Don't Stuff Your Cash Under This Metris

Metris (MXT - Cramer's Take - Stockpickr) has fallen nearly 20% since reporting third-quarter numbers last week that were hailed by sell-side analysts.

So why the selloff? Three reasons: Recent company data show bad loans rising. Metris' practices have fallen afoul of the New York State attorney general. And questions are being raised about how the company is booking fee revenue.

Metris didn't return calls seeking comment. The stock dropped 95 cents Wednesday to $20, on three times average daily volume.

Protection

Loan losses jumped in September in a large part of the Metris loan portfolio. This could force the fast-growing credit card lender to substantially increase its protection against bad loans, a move that would dent earnings. The ugly loss number will also prompt comparisons with beleaguered card company Providian (PVN - Cramer's Take - Stockpickr), whose shares fell by more than half last week after it revealed a steep earnings shortfall. Both lenders serve borrowers of low creditworthiness.

Metris sells many of its loans to investors by packaging them into special bonds, also called securitization trusts. Each month, Metris reports how many of the loans in these trusts have defaulted on an annual basis. In September, defaults were running at 13.81%, up a hefty 1.84 percentage points from August. That loss number is the highest in at least two years, except for April this year, when losses spiked to 14.5%.

Metris trust loans more than 30 days past due also rose -- to 9.39% in September, from 9.33% in the previous month. About 80% of Metris' loans have been shifted off its balance sheet through securitization, so the trust loss numbers give a useful intraquarter picture of credit quality. They can be skewed, however, if Metris shifts new loans into the trusts. Also, unlike loss numbers reported in earnings releases, the trusts' loss numbers don't factor in recoveries, which run at about 9% to 10% of the overall losses.

Parallelograms

Despite the noise in the trust data, the September loss number will reignite the debate surrounding the level of reserves Metris keeps to protect itself against bad loans. Detox noted last week that the reserve had fallen sharply when compared with the level of loans more than 30 days past due. Metris' defenders said the drop in the reserve-to-delinquency ratio wasn't necessarily negative because it was falling from a historically high level and bad-loan losses didn't seem to be rising too fast.

But with losses on the rise, Metris may have to add more than the market expects to its reserve. This could demolish earnings; if Metris had kept its third-quarter reserve-to-delinquency ratio at second-quarter levels, third-quarter earnings would have dropped 70%.

Adding to downward pressure to the stock is news of a run-in the company had with the New York Attorney General Eliot Spitzer. Metris refunded consumers $1 million as part of an agreement with Spitzer's office. This agreement settled concerns that Metris "duped consumers into purchasing credit card 'protection plans' that provide little or no real value," according to a press release on Spitzer's Web site. "Metris also automatically renewed membership contracts without giving consumers advance notice as required by state law," the press release adds.

Metris' fee business got it into trouble with the Office of the Comptroller of the Currency, a federal banking regulator, earlier this year. The regulator and Metris agreed on extensive internal reforms and refunds to consumers. The settlement with New York state could suggest the reforms aren't taking effect. And there's an ugly precedent here. Growth in Providian's fee income slowed markedly after being probed by two state attorneys general, as well as the OCC. Fee income makes up more than 90% of total revenue at Metris.

J. Accrue

Metris' decision to remove a key disclosure is coming back to haunt it, too. The company hasn't broken out the "accrued interest and fees receivable" line in its balance sheet since the third quarter of last year. This number gave investors a good feel for how many fees Metris was accruing, or reporting, on its earnings statement, without actually collecting.

This change has led some skeptics to wonder whether the company is increasing credit lines to borrowers in order to accrue fees that will boost revenue. In this view, Metris may be charging additional fees to borrowers who have already shown they can't pay. Metris could then add the unpaid fees to the debt owed. Perhaps supporting this notion, the average credit balance at Metris jumped 28% from a year ago in the third quarter, to $2,300. Notably, Providian attributed many of its problems to overexpanded credit lines.

Don't be surprised if this stock falls further.