CHAPTER
THIRTY-THREE
CREDIT CARD ASSET-BACKED SECURITIES

JOHN MCELRAVEY, CFA

Director, Head of Consumer ABS Research
Wells Fargo Securities, LLC

The securitization of credit card receivables began in 1987, and the credit card asset-backed securities (ABS) market grew rapidly over the years to become one of the largest securitization sectors. New issue volume averaged $60 billion per year from 1995 to 2008, and credit cards became a consumer ABS staple. As a result, credit card ABS outstanding grew from $130 billion in 1995 and peaked at $402 billion in 2003. Outstandings settled to about $350 billion in 2007 just ahead of the financial crisis. Because of its liquidity, transparency, and relatively high-credit-quality sponsors, credit card ABS became something of a safe haven for ABS investors during periods of market volatility. Indeed, many investors making their initial foray into ABS would likely dip their toes into credit cards before wading into the many other asset classes available.

The size of the credit card ABS market corresponded with the growth in the credit card market overall. Consumers came to rely on credit cards as a convenient method of payment for an expanding universe of goods and services, as well as an easy means of accessing credit. At the same time, credit card lenders viewed direct access to funding in the capital markets as a cost-effective alternative to gathering core deposits. Since the recession and financial crisis of 2007–2009, many credit card lenders have come to rely less on securitization than in the past. Nevertheless, the credit card ABS sector should remain a core segment of the securitization market. This chapter summarizes the key structural features of credit card securitization and provides an overview of the credit card ABS market.

SECURITIZATION OF CREDIT CARD RECEIVABLES

Credit card securitizations began in the late 1980s and early 1990s by banks looking to diversify funding sources for their credit card businesses and as a way to remove assets from the balance sheet. At this time, the banking industry faced the imposition of stricter capital standards by regulators. Securitization provided a vehicle to help meet these standards by reducing balance sheet assets and thereby improving regulatory capital ratios. Beyond the beneficial capital treatment, securitization also allowed specialized credit card banks to enter the market and grow rapidly without having to rely heavily on attracting consumer deposits as a cheap funding source. These specialty banks, which included MBNA, First USA, and Capital One, were able to access the credit markets directly and achieve funding costs that were competitive with those of the established bankcard issuers. Much of the increased innovation and competition in the credit card market during the 1990s can be traced to these banks, which could not have grown as rapidly as they did without the benefits afforded by securitization.

Certain changes in accounting rules in recent years, namely FAS 166/167, have forced most credit card securitizations back on the balance sheets of commercial banks. This move has reduced or eliminated the advantageous capital treatment of securitization relative to other forms of on-balance-sheet funding. As a result, credit card ABS will have to compete with equity, debt, and deposits to fund the credit card businesses of commercial banks. While it may be smaller than it was in the past, it seems likely that the credit card ABS market will remain a core segment of the consumer ABS market, and an important source of funding for many credit card lenders.

Basic Master Trust Structure

The structure used for credit card securitization until 1991 was a stand-alone trust with a dedicated pool of credit card accounts and the receivables generated by those accounts. Each securitization required a new trust and a new pool of collateral, and the securities were backed only by that collateral pool. Since 1991, the master trust has become the predominant structure in the market (Exhibit 33–1). As the name implies, the issuer establishes a single trust that can accept periodic additions of accounts and issue multiple series of securities. All of the securities issued by the master trust are supported by the interest and principal collections from all of the receivables contributed to it. The collateral pool is not segmented to support any individual securities.

EXHIBIT 33–1
Basic Master Trust Structure

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The credit card issuer, and seller/servicer of the accounts and receivables, pledges the accounts to the master trust (step 1). The master trust sells securities to investors (step 2) in various series. The investors are entitled to their share of interest and principal collections, and are allocated their share of defaults and losses. At the same time, the seller/servicer maintains an interest in the master trust called the seller interest. This seller interest is not credit enhancement for investors, but is pari passu with investors. The seller interest receives its share of interest and principal collections, and is allocated its share of defaults and losses. This is returned to the issuing bank (step 3).

