Subprime lending giant CardWorks offers a glimpse into consumers’ wallets—and some surprising clues about the economy

But investors fretted that Ally was paying a big price at the peak of an unusually strong credit cycle. When the inevitable recession arrived, the skeptics worried, subprime borrowers would revert from their unusually terrific payments record to the normal level of much higher delinquencies. Then the coronavirus crisis pummeled the outlook for all consumer credit, but especially for the low-income folks hardest hit by unemployment, making the merger look even more like a loser and sharpening the descent in Ally’s stock.

The second-largest pending financial services merger of 2020, behind only Morgan Stanley’s $13 billion acquisition of eTrade, soon fell victim to the pandemic. On June 24, Ally issued a press release declaring that it had “mutually agreed” with CardWorks to scuttle the union. Jeffrey J. Brown, Ally’s CEO, provided no details on the reason for the breakup, stating only, “Given the unprecedented market conditions resulting from the COVID-19 global pandemic, Don Berman and I…believe it’s in the best interests of our customers and stakeholders to terminate the agreement.” Wall Street cheered the breakup, boosting Ally’s shares that day by 12%.

The companies’ decision to walk, in and of itself, raised a red alert for money managers that specialize in backing low-income lenders. They reckoned that the cancellation was a bellwether for a meltdown in subprime. As one prominent investor who has prospered by betting on the sector told me on background: “My theory is that abandoning the deal showed that there would be all kinds of problems coming in consumer finance.” He also noted that the key metric for subprime is unemployment, and that “when you have a hiccup in unemployment, you have problems.” He went on to say that to nix the deal, both sides must have seen far worse times ahead than even the scale of delinquencies the markets were expecting.

It was the death of the Ally-CardWorks merger that confirmed his worst fears: “I thought there might be a soft landing up until the CardWorks deal got canceled.”

On July 9 I spoke to Don Berman to get his firsthand view of how America’s wage earners will weather the crisis. I asked Berman if he and Ally had scotched the merger because of severe problems brewing in his portfolio. Berman dismissed that notion with a single word: “Hogwash.”

Born in the Bronx

Berman provided a brief profile of CardWorks and its borrowers, and his own story growing up in what he calls a “subprime family in the Bronx.” Berman’s father owned modest restaurants, and his mother was a schoolteacher. “We lived in a five-story walkup,” he recalls. “I shared a bedroom with my brother until I was 15.” Berman made the freshman basketball team at the University of Maryland. But when he came home for Thanksgiving that year and told his mom, she ended his hoop dreams for good. “Paying for college was a real stretch,” he says. “My mother was the only person allowed to call me Donald. She told me, ‘Donald, you have a choice. You either keep going to college and study, or leave college and play basketball.’ The message was clear–––if I played freshman year, she’d stop paying my tuition.” The strapping six-footer sports a clean-shaven Mr. Clean dome that he keeps barren using a Gillette razor every morning.

Postcollege he quit his job running sales and marketing for a credit card processor to found CardWorks in 1987. From 2016 to 2019, in a great market where the pool of subprime customers kept growing, lifting total balances, while delinquencies stayed extremely low, Berman grew revenues 30%, to nearly $1.1 billion, and pretax profits 46%, to $343 million. Today, CardWorks remains privately held, and Berman holds the majority of the shares.

Although CardWorks also finances boats and trailers, and processes payments for merchants and banks, the bulk of its business by far is credit cards. “Big banks have to worry about trading, real estate lending, and 10 other sectors,” he told me. “Our business is very monoline. We worry mainly about one kind of risk, for credit card loans.”

CardWorks provides financing through its captive lender, Merrick Bank. It boasts almost 4 million credit card accounts. “We’re in the top 20 of all credit card companies,” says Berman. But he’s a giant in his field: In subprime, CardWorks’ $3.8 billion in balances ranks second only to Capital One’s. Of course, default rates are a lot higher in subprime than prime. CardWorks charges customers a range of between 17.9% and 29.9%; its average rate is 23.3% on balances. Those high rates cover the nonpayments, which run 10% to 12%, versus 3% to 5% for prime customers.

The typical CardWorks customer is a wage earner making $15 to $20 an hour, contributing to a total family income of $45,000 to $65,000 a year. Their average credit scores are 630, about the average for subprime borrowers. These aren’t the folks who bank at JPMorgan Chase or Wells Fargo. Yet, says Berman, their slender means forces these families to be in some ways more careful with their finances than high earners. “Subprime consumers live their entire lives in their own recession,” he notes. “They have no excess disposable income. Eighty percent of our borrowers are renters, not homeowners, where it’s practically the reverse for the middle class and up.”

While foreseeing tougher times ahead, Berman expresses amazement at how well his customers are faring so far. “What we see from our portfolio’s performance is that our consumer seems to be in better condition today than before the pandemic,” he says. “To a large degree it’s because of actions taken by the government through stimulus checks and unemployment benefits. But it’s about being much more careful as well.”

