PROVIDIAN: Sleazy Credit

Think only Enron epitomized late-'90s excess?
Check out subprime lender Providian Financial.

FORTUNE
March 4, 2002
Suzanne Koudsi

There once was a company that invented a business, and it made a lot of people a lot of money. But it was also doing some crummy things. It made a quiet accounting move that shook Wall Street's confidence. Top execs started selling stock. The share price cratered. The CEO abruptly resigned.

No, it isn't Enron. It's Providian Financial, the San Francisco-based credit card company that pioneered the business of issuing plastic to risky, or "subprime," customers. Today the whole subprime lending industry is in terrible shape--and no company better illustrates that than Providian. The company's market cap is down more than 90% from its peak of $19 billion in October 2000, and its stock is trading at $4.40, 93% off its 52-week high. Its fate now lies in the hands of new CEO Joseph Saunders, a former executive at FleetBoston Financial, who is trying to save Providian from becoming one of the biggest failures in credit card history. Given that the company has just reported a fourth-quarter loss of $395 million--and with no particular light at the end of the tunnel--it's not clear whether he can succeed.

Falling as it did after the dot-com bust but before the Enron scandal, Providian's debacle slipped between the cracks. It shouldn't have. Providian exemplifies all the excesses of the 1990s: cheerleading analysts, a CEO who wanted to get rich, and a company that sacrificed its business model for its stock price. Providian was one of those companies--in one of those industries--that were selling a story of unlimited growth to Wall Street. But the harsh truth about the subprime industry is that there are only so many risky borrowers you can give credit cards to and still make money. Once that became clear, the game was over--not just for Providian but for all the so-called growth companies making subprime loans.

Let's be blunt: subprime lending can be a pretty sleazy business. Lenders seek out customers with either spotty credit histories or no credit histories at all--typically low-income people--and often charge them exorbitant interest rates and fees to compensate for the risk that they might default. It's not a new idea, of course; finance companies were built on subprime loans made during the Depression, though nobody used the term back then. But once credit cards became a ubiquitous part of American life, and companies got better at using demographics to target potential borrowers, the business really began to flourish.

Providian may not have invented subprime lending, but it certainly perfected it. The company's genius was in segmenting people based on financial behavior. Founded in the mid-1980s and originally called First Deposit, Providian created a system that made it possible to find the "perfect" credit card customer: someone who cared more about low minimum monthly payments than high interest rates and who would pile up debt but would rarely default. "We found the best of the bad," says a former executive.

How it developed the complex mathematical models that allowed it to find such customers was the company's trade secret. One of the people who helped develop those models was an Indian-born math whiz named Shailesh Mehta, who joined First Deposit in 1986. Two years later, when the founding CEO cashed out, Mehta took over.

At first, the company had the subprime credit card market largely to itself--and it made the most of it. It charged some customers an application fee, in addition to an annual fee, for a card with a limit between $300 and $500. Interest rates could soar to nearly 24%. Early on, the company sent checks to potential customers. Those who cashed the checks would start racking up interest charges right away. Those who declined didn't get credit cards; apparently they weren't the kind of debt-embracing customers the company wanted. Later Providian would launch some questionable promotions. For example, after targeted customers accepted a "no annual fee" credit card, Providian charged them a mandatory $156 "credit protection fee."

Almost from the start, the company had scrapes with consumer advocates who criticized its tactics. But Mehta (who didn't respond to FORTUNE's request for comment) had a ready response: His company was providing a valuable service in offering credit to customers whom other banks refused to serve.

As Providian started making serious money in the subprime credit card biz, competitors like Capital One and Household International wanted a bigger piece of the action. Even the large banks that served the higher end of the market--which had long been saturated--couldn't resist the lure of the subprime segment. And in the 1990s the bet seemed to pay off. With the economy booming and unemployment low, default risk was manageable. Between 1997 and 2001, the number of active subprime credit card accounts surged 215%, to 26.8 million, estimates David Robertson, president of The Nilson Report, an industry newsletter.

In 1997, Providian Financial--as it had been renamed --was spun off as a publicly traded company, with Mehta as chairman and CEO. In retrospect, that's when the trouble began. Wall Street wanted "growth stories," and Mehta was determined to provide one. In 1997, Providian reported earnings of $191 million; two years later earnings were up a stunning 187%. Its loan portfolio grew from $9.9 billion to $21 billion. Between 1997 and 2000, its market cap skyrocketed 453%. By the end of 2000, according to The Nilson Report, Providian was the fifth-largest credit card issuer in the nation.

As Providian stock soared, so did Mehta's personal wealth. When Providian's stock hit its all-time, split-adjusted high of $66.72 in October 2000, the bespectacled CEO was worth more than $300 million. He lived with his family in a 17,000-square-foot house--a replica of the White House--that he'd bought three years before in tony Hillsborough, Calif. Says a former Providian board member: "He was more motivated by money than anyone I've ever met."

