate spending an average of just under $10.0 million more per quarter on marketing in 2007 than we spent in the fourth quarter of 2006.
We expect to incur higher operating costs in 2007 associated with the move of our corporate headquarters and other Atlanta, Georgia facilities to new buildings in mid-2007; among these higher costs are the physical costs of moving, the costs associated with a net increase in our total square footage being leased, heightened levels of technology spending associated with the move, the duplication of some facilities rental costs while we seek to sublease our existing facilities, potential loss recognition if we determine that we are unable to sublease our existing facilities at lease rates in excess of the costs of our existing leases, additional depreciation for leasehold improvements and additional furniture & fixtures related to the new lease and accelerated depreciation associated with shortened useful lives of our leasehold improvements within our existing facilities.
Minority interests. We reflect the ownership interests of minority holders of equity in our majority-owned subsidiaries (including management team holders of restricted shares in our subsidiary entities as referenced in Note 20, Stock-Based Compensation, to our consolidated financial statements included herein) as minority interests in our consolidated statements of operations. The minority interests expense associated with these subsidiaries totaled $12.9 million and $13.3 million for 2006 and 2005, respectively. Generally, this expense is declining, which is consistent with liquidations of acquired credit card portfolios within securitization trusts, the retained interests of which are owned by our majority-owned subsidiaries, and the resulting relative contributions of our majority-owned subsidiaries (as discussed in Fees and related income on securitized earning assets, above) to income from retained interests in credit card receivables securitized as noted above.
Income taxes. Our effective tax rate was 36.0% for 2006, compared to 36.5% for 2005. The decrease of 0.5% in our effective tax rate between 2006 and 2005 is principally due to the favorable state income tax effects of several of our recent expansion and diversification initiatives.
Year Ended December 31, 2005, Compared to Year Ended December 31, 2004
Total interest income. Total interest income consists primarily of finance charges and late fees earned on our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range and interest and fee income associated with our CAR operations within our Auto Finance segment, which we acquired in April of 2005. The approximate $84.9 million increase when comparing 2005 to 2004 was primarily due to
growth in our credit card receivables associated with our largely fee-based credit card offerings to customers at the lower end of the FICO scoring range, as well the addition of our Auto Finance segment and its related loans receivable, none of which we have securitized. Also included within total interest income (under the other category) is the interest income that we have earned on our interest-bearing cash accounts and various investments in debt securities, including interest earned on CSG Trust bonds and on our subordinated, certificated interest in the Embarcadero Trust. Principal amortization caused reductions in interest income levels associated with our CSG Trust bonds and the Embarcadero Trust interest. Nevertheless, our other interest income levels increased between 2004 and 2005 due to other bond investments that we made (typically in bonds issued by other third-party asset backed securitizations) throughout 2004 and 2005 and given the cash deposits that we accumulated in interest-bearing accounts during 2005 associated with our $250.0 million and $300.0 million Convertible Senior Notes offerings and our receipt of $143.0 million in cash from the sale of assets within our Investments in Previously Charged-Off Receivables segment.
Interest Expense. Interest expense increased $29.2 million in 2005 when compared to 2004, principally due to an $11.0 million final settlement of our obligations to a lender that financed our original equity investment in CSG, an equity-method investee. Under the terms of the original loan agreement, in addition to principal payments to be made, which were repaid during the fourth quarter of 2002, the lender was entitled to receive 15% of all future excess cash flows we receive from our investment in CSG. Because of our $11.0 million settlement payment to the lender, we became entitled to receive 100% of all future excess cash flows attributable to our investment in CSG; we started receiving these excess cash flows (and hence began realization of the benefits of our settlement payment to the lender) during the fourth quarter of 2005. Additional 2005 interest costs were associated with:
Fees and related income on non-securitized earning assets. The increase during 2005 of $235.5 million in fees and related income on non-securitized earning assets was largely attributable to:
The bulk sale of previously charged-off receivables transaction is discussed further in the specific segment discussion for our Investments in Previously Charged-Off Receivables segment. Because of the September 2005
securitization of the Fingerhut receivables, income from then through late in the fourth quarter of 2006 associated with the Fingerhut receivables is represented exclusively within fees and related income on securitized assets (as income from retained interests in credit card receivables) and as part of servicing income on our consolidated statements of operations. Upon securitization of these receivables in September 2005, we recorded a securitization gain (as part of fees and related income on securitized earning assets on our consolidated statement of operations) of $31.6 million.
The other category above includes gains on put options that we wrote on our stock, gains associated with our investments in securities and fees associated with our stored-value card, merchant credit, on-line micro-loan and third-party consumer finance receivable servicing operations, none of which represented significant activities for us in either 2005 or 2004.
Provision for loan losses. Our provision for loan losses increased to $140.7 million in 2005, from $61.9 million in 2004. The $78.8 million increase was principally due to significant year-over-year growth in on-balance-sheet loans and fees receivable related to: (1) our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range; (2) our Retail Micro-Loans segment acquisitions, two of which occurred in the second and third quarters of 2004; and (3) our second quarter 2005 Auto Finance segment acquisition.
The provision for loan losses is provided to cover aggregate loss exposures on (1) principal receivable balances, (2) finance charges and late fees receivable underlying income amounts included within our total interest income category, and (3) other fees receivable. Our provision for loan losses as a percentage of average loans and fees receivable in 2005 was significantly lower than 2004, principally due to our acquisition of CAR during the second quarter of 2005 and the attendant lower loan losses for this business as described above. The effects of our CAR acquisition also account for the reduction in the ratio of our allowance for uncollectible loans and fees receivable as a percentage of period-end loans and fees receivable at December 31, 2005, versus recent prior quarters. Another factor favorable to the above ratios is $20.9 million of a new 2005 category of receivables within our retail micro-loan operations for which we have low loss expectations given underlying credit enhancements in the form of corporate guarantees and bank-issued standby letters of credit; we did not provide an allowance for these loans receivable because we did not expect to see any charge offs of these receivables. Lastly, the aforementioned ratios were also favorably influenced in 2005 by the improved overall credit environment that we experienced within our portfolio of credit card and auto finance loans and fees receivable.
Fees and related income on securitized earning assets. Fees and related income on securitized earning assets decreased $30.4 million as a result of the following trends:
Servicing income. Servicing income increased $50.8 million due in part to the growth in receivables in our originated portfolio master trust throughout 2005 as well as $18.8 million higher servicing fees realized during 2005 for the two term securitization facilities issued out of the originated portfolio master trust in October 2004. These two term securitization facilities permitted an increase in our servicing rates to 4.0% (i.e., from the 0.1% level that we have historically experienced for facilities issued out of our originated portfolio master trust). Also contributing to the servicing income increases were (1) $6.4 million of higher retail micro-loan processing and servicing fees during 2005 when compared to the prior year and (2) the addition of servicing income related to the $92.0 million (face amount) in receivables that we acquired and securitized during the third quarter of 2004, the $996.5 million (face amount) in receivables that our equity-method investee, Transistor, acquired during the fourth quarter of 2004, the $376.3 million (face amount) in receivables that our newest equity-method investee acquired during the first quarter of 2005 and the $72.1 million (face amount) in receivables that we acquired during the first quarter of 2005.
The above-noted servicing income increases were offset partially by declines in the Embarcadero Trust and CSG Trust managed receivables and the third quarter 2004 de-securitization of the Fingerhut receivables (which were subsequently re-securitized in September 2005). The de-securitization of the Fingerhut receivables in the third quarter of 2004 resulted in a year-over-year reduction of $16.1 million in servicing revenues, relative to 2004.
Ancillary and interchange revenues. Ancillary and interchange revenues increased $4.7 million primarily due to growth in both categories as a result of the addition of new accounts in our originated portfolio master trust, growth in our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, as well as the addition of new purchased portfolios. We typically experience higher purchasing volumes and higher associated interchange fees for newer cardholders than for more mature cardholders. As a result, our 2005 emphasis on new account additions produced higher interchange revenues.
Equity in income of equity-method investees. Equity in income of equity-method investees increased $43.6 million principally due to income associated with our investments in our Transistor and Capacitor (33.3% each) equity-method investees made during the fourth quarter of 2004 and our first quarter 2005 investment in a 47.5%-owned equity-method investee that acquired a credit card receivables portfolio in that same quarter. Additionally, our then 50%-owned equity-method investee, CSG, began to receive cash flows again from its underlying securitization trust after an extended blackout period, thereby resulting in the resumption of its recognition of income from retained interests in credit card receivables securitized (and hence our income in this equity-method investee).
Total other operating expense. Total other operating expense increased by $177.4 million between 2004 and 2005 principally due to:
Relative to average managed receivables levels, our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range are more costly products than the credit card products underlying our originated portfolio master trust and acquired portfolios. There are a far greater number of accounts and hence touches of the consumer for each $1 million of managed receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range than for the receivables underlying our other credit card products.