For the issuer, the master trust structure lowers the cost of issuing ABS and provides greater flexibility. From the investor’s point of view, assessing the credit quality of a new issue may require less analysis because there is only one pool of collateral to review. As the collateral pool in the trust grows, it generally becomes more diversified. While the characteristics of the collateral pool may change somewhat over time owing to changes in interest rates, underwriting criteria, industry competition, and so on, any change in the master trust would likely be more gradual than would the differences in stand-alone pools.

Master Note/Owner/Issuance Trust Structures

Credit card master trust structures evolved over time, and now most issuers utilize structures called master note or owner or issuance trusts. This chapter will refer to them as issuance trusts (IT). The bonds issued by an IT are still backed by a pool of revolving credit card accounts and receivables, and the credit analysis for investors is not affected in a meaningful way. However, there are important structural differences from older credit card master trusts using earlier technology. Perhaps most importantly, the IT structure provides the issuer with additional flexibility to meet investor demand for different maturities or types of bonds.

Because of consolidation in the credit card industry over time, many surviving credit card ABS issuers may have more than one legacy credit card trust with its particular collateral pool. Exhibit 33–2 presents an example of an IT structured by an issuer active in the market with a legacy credit card master trust. Like our simple example above, the credit card bank pledges the accounts and receivables to its credit card master trust. This legacy trust has several series outstanding in the investor interest and each series has its own dedicated credit enhancement (Series 1–3). Then, the credit card bank decides to establish an MOT to take advantage of the state of the art in the securitization market. To accomplish this, the existing master trust issues a collateral certificate (Series 4). The collateral certificate represents an undivided interest in the assets of the legacy master trust and is allocated its proportionate share of principal collections, finance charges, defaults and losses, and servicing fees. For credit card banks with more than one legacy master trust, it is conceivable that each one could issue a collateral certificate that could be used to pass through to the IT.

EXHIBIT 33–2
Master Issuance Trust Structure

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Credit card ABS issuers gravitated to the IT structure primarily for the increased flexibility that it allows when issuing new securities. Under the early master trust programs, issuers were required to issue subordinated bonds at the same time as the senior bonds. The senior and subordinated bonds were linked. However, the current credit card issuance trusts can be likened to a corporate medium-term note program. Different classes of securities can be issued at different times, in varying sizes, and with distinct maturities. This flexibility allows the issuer to be opportunistic with regard to the timing of new ABS securities, and tailor those securities to the demands of its investor base.

This characteristic of the IT is sometimes referred to as a “delinked” issuance trust because the AAA-rated senior securities can be issued separately from the subordinated bonds that provide credit enhancement for the senior notes. The subordinated bonds are no longer directly linked to a specific series of senior bonds having the same maturity. In the IT structure, all of the outstanding subordinated classes act as credit enhancement for all the senior classes. These may be known as shared enhancement series, and can be seen in the lower section of Exhibit 33–2. New senior bonds can only be issued to the extent that there is a sufficient amount of subordinated bonds already outstanding. For example, Class B bonds can only be issued if there is a sufficient amount of Class C bonds already outstanding to support them, and Class A bonds can only be issued to the extent there is an appropriate amount of Class B and Class C bonds. A “sufficient amount” is the amount of credit enhancement required by the rating agencies to maintain the desired credit ratings on the bonds.

The subordinated bonds may have different maturity dates than the Class A bonds. If a subordinated class matures prior to a senior class, then a replacement subordinated bond must be issued prior to the maturity to take its place. If a replacement bond cannot be issued in time to maintain the required credit enhancement, then principal collections would be deposited into an account that would support the senior bonds. Therefore, the senior bonds would always have an appropriate amount of credit enhancement outstanding. The senior bonds benefit from the subordination up to and including the required amount. They would not have the benefit of subordinated bonds issued in excess of the required amount.

The IT structure also became popular with issuers and investors because it allowed for an expansion of the potential investor base for credit card ABS, especially for the subordinated bonds. Securities could be issued as notes rather than as pass-through certificates. In doing so, all classes, including the subordinated classes, can achieve ERISA (Employee Retirement Income Security Act) eligibility. This feature is important because pension funds, a significant source of fixed income investor funds, can only buy securities that meet ERISA guidelines. In this way, the total investor base for credit card ABS was expanded, especially for subordinated bonds, which very often could not achieve ERISA eligibility. Liquidity improved for subordinated bonds, which had lagged the senior classes. In addition, the IT structure allows for easier and more timely execution of reverse inquiry issuance when an investor has a particular coupon or maturity need.

