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Metris Numbers Add to Late-Loan Worries

The third quarter shows delinquencies rising but reserves not keep pace.



third-quarter earnings would've been a fraction of the number reported Wednesday if the company hadn't substantially weakened its protection against bad loans and apparently accelerated revenue recognition.

The Minnetonka, Minn.-based credit card lender posted third-quarter earnings of 70 cents a share. But earnings would've been closer to 20 cents had Metris maintained its previous stance of keeping its loan-loss reserve close to, or above, the level of delinquent credits. The loan loss reserve is the cushion that a lender keeps to protect itself against bad loans.

When asked for comment, Metris spokesman Mike Smith said: "We don't comment to

." Metris shares fell 16 cents Wednesday to $23.87.

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Credit card watchers compare the dollar value of the reserve to the dollar value of delinquencies as a way a gauging how conservative a lender is. This metric has taken on increased importance as the economy has slowed and bad loans have started mounting, especially among the borrowers with tainted credit histories that Metris lends to.

In the second quarter, Metris' bad loan reserve of $826 million was equivalent to 98% of delinquencies, slightly below the ratio seen in the previous quarter.

But in the third quarter, that ratio plunged to 90% of delinquencies. The reserve in the quarter was $880 million, compared with delinquencies of $981 million. If the ratio had been maintained at 98%, Metris would have needed to add $80 million to its reserve; all additions to reserves must be subtracted from earnings. After taxes, then, the reserve addition would reduce net income by some $50 million, which is equivalent to 70% of the $70.7 million in net income that Metris reported in the quarter.

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If anything, there seems to be good reason for Metris to increase its reserve. Delinquencies in the third quarter were 8.9% of loans, up from 8.3% in the second quarter. Rival credit card company


has lost 78% of its value in recent weeks due to a worsening in credit quality.

On a Wednesday conference call, a senior Metris executive defended the reserve, saying it was set in line with expected losses. He added that Metris can predict losses better than others because its loans tend to be older.

In addition, Metris appears to have sped up recognition of the high-margin fee revenue that it includes in its so-called enhancement services line. Revenue from enhancement services totaled $86.2 million in the third quarter, 4% above the $82.9 million in the second quarter. What seems to be amiss? In the previous 10 quarters, enhancement services revenue equaled an average of 33% of the previous quarter's deferred income (a balance sheet item that represents money received but not booked as revenue in the income statement). A hefty chunk of the deferred income orignates from the enhancement services business.

But in the third quarter, enhancement services revenue jumped to 41% of the previous quarter's deferred income. Did Metris, fearing that it would miss earnings forecasts, decide to recognize as sales a greater share of its deferred income than before? If the ratio of 33% had been applied to second-quarter deferred income, enhancement services revenue would have been $70 million -- $16 million less than reported. That would mean an additional $10 million hit to net income.

On the call, the Metris executive said a change in the way that Metris books certain enhancement services fees explains the drop in deferred income.

If we subtract from net income both the $50 million gained from reducing the reserve-to-delinquency ratio as well as the $10 million boost to enhancement services revenue, then Metris can be seen to have made only $10 million in the third quarter, or 10 cents a share.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.