Minority Interests. The ownership interests of minority holders of equity in our majority-owned subsidiaries are reflected as minority interests in our consolidated statements of operations. The minority interests expense associated with these subsidiaries totaled $13.3 million in 2005 versus $22.3 million in 2004. These trends are consistent with the relative contributions of two of our majority-owned subsidiaries to income from retained interests in credit card receivables securitized as discussed above, offset by the adverse effects of increased bankruptcy charge offs experienced in the fourth quarter. One of our majority-owned subsidiaries owns the retained interests in the Embarcadero Trust, and another owns the retained interests in the trust that we formed in 2004 to facilitate the securitization of $92.0 million (face amount) of credit card receivables acquired in the third quarter of 2004 and $72.1 million (face amount) of credit card receivables acquired in the first quarter of 2005. For more details, see the above discussion of purchase discount effects and receivables mix changes in the analysis of income from retained interests in credit card receivables securitized trends.
Additionally, certain of our subsidiaries (comprising our Investments in Previously Charged-Off Receivables segment, our Retail Micro-Loans segment and our Other segment) have management team members who are minority owners for which we record minority interests. The minority interests associated with these minority holders are not material to our financial statements.
Income Taxes. Our effective tax rate was 36.5% for 2005 compared to 35.9% for 2004. The 0.6% increase in our effective tax rate between 2004 and 2005 is principally due to our expansion into additional state tax jurisdictions through acquisitions which have caused us to incur tax liability in those jurisdictions. See Note 18, Income Taxes, to our consolidated financial statements included herein for further explanation of income tax expense and a reconciliation of reported income taxes to the amount that would be computed using the federal statutory rate.
Credit Cards Segment
Included at the end of this Credit Cards Segment section under the heading Definitions of Financial, Operating and Statistical Measures are definitions for various terms that we use throughout our discussion of the Credit Cards segment.
Our Credit Cards segment consists of our credit card investment and servicing activities, as conducted with respect to receivables underlying accounts originated and portfolios purchased by us. This segment represents aggregate activities associated with substantially all of our credit card products, including our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Because we have not securitized the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range through an off-balance-sheet securitization, revenues associated with these offerings include interest income (along with late fees), fees and related income. With respect to our securitized credit card receivables (which represent a substantial majority of our credit card receivables), our fees and related income on securitized earning assets within the Credit Cards segment include (1) securitization gains, (2) income from retained interests in credit card receivables securitized and (3) returned-check, cash advance and other fees associated with our securitized credit card receivables. Also within our Credit Cards segment are equity in the income of equity-method investees and servicing income revenue sources. We earn servicing income from the trusts underlying our securitizations and the securitizations of our equity-method investees. Our revenue categories most affected by delinquency and credit loss trends are the net interest income, the fees and related income on non-securitized earnings assets (which are net of a provision for loan losses) and the income from retained interests in credit card receivables securitized categories.
For our credit card securitizations that qualify for sale treatment under GAAP, we remove the securitized receivables from our consolidated balance sheet. The performance of the underlying credit card receivables will nevertheless affect the future cash flows we actually receive. Various references within this section are to our managed receivables, which include our non-securitized credit card receivables and the credit card receivables underlying our off-balance-sheet securitization facilities. Managed receivables data also include our equity interest in the receivables that we manage for our equity-method investees but exclude minority interest holders shares of the receivables we manage for our majority-owned subsidiaries.
Financial, operating and statistical data based on these aggregate managed receivables are key to any evaluation of our performance in managing (including underwriting, valuing purchased receivables, servicing and collecting) the aggregate of the portfolios of credit card receivables reflected on our balance sheet and underlying our securitization facilities. In allocating our resources and managing our business, management relies heavily upon financial data and results prepared on a so-called managed basis. It is also important to analysts, investors and others that we provide selected financial, operating and statistical data on a managed basis because this allows a comparison of us to others within the specialty finance industry. Moreover, our management, analysts, investors and others believe it is critical that they understand the credit performance of the entire portfolio of our managed receivables because it reveals information concerning the quality of loan originations and the related credit risks inherent within the securitized portfolios and our retained interests in our securitization facilities.
Managed receivables data assume that none of the credit card receivables underlying our off-balance-sheet securitization facilities was ever transferred to securitization facilities and present the net credit losses and delinquent balances for the receivables as if we still owned the receivables. Reconciliation of the managed receivables data to our GAAP financial statements requires: (1) recognition that a significant majority of our credit card loans and fees receivable (i.e., all but $760.8 million of GAAP credit card loans and fees receivable at gross face value) had been sold in securitization transactions as of December 31, 2006; (2) an understanding that our managed receivables data are based on billings and actual charge offs as reported to us through underlying systems of record (i.e., without regard to an allowance for uncollectible loans and fees receivable); (3) a look-through to our economic share of (or equity interest in) the receivables that we manage for our equity-method investees; (4) removal of our minority interest holders interests in the managed receivables underlying our GAAP consolidated results; and (5) recognition that our Fingerhut managed receivables were recorded at a $0.0 basis in our GAAP financial statements prior to our re-securitization of these receivables in September 2005.
The period-end and average managed receivables data (as well as delinquency and charge off statistics) that follow within this section exclude receivables associated with accounts in late delinquency status in sellers hands as of the dates of our acquisitions of the receivables or interests therein. Pursuant to this treatment, the only activity within the following statistical data associated with these excluded accounts are recoveries, which we include within the numerator of the other income ratio computation, as well as the costs of pursuing these recoveries, which we include within the numerator of the operating ratio computation. Summarized (in thousands) in the table below are the numbers of managed accounts underlying our acquisitions, as well as the numbers of those accounts that have been excluded from our credit card data because they were in a late stage delinquency status at the time of our purchases.
We typically have purchased credit card receivables portfolios at substantial discounts. A portion of each acquisition discount is related to the excluded receivables and accounts described above. Another portion of each discount relates to the credit quality of the remaining acquired receivables, which we calculate as the difference between the face amounts of the receivables purchased (less the excluded receivables described above) and the future cash flows we expect to collect from the receivables. We refer to the balance of the discount for each purchase not needed for credit quality as accretable yield, which we accrete into net interest margin using the interest method over the estimated life of each acquired portfolio. As of the close of each financial reporting period, we evaluate the appropriateness of the credit quality discount component of our acquisition discount and the accretable yield component of our acquisition discount based on actual and projected future results. Prior to the third quarter of 2003, we never had determined that the amount allocated to credit quality discount exceeded the needed amount. Accordingly, no adjustments to accretable yield had occurred. In the third quarter of 2003, however, we determined that the amount allocated to credit quality discount exceeded the needed amount for one of the portfolios acquired in 2002. Accordingly, in our third quarter of 2003 we reallocated $98.4 million of unused credit quality discount to our accretable yield for amortization into our net interest margin using the effective yield method over the remaining estimated life of the receivables underlying the acquired portfolio. For similar reasons, and for the same portfolio for which the reallocation was performed in the third quarter of 2003, we reallocated $28.0 million of additional unused credit quality discount to accretable yield in the second quarter of 2005. Lastly, for this same portfolio, we determined in the fourth quarter of 2006 that the acquired receivables had completely turned over, yet there was a remaining balance of $3.7 million in unused credit quality discount on the date the acquired receivables had turned over; accordingly, this $3.7 million in unused credit quality discount was fully absorbed against fourth quarter 2006 net charge offs. These particular adjustments do not affect our reported GAAP income, but do affect the amounts included within this discussion of our Credit Cards segment data, in particular net interest margin and adjusted net charge offs.
The following table summarizes (in millions), for acquisitions occurring in 2004 through 2006, the discount components associated with our economic interests in the acquired portfolios.
Zero balances in the two above tables for 2006 reflect the fact that we did not acquire any credit card receivables portfolios during 2006.
Our delinquency and charge off data at any point in time reflect the credit performance of our managed receivables. The average age of our credit card accounts, the timing of portfolio purchases, the success of our collection and recovery efforts and general economic conditions all affect our delinquency and charge off rates. The average age of our credit card receivables portfolio also affects the stability of our delinquency and loss rates. We consider the delinquency and charge off data reflected herein in determining our allowance for uncollectible loans and fees receivable with respect to our non-securitized earning assets, net on our consolidated balance sheets, as well as the valuation of our retained interests in credit card receivables securitized which is a component of securitized earning assets on our consolidated balance sheets. As we charge off receivables, we reflect the charge offs of non-securitized receivables within our provision for loan losses, and we reflect the charge offs of securitized receivables as an offset in determining income from retained interests in credit card receivables securitized (within fees and related income on securitized earning assets) on our consolidated statements of operations.
Late in the third quarter and continuing into the fourth quarter of 2006, we discontinued our practice of billing finance charges and fees on credit card accounts that become over 90 days delinquent. Prior to this change our policy was to bill finance charges and fees on all credit card accounts, except in limited circumstances, until we charged off the account and all related receivables, finance charges and other fees. In such prior periods, however, we excluded from our GAAP income and gross yield, net interest margin and other income ratio managed receivables data the finance charge and fee income on all significantly delinquent on-balance-sheet credit card receivables for which we believed that collectibility was significantly in doubt on the date of billing. As such, we do not expect that our change in practice will affect managed receivables charge off data associated with our on-balance-sheet credit card receivables. We do expect such data to be affected, however, with respect to our securitized off-balance-sheet managed receivables.
