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"You've successfully moved beyond bankruptcy and deserve a new beginning," reads a credit-card mail offer from Capital One Financial Corp. (COF).

The pitch, aimed at consumers who have suffered a serious financial setback, underscores the challenge for U.S. financial institutions such as Capital One, Bank of America Corp. (BAC) and Wells Fargo & Co. (WFC): Faced with an erosion in profits stemming from shrinking loan books, and new expansive rules curbing income on credit and debit cards, lenders are exploring ways to lend to a growing breed of borrowers with blemished credit.

A Deloitte Consulting LLP study published earlier this month on first-time defaulters found 11% of 5,142 retail banking customers suffered for the first time a significant financial setback in the last two years, jeopardizing their access to credit from banks.

Not only are the numbers for these first-time credit offenders too large for lenders to ignore, but also a portion still wield the financial heft to take on credit. For U.S. consumers shut off from credit, a new openness by lenders to first-time defaulters may open up funding and a means to rebuild their fractured credit. Finding ways to lend to those with blemished credit is also crucial to the U.S. economy, with the hope that a pick-up in consumer spending will spark job growth.

"The universe of people that are potential candidates for credit isn't as big as it was before the recession. So what do you do? We intend to deploy strategies to address that," said Jim Panzarino, chief credit risk officer at Discover Financial Services (DFS). The card issuer and payments processor reported Thursday an 8% decline in net revenue from a year earlier, on an adjusted basis, to $1.6 billion. Its average credit-card loan balances dropped 6% to $44.7 billion during the same period.

Discover says it will soon start testing findings from its research on means to gauge the creditworthiness of these first-time defaulters. One element in its plan: it will double the number of employees evaluating credit-card loan applications to 400 by the end of 2011. In 2008, Discover had 10 such employees.

In every economic downturn, there are strapped borrowers, likely struggling with unemployment, unable to fulfill their debt obligations. Banks typically write off these loans as losses, and cease lending to these customers. Some consumers eventually find their way back onto lenders' books after rebuilding their credit through, for instance, a secured credit card.

But this time around, many first-time defaulters are likely to rebound more quickly from their setbacks than defaulters in the past, lenders and analysts theorize, since the economic downturn hurt so many people with otherwise sterling financial habits and credit.

One subgroup in particular warrants attention. A large segment of borrowers, known as "strategic defaulters," are walking away from underwater mortgages, even though they have jobs, can afford the debt payments and are current on other loans. Strategic defaults totaled 19% of all mortgage delinquencies in the second quarter of 2009, according to data from Experian-Oliver Wyman.

Credit-card lenders are differentiating between strategic defaulters and "other borrowers who may be in trouble across all of their loans," said Cristian deRitis, a director at Moody's Analytics, an economics and credit consulting firm. "They are continuing to lend, at higher rates of course, to those first-time defaulters with otherwise good credit."

Some lenders are looking at the broader group of first-time defaulters, while others are more focused on the subset of strategic defaulters.

"We continue to analyze and reflect on the opportunity" presented by strategic defaulters, said Mike McCoy, head of consumer credit cards at Wells Fargo. The lender has yet to modify its existing credit standards for these borrowers.

One in four offers for new credit cards are targeted at non-prime consumers, says Andrew Davidson, senior vice president at Mintel Comperemedia. In all, lenders mailed 1.2 billion credit card solicitations in the third quarter, a three-fold increase from 391 million a year earlier, according to the firm, which tracks credit-card mail offers.

A spokeswoman for Capital One said the credit card lender-turned-bank has "a wide range of products for customers based on their needs and profile to include those who may have experienced financial challenges such as bankruptcies."

These explorations come as lenders look for ways to make new loans to spur profits at a time when their loan portfolios continue to shrink. Borrowers reduced their revolving credit lines--mainly card balances--by about $5.6 billion in October from September, according to the Federal Reserve. That's an annualized rate of decline of 8.4%. Since the end of 2008, these balances have shrunk by about $157 billion to $800.5 billion.

At the same time, lenders, still recovering from a massive spate of defaults and delinquencies, have to steer clear of mistakes that fueled recent losses.

"It's extremely important to piece together whether a first-time default is an isolated incident with the consumer getting back on his feet, or something more," said Chip Rossi, Bank of America's head of credit and underwriting for deposits and card products.

-By Aparajita Saha-Bubna, Dow Jones Newswires; 617-654-6729; aparajita.saha-bubna@dowjones.com

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