10-K: NEXTCARD INC
(EDGAR Online via COMTEX) -- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements
and the notes thereto which appear elsewhere herein. The following discussion contains
forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could
differ materially from those projected in the forward-looking statements. Factors that could cause or
contribute to differences include, but are not limited to, those discussed below and elsewhere in this
Annual Report on Form 10-K, particularly in "Factors Affecting Future Results."
OVERVIEW AND RECENT EVENTS
Until February 7, 2002, when the OCC appointed the FDIC as receiver for NextBank, we were an
Internet-based provider of consumer credit. Our product, the NextCard Visa, was marketed to
consumers through our website, www.nextcard.com. We had entered into marketing agreements
with leading websites on the Internet. We also had marketing relationships with Internet-based
affiliates, co-branded partners and affinity groups. We were incorporated on June 5, 1996. The
NextCard Visa was first offered to the public on December 23, 1997. In September 1999, we
acquired Textron National Bank at which time Textron converted into a national bank limited to credit
card operations, changed its name to "NextBank, N.A." and became a member of the Visa system.
Prior to its closure by the OCC, our subsidiary, NextBank, was a limited purpose credit card bank
chartered as a national banking association. As such, NextBank was subject to comprehensive
regulation and periodic examination by the OCC, its primary regulator, and to the risk-based capital
and other guidelines adopted by the OCC. The FDICIA expanded the powers of federal bank
regulatory authorities to take corrective action with respect to banks that do not meet minimum
capital requirements. For these purposes, the FDICIA established five capital tiers: well capitalized,
adequately capitalized, undercapitalized, significantly undercapitalized and critically
undercapitalized.
In September 2000, the OCC completed its first annual examination of NextBank. As a result of the
OCC's examination, the OCC suggested certain improvements in, and enhancements to,
NextBank's infrastructure and operating environment, and requested that NextCard and NextBank
enter into a capital assurance agreement. In response to the OCC's recommendations, NextBank
undertook a number of actions to implement the OCC's suggested improvements and to generally
strengthen its controls over bank operations. In addition, on October 26, 2000, NextCard and
NextBank executed a capital assurance agreement, stating that, in the event that NextBank fell below
"well capitalized" status, NextCard would commit additional capital to NextBank in an amount
sufficient to return NextBank to a capital level equal to or exceeding "well-capitalized" status.
In May 2001, the OCC began its second annual examination of NextBank. In connection with that
examination, in September, 2001 the OCC notified NextBank that, as a result of NextBank's
previously adopted classification of certain loan losses as fraud losses rather than credit losses, the
OCC had determined that NextBank's securitization activities could not qualify for "low-level
recourse treatment" under applicable regulations and such disqualification was incapable of being
cured. The OCC confirmed this position with an interpretive letter dated October 29, 2001. While the
OCC did not conclude that these loan losses were not the product of fraud, the OCC took the
position that such a characterization required detailed account-level procedures. Pending the
development and implementation of such account-level processes, the OCC required that all
affected loan losses be reclassified as credit losses. Although our professional advisors agreed with
our contention that, even assuming that the asserted disqualification for "low-level recourse
treatment" was proper, the disqualification should be curable, the February 7, 2002 seizure of
NextBank has rendered any further appeal or discussion impractical, if not impossible.
The effect of the OCC's decision to disallow low-level recourse treatment on NextBank's securitized
assets was to increase NextBank's risk-weighted assets by approximately $537.5 million, to $2.1
billion as of September 30, 2001, as reported in NextBank's Call Report filed with the FDIC on
October 30, 2001. Inclusion of those assets for purposes of calculating regulatory capital was a
significant factor resulting in NextBank's risk based capital ratios being at a level that rendered
NextBank "significantly undercapitalized" under applicable federal banking regulations.
On October 31, 2001, we announced that NextBank was considered "significantly undercapitalized"
under federal regulations, and that we had engaged Goldman Sachs & Co. to assist us in finding an
acquisition partner for NextCard. From October 31, 2001 until December 31, 2001, we actively
marketed NextCard and NextBank and several potential bidders performed on-site due diligence
examinations of the NextBank portfolio. However, by December 31, 2001, no acquisition transaction
had been consummated.
On November 15, 2001, the OCC issued a Prompt Corrective Action Directive against NextBank.