Our strategy for managing delinquency and receivables losses consists of account management throughout the customer relationship. This strategy includes credit line management and pricing based on the risks of the credit card accounts. See also our discussion of collection strategies under the heading How Do We Collect from Our Customers? in Item 1, Business, above.
Delinquencies. Delinquencies have the potential to impact net income in the form of net credit losses. Delinquencies are also costly in terms of the personnel and resources dedicated to resolving them. We intend for the account management strategies that we use on our portfolio to manage and, to the extent possible, reduce the higher delinquency rates that can be expected in a more mature managed portfolio such as ours. These account management strategies include conservative credit line management, purging of inactive accounts and collection strategies (as described under the heading How Do We Collect from Our Customers? in Item 1, Business, above) intended to optimize the effective account-to-collector ratio across delinquency buckets. We measure the success of these efforts by measuring delinquency rates. These rates exclude accounts that have been charged off.
The following table presents the delinquency trends of the credit card receivables that we manage (in thousands; percentages of total):
The increases in our 30-plus day delinquencies and 60-plus day delinquencies between December 31, 2005 and December 31, 2006 are predominantly attributable to growth in our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, the receivables of which experience greater delinquency and charge-off levels than we experience with respect to our other credit card receivables. As these receivables underlying our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range become a larger component of our overall managed receivables balance as we expect that they will over the next several quarters, we expect this mix change to cause further trending increases in our overall delinquency and charge-off levels. Additionally, given the shorter life cycle of many of the accounts underlying the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, we can also expect some volatility in our delinquency statistics based on the timing and relative volumes of quarterly account growth underlying these receivables. We believe that the heightened delinquency and charge-off levels and greater volatility in our delinquency statistics associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range are reasonable based on the relative returns offered. Our expected future trending increases in delinquencies associated with the aforementioned mix change should be offset to some degree, albeit somewhat modestly, by our decision to cease finance charge and fee billings on credit card accounts once they become over 90 days delinquent as mentioned above.
While most of the trending increases in delinquencies are attributable to the above-discussed structural shift in our managed receivables portfolio to a portfolio with a far greater and increasing percentage of receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, we have also experienced higher delinquency rates overall relative to the exceptionally low levels we had seen in 2005 and in the first half of 2006. Nevertheless, our credit card receivables continue to perform in line with our expected vintage performance levels. Moreover, based on our analyses of vintage data, we continue to be pleased with the overall credit quality of our managed receivables, including those underlying our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. In fact, based on delinquency roll rates we have seen subsequent the close of 2006, we actually are seeing some improvements in roll rates that cause us to be optimistic that we will realize credit quality improvements in 2007.
Charge offs. We generally charge off credit card receivables when they become contractually 180 days past due or within 30 days of notification and confirmation of a customers bankruptcy or death. However, if a cardholder makes a payment greater than or equal to two minimum payments within a month of the charge off date, we may reconsider whether charge off status remains appropriate. Additionally, in some cases of death, receivables are not charged off if, with respect to the deceased customers account, there is a surviving, contractually liable individual or an estate large enough to pay the debt in full.
The following table presents charge off data (dollars in thousands; percentages annualized) for: (1) all of the credit card receivables underlying the securitizations by our consolidated subsidiaries (adjusted to exclude the receivables associated with minority interest holders equity in our majority-owned consolidated subsidiaries); (2) our respective 61.25%, 33.3% and 47.5% shares of the receivables that we manage on behalf of our equity-method investees; and (3) all non-securitized credit card receivables ($760.8 million face amount of receivables at December 31, 2006), including the Fingerhut receivables while they were held on balance sheet and the receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range.
Factors relevant to an analysis of this table are as follows:
Definitions of Financial, Operating and Statistical Measures
Adjusted charge offs. Represents principal net charge offs as adjusted to apply a discount related to the credit quality of acquired portfolios to offset a portion of actual net charge offs. Historically, upon our acquisitions of credit card receivables, a portion of the discount reflected within our acquisition prices relates to the credit quality of the acquired receivablesthat portion representing the excess of the face amount of the receivables acquired over the future principal cash flows expected to be collected from the receivables. Because we treat the credit quality discount component of our acquisition discount as related exclusively to acquired principal balances, the difference between our net charge offs and our adjusted charge offs for each respective reporting period represents the total dollar amount of our charge offs that were charged against our credit quality discount during each respective reporting period.
Combined gross charge offs. Represents the aggregate amounts of accrued finance charge, fee and principal losses from customers unwilling or unable to pay their receivables balances, as well as bankrupt and deceased customers, less current-period recoveries. Recoveries on managed receivables represent all amounts received related to managed receivables that previously have been charged off, including payments received directly from customers and proceeds received from the sale of those charged off receivables. Recoveries typically have represented less than 2% of average managed receivables.
Gross yield ratio. Represents billed finance charges and late fees (annualized) as a percentage of average managed receivables.
Net charge offs. Includes only the principal amount of losses, net of recoveries (and it excludes accrued finance charge and fee charge offs, which are charged against the related income item at the time of charge-off, as well as losses from fraudulent activity in accounts, which are included separately in other operating expenses).
Net interest margin. Represents an annualized fraction, the numerator of which includes all accrued finance charge and late fee income billed on all outstanding receivables, plus amortization of the accretable yield component of our acquisition discounts for portfolio purchases, less interest expense associated with portfolio-specific debt and securitization facilities and accrued finance charge and late fee charge offs, and the denominator of which is average managed receivables. Net interest margins are influenced by a number of factors, including (1) the level of accrued finance charges and late fees billed, (2) the weighted average cost of funds underlying portfolio-specific debt or within our securitization structures, (3) amortization of the accretable yield component of our acquisition discounts for portfolio purchases and (4) the level of our accrued finance charge and late fee charge offs. On a routine basis, generally no less frequently than quarterly, we re-underwrite our portfolio to price our products to appropriately reflect the level of each customers credit risk. As part of this underwriting process, existing customers may be offered increased or decreased pricing depending on their credit risk, as well as their supply of and demand for credit. Increases in pricing may increase our net interest margin, while decreases in pricing may reduce our net interest margin.
Operating ratio. Represents an annualized fraction, the numerator of which includes all expenses associated with our Credit Cards segment, net of any servicing income we receive from third parties associated with our role
as servicer, other than marketing and solicitation and ancillary product expenses, and the denominator of which is average managed receivables.
Other income ratio. Represents an annualized fraction, the numerator of which includes credit card fees (including over-limit fees, cash advance fees, returned check fees and interchange income), plus earned, amortized amounts of annual membership fees and activation fees with respect to certain of our credit card products, plus ancillary product income, less all fee charge offs (with the exception of late fee charge offs, which are netted against the net interest margin), and the denominator of which is average managed receivables.
Investments in Previously Charged-Off Receivables Segment
For 2006 and 2005, the following table shows a roll-forward of our investments in previously charged-off receivables activities (in thousands of dollars):
The above table reflects our use of the cost recovery method of accounting for our investments in previously charged-off receivables. Under this method, we establish static pools consisting of homogenous accounts and receivables for each portfolio acquisition. Once we establish a static pool, we do not change the receivables within the pool. We record each static pool at cost and account for it as a single unit for payment application and income recognition purposes. Under the cost recovery method, we do not recognize income associated with a particular portfolio until cash collections have exceeded the investment. Additionally, until such time as cash collected for a particular portfolio exceeds our investment in the portfolio, we will incur commission costs and other internal and external servicing costs associated with the cash collections on the portfolio investment that we will charge as an operating expense without any offsetting income amounts.
In June 2005, the subsidiary that comprises our Investments in Previously Charged-Off Receivables segment sold a portfolio of charged-off credit card receivables having a face amount of $2.9 billion to Encore and agreed to sell Encore up to $3.25 billion in face amount of future charged-off credit card receivables at an established price over the next five years. As consideration for these transactions, the subsidiary received $143.0 million in cash. The purchase price included $76.0 million related to the portfolio of charged-off credit card receivables and $67.0 million related to the forward flow contract. The sale of the portfolio of charged-off credit card receivables resulted in a gain of $69.6 million, which has been recorded in fees and related income on non-securitized earning assets on our consolidated statements of operations for 2005. Ten million dollars of the $67.0 million in deferred revenue related to the forward flow contract is required to be held in escrow until the performance of certain conditions under the contract and is included in restricted cash on our consolidated balance sheet; as such, this $10 million will be excluded from income recognition computations until the conditions are satisfied. The remaining $57.0 million of deferred revenue will be recognized into income over the life of the contract as our subsidiary delivers its associated volumes of charged-off credit card receivables to Encore. Based on the forward flow contract, our subsidiary is expected to purchase for delivery to Encore over
the life of the contract certain previously charged-off receivables from trusts, the receivables of which are serviced by us, as well as certain previously charged-off receivables associated with our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range. Any shortfalls in delivery of minimum periodic dollar amounts of previously charged-off receivables to Encore could result in the subsidiary being required to return a portion of the purchase price related to the forward flow contract. As of December 31, 2006, our subsidiary had delivered $950.1 million of associated volumes of charged-off credit card receivables to Encore under the forward flow contract.