Investor Interest and Seller Interest

Credit card master trusts allocate credit and cash flows between the ABS investors and the master trust sponsor. The sponsor is typically the seller/servicer of the accounts pledged to the trust. The investor interest is simply the aggregate principal amount owed to the ABS investors. The seller interest is a residual interest in the trust that the credit card issuer is required to maintain. The seller interest aligns the incentives of the credit card bank with those of the outside investors because the seller has a pari passu claim on the cash flows of the trust. As noted earlier, the seller interest receives its share of finance charge collections and principal repayments, as well as it allocation of defaults and net losses.

The minimum required seller interest for most master trusts tends to be in the 4% to 7% range of outstanding receivables balances. In practice, the seller interest is likely to be higher than the minimum required by the rating agencies depending on the sponsor’s strategy toward using securitization for its funding needs relative to other forms of financing. In addition to aligning the interests of the issuer and the investors, the seller interest is in place to absorb the fluctuations in the amount of outstanding receivables. For example, seasonal patterns of credit card usage mean that the receivables outstanding can change substantially from month to month. In addition, the seller interest would be allocated dilutions from purchases that have been reversed and any ineligible receivables to back the ABS. The seller interest does not provide credit enhancement for the ABS, at least not directly. Credit enhancement for the ABS, discussed more fully later, is provided by subordinated securities in the investor interest, or by other structural features of the master trust.

As an issuer’s credit card business grows, new accounts that meet the eligibility criteria may be added to a master trust. An account addition normally requires rating agency approval, unless it would amount to a relatively low percentage of the current receivables balance (usually 10% to 15%). Sponsors may also withdraw accounts from the master trust, again with rating agency approval. Sellers are obligated to add accounts if the seller interest falls below the minimum level. If the seller is unable to add receivables, then an early amortization event is triggered and investors begin to receive principal repayments immediately. The risk of an early amortization gives the seller a powerful incentive to support its credit card securitization, because it is often a substantial portion of the funding for the credit card business. Early amortization and sponsor support will be addressed more fully later in the chapter.

THE CREDIT CARD ABS LIFE CYCLE

Under normal circumstances, the life cycle of credit card ABS can be divided into two main periods after it has been issued: the revolving period and the amortization period. We discuss each in the following.

Revolving Period

During the revolving period, investors receive interest payments only. Principal collections on the receivables are used to purchase new receivables created from customer card usage, or to purchase a portion of the seller interest if there are not enough new receivables being generated by the designated accounts. The revolving period can be used by an issuer to finance short-term credit card loans over an extended period of time. Furthermore, the revolving period is a structural device used to maintain a stable average life on the credit card ABS, and to create more certainty for investors for the expected maturity of the bonds.

Amortization Period

After the end of the revolving period, the amortization period begins and principal collections are used to repay the ABS investors. The length of the amortization period may vary depending on the monthly payment rate (MPR) of outstanding principal of the accounts in the master trust. The MPR is the un-annualized percentage of the principal receivables balance repaid each month. Trusts with slower MPRs would likely require longer amortization periods than those with faster MPRs. For example, credit card ABS with a five-year expected maturity might have a 48-month revolving period and then enter amortization for the final 12 months of its life. The amortization period of credit card ABS usually may be accomplished through either controlled amortization or controlled accumulation. Most trusts today favor a controlled accumulation of principal to pay off its maturing ABS.

In a controlled amortization, principal payments are made to ABS investors in equal payments during the amortization period (Exhibit 33–3). This simplified example assumes that one investor series has been issued out of the master trust. During the four-year revolving period, investors receive only interest payments and principal collections are used to purchase newly created credit card receivables. The total amount of receivables varies over time between $700 million and $800 million during the revolving period, and these fluctuations are absorbed by the seller interest. The seller interest percentage averages 19% through the first 48 months, well above the typical minimum levels. At the beginning of year five, the revolving period ends and the controlled amortization begins. In our example, investors receive principal payments in 12 equal installments, and principal collections not needed to repay ABS investors are used to purchase newly created receivables from the cardholders. Interest payments continue based on the declining principal balance of the ABS.

