Credit Card Receivable-Backed Securities Analysts: Thomas Upton, New York The securitization of credit card receivables presents the issuer with several potential benefits, including the efficient use of capital, a potentially lower weighted average cost of funds, a diverse source of funding, improved asset and liability management, and enhanced balance-sheet liquidity. Investors are attracted to credit card-backed debt because the underlying assets, in the absence of a change in business strategy, tend to exhibit relatively stable characteristics. Most credit card securitizations display many of the following structural features. Characteristics of a Typical Credit Card-Backed Structure The two classes of certificates are: an investor certificate and a seller certificate. Each represents an ownership interest in the assets of the trust. Under normal conditions, the trust will have perfected security interest in the existing receivables, future receivables arising from the selected accounts, and the proceeds thereof. New receivables will automatically be conveyed to the trust. When securitizing credit card receivables, it is the receivables themselves, not the underlying accounts that are either sold or transferred to the trust. The seller of the receivables retains full control and ownership of the credit card accounts and thus the ability to change the terms and conditions of the credit card agreement, including minimum payment terms. Revolving period. During this period, typically the first 18 to 36 months, no principal is passed through to investors. Principal payments that are allocated to investors are reinvested in new receivables. 1
Amortization period. This period begins at the end of the revolving period or after the occurrence of an early amortization event. During this period, a percentage of principal collections and charge-offs are passed through to investors. Sellers interest. The residual interest between the total principal receivables owned by the trust and the principal amount of the investor interest belongs to the seller and is represented by a seller certificate. As cardholder balances vary, the residual interest will fluctuate. Allocation of cardholder payments. A number of methods have been applied to the distribution of cardholder payments between the two types of certificates. Cardholder finance charge payments and charge-offs are normally distributed proportionately. Early amortization events. These events are designed to enhance the transaction's credit quality by discontinuing the revolving period if the reinvestment of investor principal payments becomes significantly less desirable. Early amortization events that could cause the early distribution of principal to investors may include the insolvency of the seller, a servicer default, excessive dilutions, charge-offs or delinquencies and significant declines in portfolio yield, portfolio growth, or payment rates. Selection criteria. The credit quality of the pool may be enhanced by excluding certain high-risk accounts. This can be done by excluding entire segments of a portfolio or selecting accounts based on age or delinquency status. Typically, loss rates on credit cards tend to peak between 18 to 24 months after origination of the card. Addition and removal of accounts. To avoid an early amortization event and limit the size of the trust, issuers may 2
be permitted to add or remove accounts. Restrictions are typically included in the receivables purchase agreement to control the number of new accounts that can be added without a review by Standard & Poor's. Fee coverage. The transaction's cash flow should support the costs of a backup servicer. Servicing quality is extremely important and could be compromised by a failure to pay servicing fees. Servicing activities include: transaction authorization, credit extension, customer service, posting of transactions, statement mailing, payment processing, accounting, and collections. A deterioration in servicer performance could have an immediate adverse effect on the credit quality of the portfolio. If the seller or servicer enters insolvency or defaults, the lack of a guaranteed servicing fee could affect the trustee's ability to obtain a substitute servicer. Credit enhancement. For a security to achieve a rating, the assets of the trust may require credit enhancement. This support may be achieved using a letter of credit, subordination, overcollateralization, or via the use of some form of reserve account. Key Rating Considerations Key rating considerations for credit card-backed securities reflect the nature of the collateral and the structure of the securities. The analytical focus is on the collateral, portfolio yield, payment rates, portfolio growth, regulatory constraints, and credit enhancement. Collateral loss rates. Credit cards are unsecured, revolving debt obligations, supported only by the customer's contractual promise to pay. Since there is no tangible asset to repossess in the event of a cardholder default, recovery of amounts written off is low. In addition, people who cannot pay all of their debts tend to pay their secured loans first. Standard & Poor's concern with the nature of the asset is 3