Remaining after the Encore transaction are our pools of previously charged-off receivables associated with Chapter 13 Bankruptcies and our balance transfer program, which we expect to continue to service and grow through future acquisitions. We expect our Investments in Previously Charged-Off Receivables segment to continue its acquisition and collection of Chapter 13 Bankruptcies, its balance transfer program and other previously charged-off receivables activities throughout 2007 and beyond. Such activities will include the acquisition of previously charged-off receivables and the sale of these charge offs for a fixed sales price under its five-year forward flow contract with Encore.
We generally estimate the life of each pool of charged-off receivables that we typically acquire to be between 24 and 36 months for normal delinquency charged-off accounts and approximately 60 months for Chapter 13 Bankruptcies. We anticipate collecting approximately 41.2 % of the ERC of the existing accounts over the next twelve months, with the balance to be collected thereafter. Our acquisition of charged-off accounts through our balance transfer program results in receivables with a higher than typical expected collectible balance. As the composition of our defaulted accounts includes more of this type of receivables, the resulting estimated remaining collectible portion per dollar invested is expected to increase.
During 2006, our Investments in Previously Charged-off Receivables segments pre-tax income increased 34.4% compared to 2005 (after removing the effect of the $69.6 million initial gain on bulk sale of charged-off receivables to Encore), reflecting increased volumes of charged-off accounts sold under its 5-year forward flow agreement with Encore and continued growth in charged-off receivables purchases through its balance transfer and chapter 13 Bankruptcy purchasing niches. We expect our Investments in Previously Charged-off Receivables segment to continue its revenue and income growth.
Retail Micro-Loans Segment
The Retail Micro-Loans segment consists of a network of storefront locations that, depending on the location, provide some or all of the following products or services: (a) small-denomination, short-term, unsecured cash advances that are typically due on the customers next payday; (b) installment loan and other credit products; and (c) money transfer and other financial services. The assets associated with our retail micro-loan operations were principally acquired in two separate transactions completed during 2004. During the second quarter of 2004, our subsidiaries acquired substantially all of the assets of First American, including over 300 retail locations in twelve states, for $108.9 million. Representing an initial market entry into micro-loan and servicing activities, the First American acquisition provided a platform for future growth in this market. Subsequently, during the third quarter of 2004, our subsidiaries acquired substantially all of the assets of another micro-loan provider, Venture Services, including 166 retail locations, for $33.9 million. The Venture Services acquisition provided complementary locations in four existing states and added three new states. Also in January 2005, one of our subsidiaries acquired substantially all of the assets of another micro-loan provider for $11.9 million, including transaction costs; with this acquisition, we added an additional 39 stores in the State of Ohio. As of December 31, 2006, our Retail Micro-Loans segment subsidiaries operated a total of 475 storefront locations in 17 U.S. states as well as the United Kingdom.
The micro-loan market emerged in the early 1990s in response to a shortage of available short-term consumer credit alternatives from traditional banking institutions. We believe customers seek cash advance
micro-loans as a simple, quick and confidential way to meet short-term cash needs between paydays while avoiding the potentially higher costs and negative credit consequences of other financing alternatives, which include overdraft privileges or bounced-check protection, late bill payments, checks returned for insufficient funds and short-term collateralized loans.
In most of the states in which they historically have operated, our Retail Micro-Loans segment subsidiaries have made cash advance and other micro-loans directly to customers. However, in four states (Arkansas, Florida, North Carolina and West Virginia), they previously acted only as a processing and servicing agent for a state-chartered, FDIC-insured bank that issued loans to the customers pursuant to the authority of the laws of the state in which the bank was located and federal interstate banking laws, regulations and guidelines. During February 2006, we learned from our bank partner that the FDIC had effectively asked insured financial institutions to cease deferred presentment and installment micro-loan activities conducted through processing and servicing agents. In response to the FDICs actions, our subsidiaries began to evaluate strategic alternatives within theses states, including the possibility of switching to a direct lending model in compliance with the regulatory frameworks within each of the four states, or, alternatively, closing certain branch locations within the four affected states. In addition, effective March 11, 2006, our North Carolina Retail Micro-Loans segment subsidiary agreed with the Attorney General of the State of North Carolina to cease its traditional marketing and servicing of deferred-presentment and installment micro-loans in North Carolina. As a result of this agreement, our North Carolina Retail Micro-Loans segment subsidiary began pursuing a direct lending model in North Carolina in compliance with existing regulatory frameworks, as well as closing several North Carolina locations. Subsequently, during the second quarter of 2006, our subsidiaries decided to abandon the pursuit of these alternative lending models in both North Carolina and West Virginia, because they concluded that alternative lending products would not provide acceptable long-term returns for the business. By the end of the third quarter of 2006, our North Carolina subsidiary had closed all of its original 52 branch locations and our West Virginia subsidiary had closed all of its original 11 branch locations. In Arkansas, during the second quarter of 2006, we began offering loans directly to customers under an alternative lending model, in compliance with state regulations. This alternative lending model has been well-received by our customers, and, during the third quarter of 2006, we succeeded in returning our Arkansas operations to profitability. In Florida, the fourth state in which we previously processed and serviced micro-loans on behalf of our bank partner, we began operating under an alternative direct lending model in the fourth quarter of 2006. We obtained licensing approval from the State of Floridas Office of Financial Regulation in October 2006, and we expect our Florida operations to return to profitability in 2007.
As a result of the recent changes in regulatory positions by the FDIC, the originating bank for which we serviced micro-loans in the four affected states was required to exit that business prior to May 31, 2006. Because the originating bank planned to liquidate any loans existing as of that date through a loan participation relationship that it had with Maverick Management Company LLC (Maverick), we agreed to indemnify Maverick for up to $2.8 million in losses that it may incur as a result of its being a successor to the banks interest in the loans and their liquidation and recorded a reserve for this amount in the first quarter of 2006. Richard W. Gilbert, a member of our Board of Directors and our Chief Operating Officer, has a 20% economic interest in Maverick, and Mr. Gilberts son is its manager. As of December 31, 2006, we had paid claims submitted by Maverick of $1.6 million against this indemnification obligation. Additionally, we had accrued $0.2 million against this indemnification obligation as of December 31, 2006an amount we believe to be appropriate to cover additional indemnification claims expected in the future.
During the second quarter of 2006, our Retail Micro-Loans segment completed the process of converting our entire network of branches to a common information technology platform capable of supporting multiple products. We began testing this new platform in our stores during the latter half of 2005 and into 2006. Reflecting our strategy to convert our mono-line retail micro-loan branches into full service neighborhood financial centers, we expect our suite of products to include cash advance and installment micro-loans, auto insurance, debit cards, credit cards, check cashing, money transfer, money order, bill payment, auto title loans and tax preparation service assistance. In connection with the system conversion required to support these multiple products, our Retail Micro-Loans segment incurred additional travel, training and other operating expenses during both the first and second quarters of 2006.
During 2006, we opened 37 branch locations in the United States. These branch location openings include our initial market entries into Michigan, Texas and Nevada. Including store closings in North Carolina and West Virginia, we closed 72 stores during 2006. As of December 31, 2006, we operated 20 locations in the state of Texas, where our Texas micro-loans subsidiary offers and provides credit services under a credit services organization (CSO) program to customers who apply for micro-loans offered by an independent third-party lender. In addition to assisting customers with loan applications, if the customer is approved for and accepts the loan, our Texas subsidiary provides a letter of credit to the third party lender to secure the customers payment obligations in the event of a customer default. The customer is charged a fee under the CSO program (CSO fees) for the provision of these credit services. In addition to offering credit services in our Texas retail branch locations, we also began testing the marketing of credit services via the Internet to Texas residents during the third quarter of 2006. Though representing a different marketing channel, these credit services are offered under the same CSO program as the retail branch locations.
During the first half of 2006, we began exploring potential international market opportunities for our Retail Micro-Loans segment. As part of this effort, we focused on potential opportunities in the United Kingdom, where we believe customers will be receptive to the kind of multi-line financial centers that have characterized our recent store expansion strategy in the U.S. To test market receptiveness for our products in the United Kingdom, we opened 1 de novo store in the greater London area during the fourth quarter of 2006 and have opened 3 additional stores thus far in 2007.
Financial, operating and statistical metrics for our Retail Micro-Loans segment (including both U.S. and United Kingdom locations) are detailed (dollars in thousands) in the following tables.