EXHIBIT 33–3
Controlled Amortization

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In a controlled accumulation, principal collections needed to repay ABS investors are deposited each month into a trust account and held until the expected maturity date (Exhibit 33–4). This example again assumes a four-year revolving period. At the end of the revolving period, principal collections are collected in 12 equal installments and excess principal collections are used to purchase new receivables. Interest payments to investors during the accumulation period are made based on the original outstanding invested amount. A single “bullet” payment of principal is made at maturity to the ABS investors. This structural device developed as a way to emulate the cash-flow characteristics of a corporate bond. It is generally referred to as a “soft bullet” because, like most securitizations of consumer assets, the legal final maturity of the ABS bond is beyond the expected maturity date of the bond to account for potential variations in principal collections.

EXHIBIT 33–4
Controlled Accumulation

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Early Amortization

Under certain circumstances, such as poor credit performance or a financially troubled servicer, an early amortization of the master trust could occur as a mechanism to pay off ABS investors early and minimize their potential credit losses. In most trusts, trigger events are put in place to reduce the length of time that investors would be exposed to a troubled collateral pool. Exhibit 33–5 lists some common early amortization triggers found in credit card master trusts. If an early amortization trigger is hit, then a master trust with bonds still in their revolving periods would stop revolving and immediately begin to pass through principal collections to the ABS investors in order of priority. One structural enhancement available in most trusts to protect investors allows for principal to be passed through on an uncontrolled or rapid amortization basis. This mechanism diverts principal due to the seller interest towards payment of the ABS in order to get investors repaid more quickly.

EXHIBIT 33–5
Common Early Amortization Triggers


Collateral pool credit

Three-month average excess spread falls below zero.
Seller interest less than the minimum required level.
Collateral outstanding balance below the invested amount.

Seller/servicer events

Failure to make required deposits or payments.
Failure to transfer receivables to the trust when required.
Events of default, bankruptcy, or insolvency of the seller/servicer.
Breach of representations and warranties.

Legal issues

Trust is reclassified as an “investment company” under the Investment Company Act of 1940.


Source: Various transaction prospectuses.

CASH-FLOW ALLOCATIONS

The collection of principal and interest on the credit card accounts and passing it through to the ABS trust is relatively straightforward. The allocation of cashflows to investors and the sponsor can take on more complexity.

Groups

A credit card master trust may use the concept of a group to help allocate cash flow to different ABS issued by the trust. One or more groups may be established and each series of securities issued to investors would be assigned to a group. At its highest level, the master trust allocates cash flows pro rata between the investor and seller interests. The investor interest would be divided further at the group level. Although many trusts have only one group, others could have two or more. In trusts with more than one group, series of securities with similar characteristics would likely be grouped together. For example, all the fixed-rate coupon bonds could be in one group and all the floating-rate coupon bonds could be in another group. Any sharing of excess principal or finance charge collections, if called for in the cash-flow waterfall of the master trust, would be determined at the group level.

Principal Collections

Principal collections are allocated on a pro-rata basis to each series of ABS bonds in the same group based on the size of its outstanding principal balance. The allocation of principal to each series is determined by where that series is in its ABS life cycle. Series in their revolving period are allocated no principal collections. Their principal is reallocated and may be shared with other series that are amortizing to the extent it may be needed. The sharing of principal collections is a structural enhancement to ensure timely payment of principal to ABS investors. Principal collections that are not needed to repay investors are reinvested in new receivables.

For a series in its accumulation period, principal collections would be allocated to that series. The pro-rata amount of principal allocated to that series would be determined and fixed by its original principal balance at the beginning of its accumulation period. An additional advantage of the sharing of principal collections between series means that the issuer would have less idle cash sitting in a collection account. The repayment of a maturing ABS series could be accomplished more quickly than the monthly payment rate might imply. For example, an MPR of 10% would imply a 10-month accumulation period. However, if there is only one maturity occurring, then excess principal collections could be used to shorten the accumulation period and reduce the negative carry of cash in a collection account for an issuer.