The Prompt Corrective Action Directive required that NextBank file with the OCC an acceptable
capital restoration plan by December 31, 2001 and required NextBank to limit new account
originations to those with FICO scores above 680, to suspend originations of secured credit cards
and to suspend or limit certain line management programs, re-pricing programs and fee-based
product strategies. A capital restoration plan of a significantly undercapitalized bank must include
the steps the bank will take to correct any asserted capital deficiency. On December 31, 2001,
NextBank filed a capital restoration plan with the OCC that discussed NextCard's ongoing attempts
to negotiate a sale of NextCard to a third party and, if such a sale could not be accomplished,
proposing an orderly liquidation strategy covering NextBank's assets and liabilities. On January 12,
2002, we and NextBank filed an Asset Disposition Plan with the OCC which further detailed
management's proposals to liquidate the assets and liabilities of NextBank. On February 7, 2002,
without having acted on our Capital Restoration Plan or Asset Disposition Plan, the OCC appointed
the FDIC as receiver for NextBank.
Prior to February 7, 2002, our operations consisted solely of providing support to the credit card
banking operations of NextBank. Subsequent to February 7, 2002, our operations will be twofold.
Our operations will include providing the services specified under the FDIC Service Agreement until
that agreement terminates. Additionally, we will attempt to develop a new business model which may
include licensing certain aspects of our proprietary customer service technology to other credit card
companies and adapting its proprietary account origination technology to source, on behalf of one or
more credit card issuers, credit card accounts that satisfy underwriting parameters specified by such
credit card issuers. There is no assurance that we will be successful in developing a new business
model. We are also actively exploring strategic alternatives, which might include a merger, asset
sale or other comparable transaction or a financial restructuring. Any such strategic alternative is
likely to include us making a chapter 11 bankruptcy filing.
Each year since our inception, we have incurred significant net losses. As of December 31, 2001,
we had an accumulated deficit of $409.8 million. The net losses and accumulated deficit resulted
from the significant infrastructure, marketing, technology and other costs incurred in the development
and servicing of our NextCard Visa credit card loan portoflio. Since we currently have no clients for
our proposed new business and no source of funding for our proposed operations after termination
of the FDIC Service Agreement, we expect to incur net losses for at least the next year and there can
be no assurance that we will ever be profitable.
RESULTS OF DISCONTINUED OPERATIONS
Overview
Upon the FDIC's appointment as receiver of NextBank, we ceased to own the assets and liabilities
of NextBank and accordingly we were unable to continue to conduct our banking operations.
Because NextBank was our only significant subsidiary and all of our operations were directly related
to supporting the banking operations, all of our consolidated operations, for all periods presented
have been classified as discontinued operations in the accompanying consolidated statements of
operations. In addition, we recorded a loss on disposal of discontinued banking operations of
$111.0 million. The loss on disposal of discontinued banking operations includes the net book value
of our banking related assets on February 7, 2002 of $92.3 million, as well as severance pay of $0.8
million and estimated accrued losses under our office lease agreements related to the discontinued
banking operations of $17.9 million. The income and loss from discontinued banking operations for
all periods presented are summarized below under the caption "Earnings Summary."
Earnings Summary
The discontinued banking operations' profitability was affected by the net interest income and
non-interest income earned on earning assets, consumer card usage patterns, credit quality, the
level of marketing expense and operating efficiency. Its revenues consisted primarily of interest
income on credit card loans, cash and investments and non-interest income consisting of servicing
income on securitized loans, fees (such as annual membership, cash advance, interchange,
over-limit, past-due and other fee income, which we collectively refer to as "fees") and gains on the
securitization of loans. Its primary expenses were the cost of funding assets, credit losses and
certain operating expenses.
Our banking operations grew rapidly after the NextCard Visa product was launched in December
1997. From December 31, 1997 through December 31, 2001, we significantly increased the amount
of new loans generated through our website as well as the total loans under the banking operations'
management. These increases were primarily due to our application process that allowed
customers to automatically transfer balances from their other credit cards to their new NextCard
Visa. From December 31, 1997 to December 31, 2001, the banking operations' managed credit
card loans receivable outstanding grew from $0 to $2.0 billion. As of December 31, 2001, there
were approximately 1.1 million open credit card accounts.