reflected in conservative loan loss assumptions. The severity of the loan loss assumption will vary between lenders. This is because loan losses vary considerably among credit card issuers. Pool selection criteria can also influence the assumed loan loss level. Underwriting standards, seasoning of the portfolio or selected accounts, and geographic distribution may all influence loan losses. Standard & Poor's assumes a future write-off rate after assessing the card issuer's credit policies and procedures, historic loss and delinquency data, and other portfolio characteristics. Modeling the cash flows of the transaction is undertaken to determine the level of credit enhancement required for the asset-backed securities to attain the desired credit rating. Dilutions. Dilutions represent reductions in the amount that can be collected from receivables transferred by the seller to the trust. Typically, these arise from the return by the customer of goods to the retailer or service provider, discounts for early account payment, billing errors, and adjustments. Just as losses reduce the amount that can be collected from the receivables so do dilutions. Standard & Poor's requests a detailed analysis of the historical level of dilutions experienced by the portfolio. Dilution risk can either be mitigated through the credit enhancement incorporated in the transaction or by having the dilutions entirely allocated to the seller certificate without any allocation to the investor certificates. Portfolio yield. Portfolio yield is influenced by several factors outside the card issuer's control. These include competition from other card issuers, convenience use, delinquencies, and legislative action on the interest rates that can be charged on credit card debt. Annual percentage rate income is the major component of portfolio yield. But not all credit card receivables produce this income stream, since cardholders can avoid interest expenses by paying off their entire balance on each payment date. To help mitigate the reduction in portfolio yield, issuers may increase the yield by including other income items in the cash flow, such as annual fees, foreign exchange earnings, and overdue account fees. 4
Standard & Poor's evaluates all components of portfolio yield and any potential future adverse factors in deriving conservative yield assumptions. Payment rates. Minimum and average payment rates vary across portfolios. Payment rates directly influence the timing of cash flows to investors. If cash flows are delayed, as a result of a decline in the payment rate, investor loss exposure is increased. To allow for this payment flexibility, Standard & Poor's will stress transaction cash flows by assuming payment rates well below historic experience. Issuers have converted the historically short-term credit card receivables into long-term securities by incorporating a revolving period. During this period, no principal is passed through to investors. Principal payments are instead reinvested in further receivables. The revolving period lasts for a specified duration, after which cardholder principal payments are passed through to retire investor principal. To accelerate the pass-through of principal to investors, issuers allocate principal payments to the investor's interest based on a fixed percentage. This fixed percentage is usually equal to the investor's proportionate interest in the receivables at the end of the revolving period. The investor's fixed percentage should always be greater than their proportionate ownership interest in the trust. The revolving period may be terminated early if certain trigger events occur. Examples of trigger events include a substantial decline in portfolio yield; a deterioration in the performance of the portfolio, that is, regarding delinquencies, charge-offs or dilution; and certain occurrences of issuer, servicer, or trustee default. Commonly, the historical payment rates of a portfolio may be discounted by as much as 50% in Standard & Poor's cash flow modeling of the transaction. 5
Portfolio growth. Cardholder reborrowing, new purchases, and advances play an important role in determining cash flows. The rate of customer reborrowing is determined by the individual's approved borrowing capacity and the degree of debt the cardholder is willing to accept. Customer reborrowing rates vary across portfolios and may be influenced by the availability of alternative sources of credit and economic conditions. A portfolio that is experiencing a high degree of growth and exhibiting low losses may in fact be masking that the true level of losses, which may in fact be increasing, albeit at a slower percentage rate than the growth rate of the portfolio. In these instances, Standard & Poor's usually seeks vintage analysis or static pool information on which to base its assumptions. Portfolio purchase rate. This variable will differ depending on the type of card portfolio, for example, bank card versus a retail store card. Standard & Poor's evaluates customer reborrowing patterns and behavior. Customer reborrowing may be affected by several variables, including alternative sources of credit, economic conditions, and the benefit or utility of the credit provided by the card. In addition, the portfolio purchase rate used by Standard & Poor's in its analysis will vary depending on the credit rating of the originator as well as the rating on the certificate that the issuer is trying to issue. Regulatory constraints. Regulatory controls that may govern credit card lending or cap the allowable credit card interest rates and or fees which may be charged can have a major impact on cash flows, for example, by accelerating payments and reducing the amount of reborrowing. Standard & Poor's fully evaluates the regulatory environment and assesses the potential impact on cash flows and required credit enhancement levels. 6
Credit enhancement. In addition to conservative selection criteria and the inclusion of amortization trigger events, credit quality may be enhanced by letter of credit support, a reserve account, overcollateralization, or subordination. The adequacy of the level and type of cash flow support is measured by the issue's ability to withstand worst-case scenarios, tested in Standard & Poor's cash flow models. 7