Finance Charge Collections and Allocations

The primary components of the finance charge collections by a credit card master trust include the monthly interest collected on the outstanding account balance (the APR), any annual or late fees, recoveries on charged-off accounts, interchange, and discounted principal receivables. When expressed as a percentage of the trust’s receivables balance, finance charge collections are called the portfolio yield. The portfolio yield can be thought of as the top-line, revenue number of the master trust.

Most master trusts in use today (master owner or issuance trusts) allocate finance charge collections on a socialized basis. In such a structure, finance charges are allocated to each series within a group based on need. Need is determined by the costs incurred by each series—the bond coupon, servicing fees, and allocated charge-offs based on the size of the series in the group. The expenses for the group are the weighted average of the expenses for each series. Since servicing and charge-offs are allocated on a pro-rata basis, the series with higher coupon costs would receive a larger allocation of finance charge collections. The advantage of this method is that collections are combined to help support higher-cost series. However, the fates of all series are linked—all bonds will receive payments as expected, or the entire trust will enter early amortization together.

A few legacy master trusts with bonds still outstanding use older securitization technology that allocates finance charges based first on the size of the series outstanding rather than sharing according to need at the top of the cash-flow waterfall. These are known as nonsocialized master trusts. In these trusts, each series receives a “floating” allocation of finance charges based on the outstanding invested amount of each series. Excess finance charge collections may or may not be shared based on the cash flow rules for the trust. A potential advantage of a nonsocialized trust is that the risk of early amortization can be more isolated at the series level rather than risking the unwinding of the entire trust. The disadvantage is that higher coupon series could be at relatively greater risk of early amortization if there is a shortfall in finance charge collections or charge-off rates increase sharply. The sharing of excess finance charges helps mitigate, but does not eliminate, this risk.

Principal Discounting, Interchange, and Recoveries

One of the key sources of support for credit card master trusts during the financial crisis of 2007–2009 was the discounting of principal receivables by the trust sponsors. This support mechanism had long been available to credit card ABS issuers, but it had rarely been used. Most master trust documents allow for the discounting of principal receivables, which are counted as finance charge collections. Discounting is a way to temporarily boost portfolio yield and excess spread. An issuer would most likely use this approach when a trust is under stress from lower finance charge collections and higher charge-off rates, and thus avoid an early amortization.

During the recession that began in December 2007, charge-off rates rose sharply and peaked in the 10% to 11% range by the middle of 2009. This weak credit performance reduced the excess spread substantially for most credit card master trusts. Since the level of excess spread is a major early amortization trigger many issuers supported their trusts by discounting principal receivables. Many of the major credit card ABS issuers supported their master trusts in this way.

Two other parts of the finance charge collection calculation deserve some additional attention: recoveries on defaulted accounts and interchange. Recoveries are generally reported as part of finance charge collections, and so they are accounted for in the calculation of the portfolio yield. As a result, when reviewing charge-off rates, it would be more consistent to analyze the gross default rate rather than the net charge off rate. That way any double counting of recovery collections would be avoided in the calculation of excess spread. This calculation of excess spread is discussed in more detail in the Credit Considerations section below. Interchange is a fee paid to the bank that issues the credit card. It compensates the bank for taking on credit risk and allowing a grace period before making a payment. Interchange is created when a bank discounts the amount paid to a merchant for a credit card transaction. It is shared by the merchant’s bank, the bank issuing the credit card, and the clearing network (e.g., Visa or MasterCard) of the transaction.

CREDIT AND INVESTMENT CONSIDERATIONS

We analyzed above the key structural features and cash-flow allocations of a credit card master trust. In this section, we review some of the most important considerations for investors purchasing credit card ABS. Most investors in securitized products require an investment grade rating in order to add a security to a portfolio. Furthermore, many ABS investors focus more exclusively on bonds rated AAA by one or more credit rating agencies. Despite the moves by regulators to reduce the fixed income market’s reliance on credit ratings, it seems likely that credit ratings will remain an important consideration for ABS investors for the foreseeable future because of a lack of a workable alternative.

In order to establish an investment grade rating on credit card ABS, credit enhancement is necessary to absorb potential losses on the collateral pool. The amount of credit enhancement needed will vary from one master trust to another based on the desired rating level and the credit performance of an issuer’s credit card portfolio. In addition, the rating agencies will take into consideration the financial strength of the bank sponsoring the securitization. The credit rating of the bank sponsor has taken on even greater prominence in the rating agency review since the financial crisis of 2008–2009.