And as long as the stock continued to rise, Wall Street was only too happy to go along. Rather than asking hard questions about the subprime business, analysts cheered Mehta on. "He developed a small cult [on Wall Street] that thought he was just a guru," says Reilly Tierney, an analyst at brokerage firm Fox-Pitt Kelton.

In mid-1999, Providian hit its first bump: the San Francisco district attorney's office and then the Office of the Comptroller of the Currency (OCC) opened investigations into Providian's business practices. A year later the OCC found that the company was using "misleading, unfair, deceptive practices" to increase its profits. In June 2000 the OCC ordered Providian to stop some of its marketing campaigns--including the notorious "no annual fee" promotion--and ordered the company to pay $300 million in restitution to customers, the biggest penalty in OCC history. (The company paid up without admitting guilt.) Did Wall Street care? Apparently not. Four months later the stock hit its all-time high.

At this point, Mehta had two choices. He could concede that Providian's growth would have to slow because the company simply wasn't going to be able to generate fee and interest income at the same rate as before. Or he would have to find some other way to come up with the earnings he had promised the Street. He chose the latter course. Says Charlotte Chamberlain, an analyst at Jefferies & Co.: "Providian insisted that they could keep the earnings machine running."

How did he go about it? The only way he could--by generating more and more subprime customers. And the only way Providian could do that was by lowering its standards, handing out credit cards to people that its prized mathematical models would previously have rejected. (Providian also ventured into the high-end "platinum" credit card market, but the effort flopped.)

Signing up ever-riskier customers was a terrible mistake. By then, the economy was faltering, and subprime customers were the first to feel it. Consumer bankruptcies rose, as did subprime default rates. Such Providian competitors as Capital One and Household International wisely began dialing back their push into subprime. Those that didn't--or couldn't--were badly hurt. Illinois-based Superior Bank, which had a strong subprime focus, failed spectacularly in July 2001. Conseco Finance--the former Green Tree Financial, which had been bought by insurance giant Conseco--saw so many defaults that some analysts believe they could contribute to the potential failure of the parent company. Yet Mehta was still charging ahead. As he put it in a 2001 press release: "We are proud to reaffirm our long-term earnings-per-share goal of 25%."

That summer, however, Providian quietly made a change to its credit-loss accounting practices that effectively deferred about $30 million in credit losses into another quarter--and failed to inform Wall Street. Then, in late July, with Providian stock still in the high 40s, Mehta's No. 2 executive started unloading his stock. Over a four-day period, he sold more than half of his exercisable options, worth $13.5 million. Around the same time, Mehta--who had liquidated $4.8 million worth of stock the previous November--sold 75,000 shares, netting him nearly $3.7 million.

In August, when Providian filed its quarterly report with the SEC, it revealed the credit loss. "Suddenly we [Wall Street] woke up," says Jefferies & Co.'s Chamberlain.

Things were unraveling fast, but Mehta seemed oblivious--at least publicly. Recalls T. Rowe Price portfolio manager Anna Dopkin, who sat next to Mehta at a dinner in September: "He couldn't say, 'I made a mistake and things are bad.' It was as if he was in complete denial."

Mehta couldn't put on a good face much longer. On Oct. 18, he announced that third-quarter earnings had fallen 72% year over year because of lower-than-expected fee income and higher-than-expected loan losses. The same day, Mehta also announced his resignation as both chairman and CEO.

The stock price plunged to $5. Less than a week later, lawyers filed the first of several class-action complaints against the company and its top executives. The complaints accuse the defendants of fraudulently misleading investors and taking advantage of insider knowledge to sell their stock at inflated prices.

Sitting in a bland conference room at Providian's headquarters in downtown San Francisco, Joseph Saunders looks harried. Since Nov. 26, when he started his new job, he hasn't been talking about growth. He's been talking about survival. "This company is going to get smaller before it gets bigger," he concedes.

It sure is. In addition to its $395 million fourth-quarter loss, Providian also reported a whopping 12.7% credit loss rate. In the short term, Saunders' sale of $8.2 billion worth of high-credit-quality receivables to a subsidiary of J.P. Morgan Chase and securitization of another $2.8 billion in funding will keep the company alive--for now.

The larger question is whether there's much of a place anymore for ambitious subprime lenders. In early February the government shut down the credit card operations of big subprime lender NextCard. And regulators are cracking down on the industry. Most companies that were deeply involved in subprime lending are trying to reposition themselves.

Including Providian, which now plans to focus on what Saunders calls the middle market--a notch higher than subprime. The problem is that even though the default rates are lower in that market, it is a lower-margin business that's riddled with competitors. "I don't know that [Providian] has a differentiated competitive advantage," says Todd Pitsinger, an analyst at Friedman Billings Ramsey Group. Even if Providian can survive, one thing is clear: Its days of crazy growth are long gone.