A different approach to this recession

CardWorks’ borrowers, he observes, are treading far more carefully than in the previous recessions of 2001 and 2008. “Going into those downturns, they were credit needy. They wanted to make sure they had enough credit to live their lives when they lost jobs.” CardWorks measures their hunger for new borrowing by the response rate to its mailings offering new or extra credit. “When the economy was worsening, we’d see response rates double from 3% to 6%,” he says. “If a family had a $1,000 credit line at Merrick, they’d on average have pulled down $650, and that number would rise to $850 or $900, from 65% to as much as 90% utilization.”

But in the COVID-19 crisis, his customers are getting more prudent and less leveraged. “They’re charging less and paying down their balances,” says Berman. “This is also happening on the national level. The latest numbers show people paying down revolving credit balances at the fastest rate in 20 years.” Instead of surging from 3% to 6%, CardWorks’ response rates dropped by half to 1.5%. Customers who in previous recessions raised balances on their credit lines from 65% to 90% are on average lowering their utilization to 62%. “I’ve never seen anything like it in a recession,” he says. “People are being far more judicious than before the crisis.”

Berman attributes that shift in behavior to two factors. First, borrowers learned tough lessons in the values of frugality from the financial crisis. “My average borrower is around 45,” he says. “He or she lived through 2008 and 2009. People came to appreciate the importance of strong FICO scores. Keeping a good credit score ensures that they can get additional credit if they need it, or qualify for a mortgage.” Second, Berman believes that people sheltering in place simply don’t have as many pleasures to swipe their cards for, compared to being out on the street and tempted by movie theaters, stores, and restaurants. “They just can’t spend as much as they usually do,” he says.

What’s left is mainly shopping online. For Berman, the digital experience is much less conducive to impulse buying than roaming boutiques and malls. “My belief is that people are a lot less spontaneous and rash when the merchandise isn’t physically in front of them,” he says. “That’s why there’s so much abandonment in e-commerce. When consumers shop on the Internet, they often get to the checkout page and don’t complete the purchase. There’s no excitement there. It’s tedious versus being in a store.” The upshot is that subprime families are either banking a higher portion of their meager incomes in the lockdown, or conserving their savings far more carefully than in prior recessions.

The unemployment picture

Still, Berman warns that credit losses will be substantial because of the spike in unemployment and that it’s impossible to fully assess the damage until government support runs out. “Based on unemployment, you’d have to be foolish not to increase your loan loss reserves,” he says. “We’re adding a lot to our reserves because the stimulus and benefits will end at some point, and joblessness will settle in the low-double digits.” He says that if the government provides another stimulus package, as he expects, it will take until December or the first quarter of 2021 to gauge how deep the losses will run.

Overall, Berman is what he calls “cautiously optimistic” that subprime will emerge without suffering anything like the deep losses that worried investors believed the Ally bust-up was signaling. In part, he says, this downturn isn’t being caused by a “fundamental weakness” in the economy. “In the Great Recession, we had a housing meltdown. And it was mainly because of defaults by prime, not subprime borrowers. This time it’s not a financially driven recession, it’s a downturn driven by an event, as opposed to a fundamental disruption like the housing crisis.”

He adds that the timeline for recessions is different for subprime workers. “They enter the recession earlier, and exit sooner,” he told me. “These are people making $15 or $20 an hour working in restaurants, hotels, or bars. The first jobs to get cut are entry-level jobs. Those workers get laid off right when business drops, at the start of the downturn. They’re also the first to be rehired when business starts to pick up, and the restaurants, bars and hotels reopen.”

Hence, his borrowers will lose income for a briefer period than salaried workers. “Think about the tens of thousands of salaried people being laid off by the airlines,” he says. “They include pilots making $250,000 a year. They may not return for a couple of years.”

In conclusion, Berman notes that CardWorks suffered significant loan losses in the Great Recession, but those losses didn’t last nearly as long as for prime customers. He expects a replay of the first-in, first-out scenario that cushioned the hit in the Great Recession. For Berman to be proved right, his subprimers can’t stay out of work too long. But unless we’re in for years of elevated unemployment, his prediction that wage earners will get through this relatively unscathed is probably the best bet.

It’s also instructive that Berman and his shareholders had a strong motive to kill the Ally-CardWorks deal, so that its demise may have nothing to do with fears of a crash in subprime credit. Berman and his fellow owners were getting $1.4 billion in cash and $1.3 billion in stock at Ally’s pre-announcement price of $32.85. But the merger agreement contained an escape for CardWorks: If Ally’s price fell by 15% for an extended period, CardWorks could walk with no penalty. By late June Ally’s shares had dropped to around $18, far below that trigger point. The amount that CardWorks’ shareholder, of whom Berman is the largest, would have received shrank almost $600 million from when the deal was announced.

It’s a sign of Berman’s faith in his customers’ prospects, even in these rough times, that he agreed to nix a deal that would have brought him over $1 billion. He’s convinced his borrowers’ fundamental strength, holding jobs that are easier to replace, means that “our portfolio will perform very well as unemployment falls.” To be sure, no one knows the market better, or has better models, than Berman. The question is whether all that expertise can reasonably gauge the future damage from a crisis unlike any other.