Credit Enhancement

Early credit card transactions carried letters of credit (LOCs) from commercial banks to guarantee the payment of the credit card ABS. However, the downgrades of the corporate ratings of a number of credit enhancers exposed ABS investors to downgrades on their investments. Over time, internal forms of credit enhancement that do not rely explicitly on the corporate credit rating of an outside entity have become the norm in the credit card ABS market.

Excess Spread

Excess spread is perhaps the most important measure of the health of a credit card master trust, and it is the first line of defense against losses to bondholders. It is also a key early amortization trigger if the credit performance of the collateral pool begins to deteriorate. Excess spread is the finance charge cash flow left over each month after the investor coupon, servicing fees, and charge-offs have been allocated to the investor interest and the seller interest. The calculation of excess spread is straightforward, as shown in Exhibit 33–6, with the values expressed as annualized percentages of the outstanding receivables balance.

EXHIBIT 33–6
Excess Spread Calculation

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In most credit card master trusts, an early amortization trigger is based on the three-month moving average of excess spread. If the three-month average falls below zero, then the revolving period stops and all principal collections are used to pay off the outstanding ABS bonds. In a nonsocialized master trust, the excess spread trigger is applied at the series level, so an individual series could experience an early amortization without causing the entire master trust to wind down.

Cash Collateral Account

A cash collateral account (CCA) is a cash reserve funded at closing and held by the trust for the benefit of the ABS investors. In most trusts, the CCA is typically available as credit enhancement only to the lowest rated class of securities issued. For example, the Class C bonds in most master trusts (generally rated BBB) are supported by the excess spread and the CCA. The Class A and Class B bonds would have the Class C bonds and the excess spread as credit enhancement, but not the CCA. Investors should carefully note these types of structural features when reviewing credit card ABS. The cash to fund the CCA is usually lent by a third party and invested in high-grade short-term securities until needed to be drawn on against shortfalls in cash flow due to rising charge-offs. Any draws on the CCA would be reimbursed at a later date from future excess spread.

Collateral Invested Amount

An alternative to a cash reserve is a collateral invested amount (CIA), which is a privately placed subordinated tranche available as credit enhancement to the bondholders. The CIA is placed with a third-party investor which may or may not require its investment to be rated by one or more credit rating agencies. The CIA can generally be considered an improvement over the CCA from the viewpoint of the issuer because this tranche is backed by collateral from the master trust rather than cash. The CIA tranche normally has the benefit of any spread account. Draws on the CIA may also be reimbursed through future excess finance charge collections.

Subordination

As the credit card ABS market has evolved, structures have become more complex to provide greater flexibility to issuers and to meet the demand of investors. In the alphabet soup of credit card ABS, LOCs have given way to CCAs or CIAs, which in turn have been replaced in most cases by rated subordinated securities as the market for subordinated bonds became larger, deeper, and more liquid. The subordinated bonds are placed with outside investors and tend to be rated in the single-A and triple-B categories. The generalized capital structure of a credit card master trust may look like the example in Exhibit 33–7.

EXHIBIT 33–7
Credit Card ABS Capital Structure

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In our example, the rating agencies have determined that the AAA-rated securities are 80% of the capital structure and require 20% subordination in addition to the expected excess spread and the implied support provided by the bank sponsor. Likewise, the Class B and Class C bonds are 12% and 8% of the capital structure, respectively. Issuing subordinated tranches to investors allows the issuer to reach a wider investor audience. As indicated earlier, the issuance trust structure allows an issuer to offer senior bonds separately from the subordinated bonds with varying maturities and coupon types.

Master Trust Credit Analysis

While some of the structures may have changed over time, the credit analysis of credit card master trusts has not changed substantially. For example, most credit analysts stress the historical performance of critical variables related to the cash flows to test the structural integrity of credit card ABS. A long period of credit performance over several credit cycles would be ideal when analyzing credit card ABS. Credit data that spans the 2007–2010 period would pick up a severe economic downturn that caused charge-off rates and delinquencies to increase sharply and put substantial stress on the credit card ABS sector. In addition, static pool vintage data would be helpful to see how performance or underwriting standards may have changed over time.

