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Profiting from Americans' Lower Credit Scores
FICO Inc., a subsidiary of Fair Isaac Corporation (FICO), calculates credit scores for individuals, and recently reported that the number of Americans with poor credit has increased materially. Financial institutions utilize credit scores to determine whether an individual is a good credit risk or a person who should be avoided. Although the housing market meltdown and the recent recession have caused the majority of corporations to tighten their lending requirements, at some point, a number of these companies may jump to do business with these risky consumers by lowering their lending standards. In the meantime, investors may be able to find some investment opportunities due to the aforementioned credit issues.
According to Fair Isaac, 43.4 million people, or 25.5% of American consumers, now possess a credit score of 599 or below. Typically, financial institutions consider a score below 600 to represent a poor and risky candidate for credit. Since the start of the recession (began December, 2007), more than 2.4 million people have sustained hits to their credit scores and have been placed in that lower tier. Due to the housing debacle and high unemployment, foreclosures remain at elevated levels. A foreclosure alone can drop one’s credit score by as much as 150 points. Missed credit card, student loan, and auto payments also hurt scores, and once the damage is done, it can take years before an individual’s score recovers--if ever.
Because of the lackluster economy, housing market, and high unemployment rate, Bank of America (BAC - Free Analyst Report), Citigroup (C), JP Morgan Chase (JPM - Free Analyst Report), and most other financial institutions continue to sustain elevated net charge-offs and loan defaults. In response, most banks have tightened their credit standards and are now much more cautious in regard to offering mortgages and auto loans. American Express (AXP - Free Analyst Report) and Capital One (COF), along with the other credit card companies, have also cut back on their credit card offerings, and are now focused on attracting less risky customers. It is safe to assume that individuals with poor credit will continue to find it difficult to secure financing.
The pawn lenders have been able to pick up some of the slack. Cash America (CSH), EZCORP (EZPW), and First Cash Financial Services (FCFS) do not perform credit checks for pawn loans and, thus, are appealing to individuals in need of short-term financial assistance. A pawn loan is a relatively simple financial transaction. An individual borrows money (typically for a term of 30 to 180 days), the amount of which is based on specific collateral (most commonly jewelry, electronics, or musical instruments). At the end of the term, the individual pays back the loan (plus interest), or the pawn lender keeps the collateral. Some of these corporations also offer payday loan services, which enable customers to receive cash immediately in exchange for their next paycheck (minus a fee). During the recession, these companies posted healthy revenue and profit growth, while the corresponding stocks reached lofty heights. Looking ahead, there may still be room for further price appreciation, since tight credit standards and high unemployment will probably continue to drive people to these lenders (For a more detailed review of the pawn industry, click here.)
Used car dealers have and may continue to benefit from the current lending environment, as well. Low credit scores make it difficult for individuals to secure auto financing for the purchase of a new car. In this case, these people have been forced to trade down to used cars, which are cheaper and can be obtained more easily. CarMax (KMX) and Group 1 Automotive (GPI) are two publicly traded auto retailers that derive a good percentage of their revenues and profits from the sale of pre-owned automobiles. Since the March, 2008 market low, both of these stocks rebounded strongly and currently trade near their 52-week highs. Nonetheless, continued tight credit standards at most banks should help sustain demand for second hand cars.
Additional investment opportunities are also likely to crop up down the road. Considering that more than a quarter of U.S. consumers are now “risky” credits, at some point, a number of banks and credit card companies will probably reduce their lending standards and aggressively court at least some members of this group. Although elevated defaults will inevitably follow, a financial institution that chooses customers wisely could reap the benefits and pick up valuable market share. In addition, due to the poor credit scores, these businesses could probably charge higher interest rates, boosting net interest margins and their profit potential. At this time, we suggest that interested investors take a look at the pawn lenders and used car dealers, as well as focus on financial institutions with healthy balance sheets and a history of successful loan activities.