The loss before income taxes for 2006 reflects impairment, indemnification, loan loss and other charges of $17.1 million (including $10.5 million of associated goodwill impairment) primarily related to operating changes resulting from the FDICs actions in February 2006. In addition, we continued to sustain significant operating losses in Florida into the fourth quarter of 2006 as we awaited licensing approval from the State of Floridas Office of Financial Regulation.
While the FDICs February 2006 actions have resulted in the losses cited above, we are pleased with the revenue growth evident in our core direct storefront micro-loan operations. Excluding fees we have earned in 2006 associated with our lending operations pursuant to certain CSO programs initiated by other micro-loan
providers during the third and fourth quarters of 2005, fees from our direct storefront operations increased from $79.9 million in 2005 to $92.4 million in 2006. We believe this growth demonstrates positive momentum and favorable operating trends in the core ongoing business of our Retail Micro-Loans segment. In 2007, we expect the new products we are rolling out under our multi-product line strategy to contribute to revenue growth within our Retail Micro-Loans segment, and we expect to see improved profitability, both overall and on a per-store basis.
The results for our Retail Micro-Loans segment operations during 2005 also reflect the impact of Hurricane Katrina. While Hurricane Rita did not affect our operations, we were forced to temporarily close 7 existing stores in Mississippi because of Hurricane Katrina, and we had to delay openings for certain planned store locations in Louisiana. Although all but one of the Mississippi stores were re-opened within a few days, we decided to ease our typical collection efforts with respect to affected customers in Mississippi, but this change did not materially impact the pre-tax results of our Retail Micro-Loans segment.
Auto Finance Segment
On April 1, 2005, we acquired Wells Fargo Financials CAR business unit for $121.5 million including transaction costs; this acquisition included all of CARs assets, business operations and employees. Upon acquisition, the business unit had approximately 300 employees and $128.9 million of auto-finance-related receivables (at face, net of unearned discounts) and operated in 38 states through its 12 branches, 3 regional processing centers and a national collection center at its Lake Mary, FL headquarters. This acquisition was part of our strategic plan to expand and diversify into other sub-prime asset classes and markets; as such, the purchase price reflected our estimate of fair value, which included our assessment of the cost associated with acquiring an established entity in this market versus the cost of new entry.
CAR consists of a nationwide network of pre-qualified auto dealers in the Buy Here/Pay Here used car business, from which CAR purchases auto loans at a discount or for which CAR services auto loans for a fee. CAR generates revenues on purchased loans through interest earned on the face value of the installment agreements combined with discounts on loans purchased. CAR generally earns discount income over the life of the applicable loan. Additionally, CAR generates revenues from servicing loans on behalf of dealers for a portion of actual collections and by providing back-up servicing for similar quality securitized assets. In the second quarter of 2006, CAR launched a new product, Dealer Equity Advance Loan (DEAL), whereby CAR earns interest income on a loan made directly to the dealer. In the DEAL program, the dealer maintains the responsibility to service the customer accounts securing the loan to the dealer. Also during the second quarter of 2006, CAR launched a contract custodial program to service smaller line of credit loan providers in the markets it services. In addition to these offerings, the business is in the process of forming strategic alliances with aftermarket product and service providers in an effort to cross-sell to their existing customer base and is testing its ability to cross-sell other CompuCredit and subsidiaries products to a select number of customers from within its existing customer base.
The number of CARs active dealers is a function of new dealer enrollments offset by dealer attrition within the states in which CAR is licensed. Dealers are certified by CAR upon being recruited by a sales force of approximately 60 resources located strategically throughout approved territories. As of December 31, 2006, CAR operated in 45 states and had approximately 1,200 active dealers.
During the first quarter of 2006, CAR completed a conversion from a system of record that it licensed from Wells Fargo Financial to a more robust system of record. Management expects the new system of record to support future growth through efficiencies created in the processing of new dealer relationships, new product offerings and potential portfolio acquisitions. Due to CARs unique product offerings and the customization required to accommodate these offerings, the system of record conversion required a significant amount of effort on the part of resources traditionally assigned to operations and sales. The system of record conversion, and the need for ongoing reconciliations between new system of record data and old system of record data for
delinquency and lender reporting purposes presented distractions for the CAR management team during much of 2006. These distractions, coupled with increases in delinquencies and charge offs that we believe were in part the result of these distractions, kept the CAR management team from meeting our 2006 growth goals for this business unit and contributed to a $2.3 million pre-tax loss for this business unit in the fourth quarter of 2006. We are optimistic that our CAR management resources have now successfully transitioned from work on the conversion and related post-conversion activities to efforts aimed at gaining operational efficiencies and additional market share. As such, we expect growth in receivables and associated revenues during 2007 and a return to profitability for this business unit in the first half of 2007.
We also expect our Auto Finance segment to realize receivables and income growth in 2007 based on our February 2, 2007 acquisition of the assets of San Diego-based ACC. ACC currently services approximately $275.0 million in auto finance receivables, operates in 12 states with collection centers in San Diego, California and Denver, Colorado and has approximately 170 employees. In conjunction with this purchase, we also acquired a $195.0 million auto loan portfolio from Patelco Credit Union. These assets were originated and are serviced by ACC on behalf of Patelco. The total purchase price paid for the two acquisitions was $168.5 million. ACC serves a consumer niche that, from a credit quality perspective, is slightly above the niche served by CAR, which makes our acquisition of ACC quite complementary to our CAR operations.
Our Other segment encompasses various activities that are start-up in nature. As reflected in the financial data for the Other segment within our segment data (see Note 3, Segment Reporting, to our consolidated financial statements included herein), we have invested significantly in a variety of start-up businesses in keeping with our diversification strategy. Moreover, as with any start-up effort, there is testing that needs to occur as we work to refine our product offerings and businesses within our Other segment. For example, we have experimented in recent months with different underwriting processes and thresholds for a variety of Internet-based micro-loan productsthis all in an effort to determine the right mix of marketing costs and systems costs versus first-pay defaults. These tests and the associated charge offs of receivables generated through these tests contributed to higher fourth quarter 2005 and first half of 2006 loan loss provisions within the Other segment.
Additionally, our overall direction has shifted significantly over the past few years with respect to our stored-value card offering. Our customer responses to this product offering support our belief that un-banked consumers want the convenience and flexibility of a stored-value card. Nevertheless, the financial investments associated with our initial strategy of tying our technologies together with third-party retail partners proved too great relative to the revenue potential of this product offering. As such, we retooled our stored-value card offering to expand the utility of the product and to focus on distribution of this product as an adjunct to certain of our credit card offerings or as an offer to consumers who come to us through Internet and other marketing channels and who may not be in a situation that currently warrants our extending credit to them through one of our lending products. Our expectations are that we can learn about the income and spending patterns of these particular stored-value card customers so that we can graduate them into our credit products over time. We also are looking at potential out-sourcing partnerships relative to this card offering to better align ourselves within the market and to further reduce costs within this area.
Beyond our shift in focus for our stored-value card offerings, we continue to develop an underwriting, servicing and collections platform that utilizes non-traditional processes to offer credit products directly to consumers. These techniques include the utilization of external databases other than the traditional credit bureaus, the application of proprietary scoring models built off of internal and external data attributes, proprietary application processing and approval methods and payment processing tools that currently are unique in the marketplace. We generally refer to these collective methods, models and processes as our MEP, and we consider them proprietary in nature. To date (and after an extensive research and development effort), we have launched the Imagine MasterCard credit card product utilizing the MEP; we now include the costs and revenues associated with this product within our Credit Cards segment. The MEP has enabled us to expand the scope of
consumers we can approve profitably for these credit card products beyond what we traditionally could approve using our credit bureau-oriented underwriting models. Customers acquired to date have lower average FICO scores than we see in our other credit card products, a very limited credit bureau history or no credit bureau history at all. The MEP also has allowed us to market our products on the Internet and through retail distribution at the point-of-sale, channels that until now have proven to be unsuccessful in generating large numbers of profitable credit card customers for us. Starting in the third quarter of this year, we began to utilize the MEP in connection with our installment lending activities, and we believe we can use it to enter other product lines, including retailer financing, auto lending and consumer receivables factoring, in the future. We also plan to utilize the MEP in the radio and television marketing channels for our products.
Our Other segment also currently is building technologies to enable us to underwrite, service and collect a wide variety of third-party consumer finance receivables. With customers that we already have in place, we have begun to make some principal investments of our own in asset-secured consumer finance receivables such as loans secured by motorcycles, all terrain vehicles, personal watercraft and the like. A significant portion of our Other segments provision for loan losses relates to the loans and fees receivable underlying this new category of asset-secured consumer finance receivable for us. For the time being, however, we have suspended loan originations within this asset class so that we can study the performance of these assets and our underwriting models for a few quarters to determine our further growth plans within this asset class.