There are several key quantitative variables needed for analyzing credit card securitizations. They include portfolio yield, charge-off rate, delinquency rate, excess spread, monthly payment rate, monthly purchase rate, and the coupon paid to investors. Each of these variables is important for analyzing the ongoing health of a credit card master trust, and they play a role in analysis of a potential early amortization.

Portfolio Yield

As noted, portfolio yield is a measure of the income generated by the credit card receivables. While portfolio yield is driven largely by the annual percentage rate (APR) paid by the cardholders, annual fees and late fees can also boost yield. Furthermore, usage by accountholders is also important. All else equal, a portfolio with proportionately more revolving accounts relative to convenience users will translate into a higher portfolio yield (Exhibit 33–8).

EXHIBIT 33–8
Wells Fargo Securities Portfolio Yield Index

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Charge-Offs and Excess Spread

Excess spread has been discussed at length earlier in the chapter, and is perhaps the most important measure of the health of a credit card master trust. Charge-offs are the credit losses experienced by the portfolio and normally are taken when an account becomes 180 days past due (Exhibit 33–9). Peak losses on static pools of credit card accounts have been observed at about 24 months of seasoning. The juxtaposition of excess spread and charge-offs can be a powerful analytical tool for determining tiering among various credit card issuers.

EXHIBIT 33–9
Wells Fargo Securities Credit Card Indexes

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Serious Delinquency Rate

A good leading indicator of future charge-offs is the delinquency rate for accounts 60 days or more past due (60+ dpd). The direction of serious delinquencies can point to important credit trends in credit card master trusts. For example, during the recession of 2007–2009, changes in the direction of 60+ dpd provided an early warning signal for the rapid increase in the charge-off rate of most credit card ABS deals.

Monthly Payment Rate

The monthly payment rate (MPR) is an important, but often overlooked, variable in the analysis of credit card ABS because high MPRs can be a source of strength and implied credit enhancement when a portfolio comes under stress. For example, a large proportion of convenience users, while depressing portfolio yield, can increase payment rates sharply (Exhibit 33–10). The faster turnover of the receivables means that investors can be repaid more quickly in the event of an early amortization.

EXHIBIT 33–10
Wells Fargo Securities Payment Rate Index

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Purchase Rate

Related to the payment rate is the purchase rate, which is generation of new receivables by the designated accounts. A higher purchase rate means that more receivables are being created to support the outstanding ABS. A bankruptcy or insolvency of the seller/servicer is the main risk with regard to the purchase rate because cardholders may stop using their cards as the utility declines. This risk can be particularly acute in private label or department store cards; however, this event can happen with bank cards as well. As the amount of receivables declines the credit quality of the portfolio is likely to deteriorate.

Investor Coupon

Floating-rate ABS may require more credit enhancement than fixed-rate bonds because the rating agencies assume in their stress scenarios that market interest rates increase dramatically. Higher funding costs for the ABS reduce the available excess spread to protect ABS investors.

Testing Master Trust Structures

In general, stress testing a credit card master trust structure would involve forcing portfolio yields, payment rates, and purchase rates down sharply at the same time that charge-off rates rise. This combination of factors compresses excess spread and causes an early amortization of the master trust. There have been only a few instances of early amortization, but in general charge-off rates do increase significantly, whereas purchase rates fall and the payment rate drops to a minimal level of about 3%. Interestingly, portfolio yield has held up relatively well in these instances. In addition, early amortization tends to have hit weaker, less diversified issuers of credit card ABS.

There are also some important qualitative elements that should go into any analysis. For example, geographic concentration, the strategic objectives of the firm, seasoning of the accounts, and the type of card (general purpose card or private label card). The underwriting standards for new accounts can also play a role in the analysis. These types of qualitative factors can help to determine the degree of stress to apply to various quantitative factors.

As the credit card lending market has consolidated over the past decade, geographic concentration has probably become less of a concern. Most major credit card issuers of general purpose cards, such as those banks that offer Visa, MasterCard, Discover, or American Express, try to source accounts from the general population. However, market pricing of credit card ABS often takes into account the corporate credit quality of the bank sponsor. Stronger banks can offer deeper pockets and more support to its credit card master trust in times of stress than a weaker bank. This tiering became more significant during the financial crisis of 2008–2009.

