CREDIT CARD RECEIVABLES
At first look, credit card receivables seem to be too short term an asset to be amenable to securitization; but not surprisingly credit card issuers have made good use of securitization markets almost everywhere in the world. Credit card receivables are short term, but they are revolved into creation of fresh receivables on a fairly steady basis. If a card user swipes the card, the amount that he or she utilizes is payable within a certain time. However, a credit card is a revolving line of credit. Therefore, they represent a steady stream of cash flows, and are a good candidate for securitization.
Though unsecured, credit card companies make high interest income due to the finance charges, fees, late fees and periodic membership fees. They have put in place systems whereby the card company has a constant watch on the account, and can immediately block a card or reduce its credit for delinquencies. The maximum amount that can be lost on a card is thus controlled. Consequently, over time, card companies have positioned themselves very well to make profit from a very well-diversified base of plastic money users.
For credit card issuers, securitization is one of the very important avenues of sourcing funds, as most traditional financiers have shunned taking funding exposure on credit card receivables. As Mason and Biggs (2002, p. 1) point out:
Credit card companies rely on securitization for funding and, if the window to the asset-backed market were to close over an extended period, their growth models would fail. However, the securitization market has proved resilient even in the face of the disruptions caused by Russia’s default and the demise of Long-Term Capital Management in 1998 and the events of September 11 2001.
As a component of the ABS market, credit cards, along with auto loans, are supposed to form the two pillars of the ABS market. From the viewpoint of resilience, the credit card market has been tested for quite some time; practices have largely been standardized and the default and downgrade history so far, barring some cases of fraud, has been quite satisfactory.
Credit card securitizations use a revolving structure where the amount of principal collected during a certain period is rotated back to the originator to acquire fresh receivables. The amortization starts after a fixed period. The revolving method used to securitize credit card receivables is also used for several other short-term receivables such as consumer finance and home equity lines of credit.
The first case of credit card securitization dates back to 1986 when Salomon Brothers applied the fast emerging securitization device to buy credit card receivables from Banc One and sell them in the form of “Certificates for Amortizing Revolving Debts” (nicknamed CARDs) in a structured, credit-enhanced transaction. Since then, the market has never looked back. Credit card ABS has been the largest component of the U.S. ABS market for several years, but has lately given the first position to home equity loans, primarily due to the massive growth of the latter collateral class. For example, according to the Securities Industry Financial Markets Association (SIFMA), in 1995, the amount of credit card ABS outstanding was $153.1 billion and represented 48% of the U.S. ABS market. While by the third quarter of 2007 there was $335.1 billion credit ABS outstanding, it represented only 14% of the U.S. ABS market.
Credit card securitizations have been relatively less significant asset class in Europe. In 2006, for instance, the share of credit card receivables securitization to the total issuance for the year was less than 1%.
Transaction Structure
A credit card debt is a retail asset. The credit card account is an ongoing service between the credit card company and the customer. When a card is used, the card company generates receivables from the customer; it is this receivable that is securitized. Therefore, the legal relation between the card company and the cardholder remains intact, and the card receivables are transferred to the trust.
The accounts, the receivables from which are to be transferred to the trust are selected based on selection criteria. The criteria are mostly standard and would rule out only such accounts as have been treated as delinquent.
Revolving Asset Structure
The use of the revolving device, whereby over a certain reinvestment period, principal collections are not used to pay down the securities but instead are used to buy new receivables and replenish the principal balance of the asset pool, is not limited to credit cards. Apart from several other short-term assets, the revolving feature is increasingly used in several other cases, including CDOs.
A revolving asset structure is not really a future flow securitization. In a future flow transaction, the receivables transferred to the SPV at the inception is much less than the funding raised from the investors, as the transaction relies on receivables to be generated and sold in the future. For revolving transactions, however, at the inception the value of the asset transferred to the special purpose vehicle (SPV) equals (or, taking into account overcollateralization and seller’s share, exceeds) the funding raised from the investors. However, there are assets acquired by the SPV on an ongoing basis until the amortization period starts.
A revolving asset securitization is, therefore, akin to a revolving credit arranged by the originator. On an ongoing basis, the originator will be able to avail of funding until the amortization period starts.
The portfolio of assets represents a revolving credit to consumers in which the outstanding principal may fall, so the trust deed contains provisions that the cash collected from the consumers will be trapped in the SPV unless the total amount of receivables in the trust is at least equal to or greater than the total outstanding funding.
Seller’s Interest
In addition, to cover the contingency of the assets suffering a decline, a buffer is kept in the form of a seller’s interest. The seller’s interest is the excess of receivables sold by the seller into the trust over the total amount of funding outstanding. This excess is not by way of overcollateralization (which, if required for credit enhancement purposes, may be in addition to the seller’s share), as the seller’s interest is not subordinated to the investors. The seller’s interest also levels off temporary fluctuations in the card balances, such as more card purchases during a holiday or festive season. The seller’s interest also absorbs dilutions in the transferred accounts due to noncash reasons, such as a reversal of debit to the card due to return of goods and processing errors.
Discrete and Master Trust Structure
Credit card securitizations could either use a discrete trust or a master trust structure. Recently, the master trust structure has been the most widely used structure.