Another activity currently underway within our Other segment is the implementation and refinement of our developed systems, marketing materials and infrastructure through which we attract currently underserved or under-banked consumers to us so that we can use a centralized decision engine to determine which of our various credit products is appropriate for each consumer. Through this effort, we have begun to engage in broad television and Internet advertising campaigns aimed at attracting consumers who may need credit or debit products; we also plan to partner with other providers of financial services and products and expect to earn fees through our referral of customers to these other providers. We currently are evaluating the marginal revenue potential our centralized decision engine against the costs that we are incurring towards its development and implementation, and we may scale back some of our development efforts and Other segment costs to some degree throughout 2007.
In summary, through our Other segment activities and by employing our credit and underwriting knowledge and leveraging and improving upon an established technology infrastructure, we can continue to develop and test new credit delivery programs. We see tremendous opportunity to grow our lending businesses through the use of Internet lead generators and search engines, and we expect most of the activities supported by the Other segment to ultimately be profitable for us. As an example, our Other segment has been instrumental in our effort to marry the MEP underwriting technologies with credit card product offerings as discussed above. These product offerings are generating incremental profits for us within our Credit Cards segment, and we have reclassified costs initially incurred within the Other segment to our Credit Cards segment so as to reflect a consistent matching of costs and revenues for these new products within the Credit Cards segment.
The following table details (in thousands) the pre-tax losses that we have incurred for our major initiatives within the Other segment:
Liquidity, Funding and Capital Resources
At December 31, 2006, we had $95.3 million in unrestricted cash. Because the characteristics of our assets and liabilities change, liquidity management is a dynamic process affected by the pricing and maturity of our assets and liabilities. We finance our business through cash flows from operations, asset backed securitizations and the issuance of debt and equity:
Historically, we have managed draws to fund cardholder purchases under our securitization facilities so as to meet our cash needs on an as-needed basis. Prior to the second quarter of 2005, this strategy generally allowed us to reduce our unrestricted cash balances to the minimal levels necessary to meet our daily operations and investment needs so as to avoid incurring costs on funds not currently needed to fund investments or operations. During the second quarter of 2005, however, we received substantial net cash flows of $141.7 million net from our Convertible Senior Notes offering (the $250.0 million Convertible Senior Notes proceeds, net of $8.3 million issuance costs and $100.0 million used contemporaneously to repurchase common shares) and $133.0 million ($143.0 million, net of $10.0 million of escrowed cash) from the Encore transaction. Additionally,
during the third quarter of 2005 we received $31.6 million of cash associated with the securitization of our Fingerhut receivables, and during the fourth quarter of 2005 we completed a second offering of Convertible Senior Notes resulting in an additional $292.3 million of cash proceeds (the $300.0 million Convertible Senior Notes proceeds, net of $7.7 million of issuance costs). With these cash flows, we continued our long-standing strategy of funding cardholder purchases underlying receivables securitized within our originated portfolio master trust so as to minimize draws on outstanding securitization facilities. The utilization of this excess cash can only occur if cash collections from credit card receivables within the securitization trusts are less than funding requirements for new purchases. To the extent possible and within the structural limitations to which we are subject, we expect always to focus on this cash management strategy because the yields that we can earn on our cash deposits are less than the costs of funds under our securitization facilities. We are confident with this strategy because of our ability to draw additional cash from a $1.0 billion 2-year variable funding facility (as well as a conduit facility) to meet our acquisition and operating needs as they arise in the future. We should also note that while our fundamental cash management strategy is to reduce draws on securitization facilities where possible, we expect, as we did in both 2005 and 2006, to continue to borrow during attractive environments to meet our ongoing acquisition and investment needs. While we may temporarily have excess funds associated with these borrowings, our belief when we have borrowed is that we can employ any borrowed amounts at returns that meet our return on equity goals.
Significant changes in our capital structure during 2006 included:
As of December 31, 2006, our collateral base within our originated portfolio master trust was sufficient to allow for additional cash draws of $450.4 million against our existing securitization facilities.
Considering all of the above factors, along with our unrestricted cash balances of $95.3 million at December 31, 2006, we had approximately $700.0 million of liquidity available as of December 31, 2006 for use in our growth, acquisition and diversification efforts. This level of liquidity is more than adequate to meet our operating needs throughout 2007, as evidenced by our recent ACC acquisition subsequent to year end. We expect to explore acquisition opportunities throughout 2007 and beyond through our efforts to acquire other credit card receivables portfolios and our expansion into product and service offerings complementary to our sub-prime consumer market.
In April 2005, we acquired Wells Fargo Financials CAR auto finance business unit. This acquisition included all of CARs assets, business operations and approximately 300 employees for $121.5 million including transaction costs. The acquisition was financed using $88.2 million in debt with the remainder paid in cash. The $88.2 million in debt was financed through a structured finance transaction. In that transaction, a newly formed special purpose subsidiary purchased the receivables and supporting collateral from the business and financed that acquisition through a secured lending facility with a bank. The debt incurred under that facility is recourse only to the assets that are pledged to the lender. We intend to finance any receivables growth in the CAR business through this same process. The sale of receivables and supporting collateral to this particular special purpose subsidiary does not qualify for gain-on-sale treatment under Statement No. 140. In February 2007, we amended the financing facility for our CAR subsidiary. This amendment provides for greater operational flexibility as well as lower pricing. Further, the term of the facility was extended to September 2008. As a part of this amendment, the facility was reduced in size to $100.0 million.
As noted previously, during the first quarter of 2004, we completed a two-year securitization facility with Merrill Lynch that was issued out of the originated portfolio master trust. This securitization facility provided for an initial one-year committed funding level of $1.25 billion, growing to a committed funding level to $1.5 billion in January 2005, with one-year renewal periods (subject to certain conditions precedent) at the expiration of the initial two-year term. It also included an orderly amortization of the facility at expiration in a manner that is expected to allow us to receive cash flows that are more than adequate to cover our servicing costs while amounts borrowed under the facility are repaid by the originated portfolio master trust. Furthermore, it included an advance rate against the originated portfolio master trust receivables that in managements opinion is sufficient to allow us to grow the originated portfolio and provide acceptable returns on equity from our credit card receivables origination activities. In connection with this new securitization facility, we issued a warrant to acquire up to 2.4 million shares of our common stock at an exercise price of $22.45 per share. This warrant was exercised in January 2007. On September 30, 2005, this facility was renewed and extended through January 2008, with reduced costs of funds and other more favorable terms to us than under the initial facility; also, given that we issued two term facilities out of the originated portfolio master trust in October 2004, thereby reducing the capacity that we need under this facility, the size of the facility was reduced to $1.0 billion in the renewal to reduce unused commitment costs associated with the facility.
We expect to continue our efforts in 2007 to acquire other credit card receivables portfolios and our expansion into product and service offerings complementary to our sub-prime consumer market, both through organic growth and through acquisitions. We anticipate using some of our existing cash reserves (and draw potential against our existing variable funding and conduit securitization facilities) to fund potential acquisitions during 2007. While these acquisitions may require the use of substantial amounts of cash or may require us to incur substantial acquisition-related debt financing, we anticipate having more than adequate cash for our operations during 2007 and for the foreseeable future. Nevertheless, we continue to evaluate potential capital sources. To the extent that we find the markets attractive enough to us to allow us to obtain long-term committed funding for future growth and acquisitions, we expect to issue the appropriate debt or equity securities.
Our most significant source of liquidity is the securitization of credit card receivables. As of December 31, 2006, we had committed total securitization facilities of $2.1 billion, of which we had drawn $1.0 billion ($220.0 million of which remained within an originated portfolio master trust special funding account at
December 31, 2006). At December 31, 2006, the weighted-average borrowing rate on our securitization facilities was approximately 6.72%. The maturity terms of our securitizations vary.
In the table below, we have noted the securitization facilities (in millions) with respect to which a substantial majority of our managed credit card receivables serve as collateral as of December 31, 2006. Following the table are further details concerning each of the facilities.
We have never triggered an early amortization within any of the series underlying our originated portfolio master trust securitizations, and we do not believe that we will. Still, it is conceivable that, even with close management, we may trigger an early amortization of one or more of the outstanding series within these trusts. Early amortization for any of the originated portfolio master trust securitization series would have adverse effects on our liquidity, certainly during the early amortization period and potentially beyond repayment of any such series as potential investors could elect to abstain from future CompuCredit-backed issuances.
Contractual Obligations, Commitments and Off-Balance-Sheet Arrangements
We have various contractual obligations that are recorded as liabilities in our consolidated financial statements. Other items, such as certain debt underlying securitization facilities as discussed above and purchase commitments, are not recognized as liabilities in our consolidated financial statements but are required to be disclosed. For example, we are contractually committed to make certain minimum lease payments for the use of property and equipment under operating lease agreements and arrangements that we classify as capital leases.
The following table summarizes (in millions) our significant contractual obligations and commercial commitments at December 31, 2006 and the future periods in which such obligations and commitments are expected to be settled in cash. In addition, the table reflects the timing of principal payments on outstanding borrowings. This table does not reflect regular recurring trade payables incurred in the normal course of business and generally due within 30 days of service. Additional details regarding these obligations are provided in notes to the consolidated financial statements also included herein, as referenced in the table:
See Note 12, Off-Balance-Sheet Arrangements, to our consolidated financial statements included herein for discussion of our off-balance-sheet arrangements.