Credit card lenders have long used certain marketing programs to gain market share and build brand loyalty among cardholders. These programs can play a role in the credit profile of the accounts backing the master trust.

Teaser Rates

For example, lenders may use offers with a low initial APR and no annual fee to lure customers away from competitors. This use of “teaser rates” may also allow borrowers to transfer existing balances from higher rate cards to the new teaser rate. These teaser rate programs may be available for only a limited time, such as 6 to 12 months. One of the potential problems with this approach is that it can create adverse selection in the account base. Borrowers with a poor credit history may be more likely to respond to the cheaper terms of credit. Most banks tend to use these programs on a targeted base of potential applicants in order to mitigate the likelihood of lending to weaker borrowers.

Affinity and Co-Branded Programs

One of the major uses of the technological investment made by credit card issuers has been in the customer retention effort. A package of interest rates, credit limits, and other services can be offered to entice customers to stay once the teaser period ends. These packages can come in myriad combinations and can be offered based on the credit profile and usage patterns of the cardholder. This strategy of mass customization is made possible by sophisticated computer systems that search huge databases and track the credit history and profitability of existing customers.

Two products created by card issuers to differentiate themselves in the minds of cardholders are affinity and co-branded programs. Affinity cards are issued by a bank in association with a special interest group such as a college alumni association, professional group, or sports team. The group receives a fee from the bank, and the bank gets to market its card to a demographic that it wants to attract. Co-branded cards are programs that associate a bank’s credit card with a commercial firm. Customers can earn certain rewards from the firm for making purchases with the card. Mileage awards with airlines, for example, are some of the most popular co-branded programs. However, gasoline companies and hotel chains also make use of these programs to build customer loyalty.

Private Label Credit Cards

The objectives of private label credit card issuers may be somewhat different from those of the general purpose card programs. Private label credit card programs are sponsored by retailers for use in their own stores as a means of boosting sales, although over the past several years the administration of these programs has moved from the retailers themselves to banks that specialize in private label credit cards. Underwriting may be less stringent than that of a general purpose card program, and losses would normally be expected to be higher for credit card ABS backed by private label accounts. On the other hand, APRs and portfolio yields tend to be much higher to compensate for the greater risk. The market pricing of the ABS issued by private label programs tends to be at a concession to that of benchmark, general purpose card programs. Good relative value can be found among private label credit card ABS issuers by investors willing to investigate them.

KEY POINTS

• The securitization of credit card receivables began in 1987, and the credit card ABS market grew rapidly over the years to become one of the largest securitization sectors. many investors making their initial foray into ABS would likely dip their toes into credit cards before wading into the many other asset classes available.

• Credit card ABSs are structured using a master trust structure. The credit card bank pledges certain accounts, and all of the receivables generated by the accounts, to the trust. The issuer establishes a single trust that can accept periodic additions of accounts and issue multiple series of securities. All of the securities issued by the master trust are supported by the interest and principal collections from all of the receivables contributed to it. The collateral pool is not segmented to support any individual securities.

• The revolving nature of credit card receivables created unique challenges for securitization. As a result, the master trust structure was developed to allow for a revolving period when only interest is paid to investors, and an amortization period when principal is allocated to pay bondholders.

• The master trust is segmented between the investor interest and the seller interest. The investor interest is the ABS sold to third-party investors. The seller interest is the bank’s retained interest in the collateral pool. The seller interest aligns the incentives of the issuer with outside investors because they share in the collections and losses of the collateral pool.

• Bonds carrying credit ratings require credit enhancement to achieve investment grade ratings. Most credit card ABS utilize internal credit enhancement in the form of subordination and excess spread.

• The key variables needed to do credit analysis on a credit card master trust are charge-offs, delinquencies, monthly payment rate, purchase rate, portfolio yield, and excess spread. In the event of distress, an early amortization of the trust could occur. Stressing these variables in a cash-flow model can help determine the structural soundness of the master trust.

• The bank sponsor of the credit card master trust is an important element in the review of credit card ABS. During the financial crisis of 2008–2009, most sponsors of credit card securitizations came to the aid of their ABS trusts. The ability of the sponsor to support its trust should be one of the factors to consider when buying credit card ABS.

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