Synthetic account fraud a likely culprit in issuers’ rising charge-off rates

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Credit card issuers are beginning to see significant upticks in credit card account charge-offs, with Discover the latest to report a spike, flagging a 55% hike in losses during the most recent quarter. But what exactly is driving the increase?

Research conducted by Auriemma Consulting suggests that one factor contributing to the charge-off spike is a sharp increase in certain forms of account fraud, particularly accounts based on fake, or synthetic identities that look legitimate to lenders when authorizing new accounts.

Historically, synthetic fraud hasn't been the primary suspect. For example, an industry-wide spike in credit card charge-off rates came after credit-underwriting policies grew too lenient following a recovery after the crash in 2008, when issuers became much stricter in the face of massive consumer defaults and bankruptcies.

Wider availability of credit is one factor driving the charge-off spike, analysts agree, but even Discover execs noted during a conference call with analysts that economic conditions currently are relatively favorable and debt-to-disposable income levels are “manageable."

In synthetic identity fraud, scammers create a fictitious but convincing identity from a combination of legitimate and stolen data to win approval for a new credit card account. After racking up big charges, they abandon the account. Losses from synthetic fraud average about $15,000 per account, typically higher than an ordinary charged-off account, Auriemma said.

Auriemma analyzed accounts that have recently been charged off and found indications that synthetic fraud is having at least an incremental effect in inflating credit card delinquency and loss rates.

Synthetic identities made up 5% of charged-off accounts and up to 20% of associated credit losses last year, totaling about $6 billion, Auriemma said. Comparable data from previous years is hard to come by, because it’s difficult for lenders to sort out whether charged-off accounts were from legitimate customers or scammers, analysts said.

“Despite issuers assigning up to a third of their new-account losses to synthetic identity cases, many don’t actually measure the phenomenon,” said Al Pascual, a senior analyst with Javelin Strategy & Research.

One reason is that methods to sift through legitimate charged-off accounts and find carefully crafted fake ones are arduous, and although synthetic fraud isn’t new, the fraud environment recently has changed significantly.

“We’ve seen a rise over the last two years of fraudulent accounts which could be due to EMV’s introduction into the U.S. market (driving fraudsters away from counterfeit fraud), more data breaches broadly exposing consumer data and weak identity verification capabilities among much of the financial industry,” Pascual said.

Synthetic fraud also has received a boost from issuers speeding up the process of approving new accounts through mobile channels, while fraudsters have honed their ability to dupe issuers on a broad scale via automation and other tricks, analysts say.

Credit card delinquency and loss rates as a whole rose 14.8% and 12.3%, respectively, in the first quarter of 2017 over the previous year, and while most of that may be attributed to accelerated consumer borrowing and a corresponding rise in defaults, evidence suggests synthetic fraud is part of the mix, according to Ira Goldman, a director at Auriemma who heads the firm’s Synthetic Identity Fraud Working Group.

Fixing such a complex problem may require cooperation from various organizations and agencies, Goldman said. Cross-checking applicants' information against Social Security Administration records isn't possible and would likely be prohibitively time-consuming, he added.

Tighter underwriting requirements won't do much to blunt synthetic identity fraud, as many of them appear to have healthy credit scores of 720 or higher, Goldman noted, but tighter pre-screening strategies are being considered, including searching for anomalies in applicants' credit profiles, adding data from payrolls and utility payments and introducing more triggers for manual review of suspicious accounts.

Discover itself is beefing up its anti-fraud tools. Last month Discover rolled out a breach-alert service to warn consumers who opt to be notified if their Social Security number appears on the “dark web” or any other risky websites.

Identity verification services that leverage biometrics and behavior are on the rise, and Discover said its delinquency rate already has leveled out since closing its books for the quarter ended June 30.

“In terms of where we stand right now, delinquency rates have largely stabilized,” R. Mark Graf, Discover’s chief financial officer, told analysts during a July 26 conference call.

But issuers will still find it challenging to stay ahead of fraud, experts say.

“While issuers may put in place early account rules to limit risky behavior, criminals have learned to wait these out so as to avoid raising any red flags and potentially allowing them to secure a larger credit limit in the interim,” Pascual said. “So whether it’s true-name fraud or synthetic identity fraud, there are plenty of underlying reasons why charge-offs are likely to continue to rise.”

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