Commitments and Contingencies
We also have certain contractual arrangements that would require us to make payments or provide funding if certain circumstances occur (contingent commitments). We do not currently expect that these contingent commitments will result in any material amounts being paid by us. See Note 17, Commitments and Contingencies, to our consolidated financial statements included herein for further discussion of these matters.
Recent Accounting Pronouncements
See Note 2, Significant Accounting Policies, to our consolidated financial statements included herein for a discussion of recent accounting pronouncements.
Critical Accounting Estimates
We have prepared our financial statements in accordance with GAAP. These principles are numerous and complex. We have summarized our significant accounting policies in the notes to our consolidated financial statements included herein. In many instances, the application of GAAP requires management to make estimates or to apply subjective principles to particular facts and circumstances. A variance in the estimates used or a variance in the application or interpretation of GAAP could yield a materially different accounting result. It is
impracticable for us to summarize every accounting principle that requires us to use judgment or estimates in our application. Described below, however, are the areas for which we believe that the estimations, judgments or interpretations that we have made, if different, would have yielded the most significant differences in our consolidated financial statements.
Valuation of Retained Interests
The most significant aspect of our business is the credit card receivables that we service for off-balance-sheet securitization structures. As of December 31, 2006, there were $1.6 billion of credit card receivables underlying our securitization programs (excluding those receivables securitized under our equity-method investees). We reflect our retained interests in these credit card receivables as a component of our securitized earning assets balance on our consolidated balance sheets. The value of this asset is critical to our financial performance and condition. We account for the portfolios that we have securitized in accordance with Statement No. 140. See Note 2, Significant Accounting Policies, and Note 12, Off-Balance-Sheet Arrangements, to our consolidated financial statements included herein for further discussion. In valuing this asset, we have to estimate several key factors with respect to the underlying credit card receivables, including yields, payment rates, credit loss rates and appropriate discount rates. Another significant component of our retained interests valuation for those retained interests accounted for under Statement No. 140 is the valuation of our retained interests in finance charge receivables and our accrued interest and fees, both of which we also reflect within securitized earnings assets on our consolidated balance sheets. We present these components of our overall retained interest valuation at estimated net realizable values. We estimate these amounts based principally upon payment and charge-off histories. To the extent that actual results differ from these estimates, our results of operations and liquidity could be materially affected.
With respect to our securitized portfolios that are accounted for in accordance with Statement No. 140, we have adjusted the underlying Statement No. 140 and retained interests valuation assumptions significantly over the last three years as a result of changing economic conditions and changes in our liquidity position. The most significant of these changes was our third quarter of 2004 reduction in the residual cash flows discount rate assumption used to value our I/O strips and retained interests based principally on new market conditions that became apparent to us in the third quarter of 2004 as a result of our negotiation of two new term securitization facilities that we subsequently completed a few weeks after the close of the third quarter of 2004. The aggregate favorable pre-tax effect of third quarter 2004 changes to our residual cash flows discount rate assumption was $21.7 million. The third quarter 2004 change in our residual cash flows discount rate assumption is not reflective of a change in estimating methodology, but rather reflects changes in facts during the third quarter of 2004. As market circumstances change and as fluctuations occur in the collateralization levels within our securitization trusts, these factors cause changes in our residual cash flows discount rate assumption. Facts continued to change in 2005, for example, during which we experienced further decreases in our residual cash flows discount rate. These decreases resulted from (1) further tightening of spreads on credit card securitization notes that we experienced in 2005 through (a) our sale to third parties of subordinated bonds in a securitization in the second quarter of 2005 and (b) the renewal at significantly lower pricing of two-year variable funding notes within our originated portfolio master trust during the third quarter of 2005, coupled with (2) significantly increased overall collateral enhancement levels within the originated portfolio master trust during 2005 given our funding of cardholder purchases. Our Statement No. 140 models recognize in computing the residual cash flows discount rate that variations in collateral enhancement levels affect the returns that investors require within securitization structures. Collateral enhancement levels increased significantly in 2005 given the liquidity generated by us based on our second quarter of 2005 Encore transaction and our $250.0 million and $300.0 million Convertible Senior Note issuances; we funded the majority of cardholder purchases underlying our originated portfolio master trust during 2005, rather than drawing against originated portfolio master trust conduit and variable funding note securitization facilities to fund these purchases. These beneficial effects on the residual cash flows discount rate were offset somewhat, however, by increases in the LIBOR rate over the same period. We have continued to experience a tightening of the spreads in transactions in which we have participated in 2006; the tightening of spreads again has served in 2006 to offset increases in our LIBOR base rate in the determination of our residual cash flows discount rate.
At December 31, 2006, the following illustrates the hypothetical adverse effect of a 20 percent adverse change in key economic assumptions on the valuation of our retained interests in credit card receivables securitized (in thousands):
These sensitivities are hypothetical and should be used with caution. For instance, changes in fair value assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Further, in this table, the effect of a variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumptions; in reality, changes in one assumption may result in changes in another. For example, increases in market interest rates may result in lower prepayments and increased credit losses, which could magnify or counteract the sensitivities.
Investments in Previously Charged-Off Receivables
We account for our investments in previously charged-off receivables using the cost recovery method of accounting in accordance with the provisions of Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, and the AICPAs Practice Bulletin 6, Amortization of Discounts on Certain Acquired Loans. We establish static pools consisting of homogenous accounts and receivables for each acquisition. Once we establish a static pool, we do not change the receivables within the pool.
We record each static pool at cost and account for it as a single unit for the economic life of the pool (similar to one loan) for recovery of our basis, recognition of revenue and impairment testing. We earn revenue from previously charged-off receivables after we have recovered the original cost for each pool. Each quarter, we perform an impairment test on each static pool. If the remaining forecasted collections are less than our current carrying value, we record an impairment charge.
Non-Consolidation of Qualifying Special Purpose Entities
As described above, we have securitized a substantial majority of the credit card receivables that we manage. In general, these securitizations involve our sale of credit card receivables to qualifying special purpose entities (QSPEs). QSPEs are governed by complex documentation, and we have filed the significant documentation for the QSPEs that we have established as exhibits to our SEC filings. Statement No. 140 governs how we account for the QSPEs that we have established. In general, Statement No. 140 requires an entity to recognize the financial and servicing assets it controls and the liabilities it has incurredthat is, the entity is required to consolidate those assets and liabilities and any related transactions and to derecognize financial assets when control has been surrendered in accordance with the criteria provided in the statement. Although Statement No. 140 provides guidance as to whether control has been surrendered, the ultimate determination is subjective in nature and requires considerable judgment.
We have reviewed the criteria provided in Statement No. 140 and believe that we have surrendered control with respect to the receivables. Statement No. 140 states that the transferor has surrendered control over transferred assets if, and only if, all of the following conditions are met:
We believe control has been surrendered with regard to receivables that we have transferred to our securitization structures, and therefore, we treat the transferred assets as having been sold under Statement No. 140.
Because the application of Statement No. 140 requires subjective judgments, it is possible, although we believe it is unlikely, that someone viewing our facts and circumstances might conclude that we had not surrendered control and, as such, that our transfers do not qualify as sales of the receivables. In that event, the credit card receivables that we have transferred to QSPEs (approximately $1.6 billion as of December 31, 2006) and any cash balances within the QSPEs would be treated as assets on our consolidated balance sheet, the securities issued (proceeds raised totaling $1.0 billion as of December 31, 2006) would be treated as liabilities on our consolidated balance sheet (as secured borrowings) and no gain or loss would have been recognized on the sale of the receivables. In addition, the credit card receivables would be subject to potential allowances for non-collectibility and would be classified as restricted assets for the repayment of the securities that were issued. This would result in a substantially different capital structure for us, although, barring unforeseen diminution in the value of the credit card receivables in the QSPEs, it would not materially impact our cash flows.
Allowance for Uncollectible Loans and Fees
Through our analysis of loan performance, delinquency data, charge-off data, economic trends and the potential effects of those economic trends on our customers, we establish an allowance for uncollectible loans and fees receivable as an estimate of the probable losses inherent within our portfolio of on-balance-sheet loans and fees receivable. Given the addition of our micro-loan operations during 2004, our auto-finance operations during 2005 and the significant growth that we have experienced in the receivables underlying our largely fee-based credit card offerings to consumers at the lower end of the FICO scoring range, our allowance for uncollectible loans and fees receivable has become much more material to our financial statements. To the extent that actual results differ from our estimates of uncollectible loans and fees receivable, our results of operations and liquidity could be materially affected. The allowance for uncollectible loans and fees receivable has grown from $54.3 million as of December 31, 2005 to $225.3 million as of December 31, 2006.