Summary financial and other information related to our discontinued banking operations as of
December 31, 2001 and 2000, and for each of the three years in the period ended December 31,
2001 follows:
DECEMBER 31,
------------------------
2001 2000
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(IN THOUSANDS, EXCEPT
PER SHARE DATA)
NET ASSETS OF DISCONTINUED BANKING OPERATION
ASSETS:
Cash and cash equivalents .................. $ 62,240 $ 131,622
Equipment and leasehold improvements, net .. 18,165 6,435
Credit card loan receivables ............... 548,239 528,110
Less allowance for loan losses ........... (81,325) (25,136)
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Net loans .................................. 466,914 502,974
Due from securitizations ................... 111,944 75,857
Prepaid and other assets ................... 46,789 52,282
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Total assets ........................... 706,052 769,170
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LIABILITIES
Liabilities:
Deposits ................................... 551,297 380,248
Accrued expenses and other liabilities ..... 10,955 14,659
Secured borrowings ......................... 64,000 211,000
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Total liabilities ...................... 626,252 605,907
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NET ASSETS OF DISCONTINUED BANKING OPERATION $ 79,800 $ 163,263
========= =========
YEARS ENDED DECEMBER 31,
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2001 2000 1999
----------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF OPERATIONS:
Interest income ................................... $ 74,665 $ 81,378 $ 22,054
Interest expense .................................. 34,051 37,156 10,902
----------- ----------- -----------
Net interest income ............................... 40,614 44,222 11,152
Provision for loan losses ......................... 117,120 57,141 12,072
Non-interest income ............................... 129,746 77,312 4,506
Non-interest expenses ............................. 175,055 146,249 80,781
----------- ----------- -----------
Loss from discontinued banking operations ......... $ (121,815) $ (81,856) $ (77,195)
=========== =========== ===========
OTHER DATA:
Total revenue-- managed basis ..................... $ 259,101 $ 158,690 $ 26,560
Loans receivable -- managed basis ................. $ 2,036,857 $ 1,312,318 $ 416,315
Average loan receivables -- managed basis ......... $ 1,913,536 $ 856,003 $ 191,852
Total number of customer accounts -- managed basis 1,127 708 220
Risk adjusted margin -- managed basis ............ 7.16% 8.38% N/a
Net interest margin-- owned basis ................. 5.64% 6.04% 4.25%
Net charge-offs -- managed basis .................. $ 118,254 $ 22,407 $ 3,085
Net charge-off rate -- managed basis .............. 6.18% 2.62% 1.61%
Delinquency rate (31+ days) -- managed basis ...... 7.23% 3.92% 1.48%
Allowance as a percent of on balance sheet loans .. 14.83% 4.76% 2.77%
The following discussion provides a summary of the discontinued banking operations' 2001 results
compared to 2000 results and its 2000 results compared to 1999 results.
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
Loss from discontinued banking operations for the year ended December 31, 2001 was $121.8
million, an increase of 49% from a loss of $81.9 million for the year ended December 31, 2000. As
of December 31, 2001, managed loans, which includes reported and securitized loans, were $2.0
billion, an increase of 55%, over the balance of $1.3 billion at December 31, 2000. Average
managed credit card loans for 2001 were $1.9 billion, an increase of 123% over the average of
$856.0 million for 2000. Total customer
accounts were 1.1 million as of December 31, 2001, an increase of 60%, from 708,000 as of
December 31, 2000. These large increases in balances and accounts were the result of our
marketing and account management strategies and the increased acceptance of credit card usage
over the Internet.
In the third quarter of 2001, NextBank increased loan loss reserves and began limiting certain of its
lending activities. These steps resulted from the worsening economic situation and declining credit
quality as well as discussions with NextBank's regulators, the OCC and the FDIC. At that time, the
OCC was in the process of completing an examination of NextBank.
In the third quarter of 2001, at the direction of the OCC, NextBank reclassified as credit losses
certain loan losses that were previously classified as fraud losses. This change in classification had
the effect of increasing reported credit losses, while decreasing reported other expenses.
Management believes that a substantial portion of these re-classified losses were related to
fraudulent account origination activity specific to the Internet channel. As a result of discussions with
OCC, NextBank began to develop an account level classification system to improve the
documentation of fraud losses. NextBank agreed to continue to classify certain loan losses as credit
losses and include them in its calculation of the allowance for loan losses until such time as a new
classification system could be fully developed and accepted by the OCC. Due to the closure of
NextBank, the OCC's acceptance of the new classification system never occurred so we were
unable to implement the system.
Based upon the above-described fraud loss re-classification, for the quarter ending September 30
2001 and all subsequent periods, the OCC determined that NextBank's securitization activities did
not qualify for "low-level recourse treatment" under applicable regulatory capital regulations. The
effect of the OCC's decision to disallow low-level recourse treatment on the approximately $1.2
billion of securitized loans was to increase NextBank's risk-weighted assets by approximately
$537.5 million.
In light of the increasing loss and delinquency trends experienced in NextBank's loan portfolio, as
well as deteriorating economic conditions generally, which management reasonably expected would
continue, and possibly worsen, and as a result of the above-described re-classification, NextBank
determined to increase its allowance for loan losses at September 30, 2001 to $71.6 million from
$31.0 million at June 30, 2001 and maintain similar levels of reserves through December 31, 2001.