Goodwill and Identifiable Intangible Assets and Impairment Analyses
Management uses judgment in assessing goodwill and other long-lived assets for impairment. Goodwill totaled $120.1 million at December 31, 2006 and represented 5.7% of our total assets. In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, we annually assess the recoverability of our goodwill. We review the recorded value of our goodwill annually at the beginning of the fourth quarter of each year, or sooner if events or changes in circumstances indicate that the carrying amount may exceed fair value. We determine recoverability by comparing the estimated fair value of the reporting unit to which the goodwill applies to the carrying value, including goodwill, of that reporting unit. We use the present value of expected net cash flows to determine the estimated fair value of our reporting units. This present value model requires us to estimate future net cash flows, the timing of these cash flows and a discount rate representing the time value of money and the inherent risk and uncertainty of the future cash flows. The discount rate applied is the estimated weighted average cost of capital based on the reporting units current cost of debt and an estimated cost of equity derived from market betas of the reporting units public market peers. The assumptions used to estimate future cash flows are consistent with each reporting units internal planning. If
the estimated fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. If the carrying amount of the reporting unit exceeds its estimated fair value, the implied fair value of the reporting units goodwill is compared to the carrying amount of that goodwill. If the carrying amount of the reporting units goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.
We assess our long-lived assets other than goodwill for impairment whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. To analyze recoverability, we project undiscounted net future cash flows over the remaining life of the assets. If these projected cash flows are less than the carrying amount, we recognize an impairment, which results in a write-down of assets with a corresponding charge to earnings. We measure the impairment loss based upon the difference between the carrying amount and the fair value of the assets.
Investments in Securities
We periodically invest through the open market in debt and equity securities we believe will provide us with an adequate return. We generally classify our purchased debt and equity securities as trading securities. Investments in securities classified as trading securities totaled $181.4 million as of December 31, 2006. Due to the nature of these investments, we rely on third-party evidence to support our valuation estimates as the securities generally are not traded in larger market exchanges. Our investments in asset-backed securities include a mix of investment grade, non-investment grade, subordinated and distressed asset-backed securities, including CDOs (Collateralized Debt Obligations), CMBS (Collateralized Mortgage Backed Securities) and CMOs (Collateralized Mortgage Obligations.) We primarily purchase these securities through an unaffiliated investment manager that is a registered broker-dealer.
On a quarterly basis, we review our significant accounting policies and the related assumptions, in particular, those mentioned above, with the audit committee of the board of directors.
Interest Rate Sensitivity and Market Risk
Interest rate sensitivity is comprised of basis risk, gap risk and market risk. Basis risk is caused by the difference in the interest rate indices used to price assets and liabilities. Gap risk is caused by the difference in repricing intervals between assets and liabilities. Market risk is the risk of loss from adverse changes in market prices and rates. Our principal market risk is related to changes in interest rates. This affects us directly in our lending and borrowing activities, as well as indirectly as interest rates may impact the payment performance of our customers.
We incur basis risk because we fund managed assets at a spread over commercial paper rates or LIBOR, while the rates on the underlying managed assets are indexed to the prime rate. This basis risk results from the potential variability over time in the spread between the prime rate on the one hand, and commercial paper rates and LIBOR on the other hand. We have not hedged our basis risk because we believe that the cost of hedging this risk is greater than the benefits we would get from elimination of this risk. We incur gap risk because the debt underlying our securitization trust facilities reprices monthly; whereas, our receivables do not adjust unless we specifically adjust them with appropriate notification. This gap risk, however, is relatively minor as we can reprice the substantial majority of our receivables very quickly in response to a rate change.
As to the issue of market risk, we attempt to minimize the impact of interest rate fluctuations on net income by regularly evaluating the risk inherent within our asset and liability structure, especially our off-balance-sheet assets (such as securitized receivables) and their corresponding liabilities. The impact of interest rate fluctuations on our securitized receivables is reflected in the valuation of our retained interests in credit card receivables securitized. This risk arises from continuous changes in our asset and liability mix, changes in market interest
rates (including such changes that are caused by fluctuations in prevailing interest rates, payment trends on our interest-earning assets and payment requirements on our interest-bearing liabilities) and the general timing of all other cash flows. To manage our direct risk to interest rates, management actively monitors interest rates and the interest sensitive components of our securitization structures. Management seeks to minimize the impact of changes in interest rates on the fair value of assets, net income and cash flows primarily by matching asset and liability repricings. There can be no assurance, however, that we will be successful in our attempts to manage such risks.
At December 31, 2006, a substantial portion of our managed credit card receivables, including those related to our equity-method investees, and other interest-earning assets had variable rate pricing, with receivables carrying annual percentage rates at a spread over the prime rate (8.25% at December 31, 2006), subject to interest rate floors. At December 31, 2006, $20.3 million of our total managed receivables were priced at their floor rate, of which, $10.4 million of these receivables were closed and therefore ineligible to be repriced and the remaining $9.9 million were open and eligible to be repriced. Every 10% increase in LIBOR that we experience until the $10.4 million in closed account receivables reach their floor rate would result in an approximate $39,000 after-tax negative impact on our annual cash flows. Nevertheless, to the extent we choose to reprice any of the $9.9 million of receivables underlying the open accounts that are below their floor rate, we can mitigate against any possible adverse impacts of these open accounts on our cash flows.
We believe we are not exposed to any material foreign currency exchange rate risk or commodity price risk.
See the Index to Financial Statements in Item 15. Exhibits and Financial Statements Schedules.
Managements Report on Internal Control over Financial Reporting
Management of CompuCredit Corporation is responsible for establishing and maintaining adequate internal control over financial reporting (as such term is defined in Exchange Act Rules 13a-15(f)) for CompuCredit Corporation and our subsidiaries. Our internal control over financial reporting is a process designed under the supervision of our principal executive and financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. Under the supervision and with the participation of management, including our principal executive and financial officers, we conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2006, based on the framework in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on our evaluation under the framework in Internal ControlIntegrated Framework, management has concluded that internal control over financial reporting was effective as of December 31, 2006. Managements assessment of the effectiveness of internal control over financial reporting as of December 31, 2006 has been audited by BDO Seidman, LLP, an independent registered public accounting firm, as stated in its attestation report, which is included on the following page.
Report of Independent Registered Public Accounting Firm
The Board of Directors
We have audited managements assessment, included in Managements Report on Internal Control Over Financial Reporting reflected in Item 8 of Form 10-K, that CompuCredit Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment about the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, managements assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We have also audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of CompuCredit Corporation and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of operations, shareholders equity and cash flows for each of the three years in the period ended December 31, 2006 and our report dated February 27, 2007 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
February 27, 2007
As of December 31, 2006, an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a15(e) under the Securities Exchange Act of 1934) was carried out on behalf of CompuCredit Corporation and its subsidiaries by our management with the participation of our Chief Executive Officer and Chief Financial Officer. Based upon the evaluation, management concluded that these disclosure controls and procedures were effective as of December 31, 2006.
Managements Report on Internal Control over Financial Reporting and the Report of Independent Registered Public Accounting Firm thereon are set forth in Part II, Item 8 of this Annual Report on Form 10-K. Our independent registered public accounting firm has attested to and reported on managements assessment of internal control over financial reporting as stated in its attestation report, which is also included in Part II, Item 8 of this report.
In addition, during the fourth quarter of our year ended December 31, 2006, no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
The information required by this Item will be set forth in our Proxy Statement for the 2007 Annual Meeting of Shareholders in the sections entitled Election of Directors, Executive Officers of CompuCredit, Section 16(a) Beneficial Ownership Reporting Compliance and Corporate Governance and is incorporated by reference.
The information required by this Item will be set forth in our Proxy Statement for the 2007 Annual Meeting of Shareholders in the sections entitled Executive Compensation, Director Compensation, Compensation Committee Interlocks and Insider Participation, and Compensation Committee Report, and is incorporated by reference.
The information required by this Item will be set forth in our Proxy Statement for the 2007 Annual Meeting of Shareholders in the sections entitled Security Ownership of Certain Beneficial Owners and Management and is incorporated by reference.
The information required by this Item will be set forth in our Proxy Statement for the 2007 Annual Meeting of Shareholders in the sections entitled Related Party Transactions and Corporate Governance and is incorporated by reference.
The information required by this Item will be set forth in our Proxy Statement for the 2007 Annual Meeting of Shareholders in the section entitled Auditor Fees and is incorporated by reference.
The following documents are filed as part of this Report:
INDEX TO FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors
We have audited the accompanying consolidated balance sheets of CompuCredit Corporation and subsidiaries (the Company) as of December 31, 2006 and 2005 and the related consolidated statements of operations, shareholders equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CompuCredit Corporation and subsidiaries at December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
We have also audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Companys internal control over financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2007 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
February 27, 2007
Consolidated Balance Sheets
(Dollars in thousands)
See accompanying notes.
Consolidated Statements of Operations
(Dollars in thousands, except per share data)
See accompanying notes.
Consolidated Statements of Shareholders Equity
For the years ended December 31, 2006, 2005 and 2004
(Dollars in thousands)