The provision for loan losses was $117.1 million for 2001, an increase of 105%, compared to $57.1
million in 2000, reflecting increased delinquency and loss rates within the portfolio. At December 31,
2001, the allowance for loan losses represented 14.8% of reported loans compared to 4.8% at
December 31, 2000. Including the change in fraud classification discussed above for the third and
fourth quarter of 2001, the managed net credit loss rate for 2001 increased to 6.18% from 2.62% in
2000. In addition, the more than 30 day delinquency rate at December 31, 2001 increased to 7.23%
from 3.92% at December 31, 2000. These increases in credit loss and delinquency rates were due
to the ongoing seasoning of the portfolio, the larger than anticipated increase in consumer
bankruptcy filings and deteriorating overall economic conditions.
Finally, during the third quarter of 2001, NextBank expensed $35.7 million in certain capitalized
intercompany acquisition costs previously expensed by us but still capitalized on NextBank's books.
This charge reduced NextBank's regulatory capital on a dollar-for-dollar basis but did not have any
effect on our consolidated financial statements.
As a result of the elimination of low-level recourse treatment for securitized assets, the increase in
our loan loss reserves and the charge for deferred acquisitions costs, NextBank announced in
October 2001 that it would be considered "significantly undercapitalized" under OCC regulations at
September 30, 2001 because its risk-based capital ratio dropped below 6% as of that date.
NextBank's leverage capital ratio remained at an amount consistent with requirements for "well
capitalized" banks. As of December 31, 2001, NextBank's Tier 1 risk based, total risk-based and
leverage capital ratios were 3.03%, 4.29%, and 8.38% respectively. An "adequately capitalized"
institution is permitted to accept brokered deposits only if it receives a waiver from the FDIC and
pays interest on deposits at a rate that is not more than 75 basis points higher than the prevailing
rate in its market. Undercapitalized institutions cannot accept brokered deposits, are subject to
growth limitations and must submit a capital restoration plan. "Significantly undercapitalized"
institutions may be subject to a number of additional requirements and restrictions.
In addition, pursuant to the OCC's Prompt Corrective Action Directive, the OCC required NextBank
to limit new account originations only to FICO scores above 680, suspended originations of secured
credit cards and suspend or limit certain line management programs, re-pricing programs and
fee-based product strategies. These restrictions had an immediate and adverse impact on our
ability to grow our credit card account base, which adversely affected NextBank's liquidity and
capitalization and reducing non-interest income beginning in the fourth quarter 2001.
In the third quarter 2001, due to worsening economic conditions and credit quality concerns,
NextBank also established a valuation reserve to recognize the estimated uncollectible portion of
accrued finance charges and fees on certain of its non-securitized loans that
were more than 30 days delinquent. This reserve at December 31, 2001 was $6.5 million.
Historically, these finance charges and fees had been reversed against current revenue upon
charge-off of the related account.
The discontinued banking operations' managed net interest margin increased to 6.93% for 2001
compared to 6.00% for 2000. The discontinued banking operations experienced continued
improvements in cost of funds during 2001 as NextBank benefited from re-pricing of its CD portfolio
and conduit borrowing facilities with the general decline in interest rates. Cost of funds decreased by
265 basis points year over year. Similarly, the yield on the credit card portfolio fell 101 basis points
year over year. Notwithstanding the continued lower cost of funds, risk-adjusted margin for 2001
declined to 7.16%, compared to 8.38% in 2000. The decrease was driven by the factors discussed
above including the third quarter 2001 reclassification of fraud losses and the establishment of a
valuation reserve for the estimated uncollectible portion of accrued finance charges and fees on
certain non-securitized loans.
Included in non-interest income are interchange and other credit card fees consisting of income from
the Visa system for purchases made with the NextCard Visa and fees paid by NextBank's
cardholders, such as late fees, over-limit fees and program fees. Such reported non-interest income
for 2001 was $45.1 million, an increase of over 50%, compared with $29.7 for 2000. The significant
increase in credit card fee income in 2001 was attributable to the increase in the credit card loan
portfolio, an increase in cardholder purchase volume, the introduction and increase in marketing of
fee-based products, our increased marketing of secured credit cards and the July 2000 change in
domicile of NextBank's charter to Arizona. In mid-2000, we began marketing fee-based products,
beginning with Credit Guard, our credit protection product. In the second quarter of 2000, we moved
the NextBank charter from California to Arizona and, as permitted under Arizona law, brought the
credit card fees we could charge to our customers more in line with the rest of the industry.
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