Where it is a discrete trust, the receivables transferred are to the extent required for the resulting securities, beneficially owned by the investors. A master trust is like an envelope entity that pools together assets that service several securitization transactions. Hence, it is like a fungible pool of assets backing several issuances made at different points of time.
In master trust mechanics, the master trust is an umbrella body covering various issuances under the trust. It may be likened to the assets sitting on the originator’s own balance sheet. Think of the assets on the balance sheet—there are various liabilities that are paid off from a common asset pool. Similarly, a master trust exports a sizeable portion of the originator’s assets into the so-called master trust. There is no demarcation of the assets attributable to a particular issuance, represented by an issuer trust or series trust. The assets are held under a common pot of the master trust from where pro-rated allocation is done to the issuer trusts. The excess of total assets in the master trusts over all the issuance amounts outstanding at the given time is the seller’s interest. The allocation of cash flow by the master trust to the various issuances or series is very similar to a corporation equitably allocating its cash flow to its various liabilities.
Allocation of Interest
The allocation of the collections by the master trust to the various issuer trusts is done based on the outstanding amount of the relevant trusts, and the outstanding seller’s interest. The finance charges and the fee income, net of the servicing fee and the charge-offs, is distributed to each series. From this allocated amount, each series takes care of its own coupon, and the excess spread in the series is dealt with (retained or returned as the seller’s interest), as per the terms of the scheme. Most master trusts also provide for utilization of the surplus excess spread; that is, over what is required as a condition to the rating need, to support the other series under the master trust. This is a sort of a “loan” from one series to another, as the amount so lent by the lending series is recoverable whenever the recipient series has enough excess spread of its own. Thus, there is a cross-collateralization of the excess spread from one series to the other, implying an additional support granted by the seller to the series in need of support, as the excess spread was returnable to the seller. In addition, as a levelling provision, the master trust documents may also provide for the pro-rated allocation of the excess spread of each of the schemes should the allocated interest in a particular month fall short of the coupon required to service investors.
Thus, the master trust method provides an interseries credit enhancement to the investors.
Allocation of Principal and Prepayments
The various series under the master trust might have differing requirements of principal for amortization. Those that are still under a reinvestment period will not need any principal at all; thus, the principal is first allocated proportional to the outstanding investment of the series that are under an amortization period, either scheduled or early amortization. Notably, the proportions of outstanding investment here would mean proportions obtained as at the time when amortization started: otherwise, the schemes which have already partly amortized their outstanding investment will see a reduced allocation. Once again, the surplus principal so allocated to the various schemes may be distributed to the schemes in deficit—the schemes that have hit early amortization triggers. (Early amortization triggers are discussed later.) The remaining surplus principal is the principal available for replenishment, and is therefore released for purchasing assets from the originator.
Delinked Structure
A fully ramped structure, the traditional picture of a securitization transaction, envisages simultaneous issuance of senior and subordinated securities. For master trusts, the single trust allows creation of various securities at different times, so the next stage of development is perfectly logical—the issue of senior and subordinated securities is delinked. In other words, subject to satisfaction of certain conditions, the senior securities may be issued without issue of subordinated securities that may be issued at an opportune time.
The delinked structure creates a common funding pot, which may continue issuing various series of Class A notes at different points of time, as long as there is a required extent of collateralized interest, the value of assets exceeding the total amount of Class A funding.
One of the important differences between the traditional master trust structure and the delinked structure is that, in the latter case, as the various Class A series are issued from the same vehicle, the amount of excess spread for each series is the same. Also, there is an automatic sharing of the excess spread of the entire asset pool by each of the issued classes.
Components of a Credit Card Structure
Below we discuss the various components of cash inflows and outflows /losses that impact the credit of a credit card portfolio. Notably, apart from the uniqueness of these components, the underwriting of credit card debt itself is different from regular loans, as it is a revolving credit.
Portfolio Yield
The portfolio yield is the rate of return on the credit card portfolio, and in the context of securitization, those parts of income transferred to the trust. Typically, in almost every transaction, the credit card issuer transfers the finance charges, fees collected from the cardholders including late fees, overlimit fees, charges for bounced cheques, interchange or merchant discount (the discount deducted on payments to the merchants), and recoveries on previous charge-offs. Understandably, this yield changes from period to period and there is no fixed rate of return for credit card debt. The portfolio yield is quite an important parameter in credit card securitizations, as it determines the level of excess spread in the transaction.
Charge-Offs
By the very nature of the credit card debt, there is a high amount of charge-offs; that is, debt written off as bad by the industry. There are periodical fluctuations in the loss rate reflecting the prevailing economic situations—unemployment and economic insecurity in general. The charge-off rate also differs greatly as between prime and subprime issuances. In addition, industry analysts say the charge-off rate is related to the vintage of the card—how long the cardholder has been enrolled. It is believed that the charge-off rate starts from nil at origination and peaks to something like 9% in the 18th-24th month, and thereafter, settles at about 6% or the industry average.
Credit Scores and the Charge-Off Rate
Credit card origination is done partly by the data in possession of the card originators, and partly relying on a personal credit rating bureau. A personal credit rating bureau supplies credit score information on individuals, which, in most cases, is based on credit scoring models provided by Fair Isaac and Company. Hence, the scores provided by the said scoring agency are referred to as FICO scores—an individual with 650 to 800 points of score is considered to be quite good.
Payment Rate
The payment rate is defined as the monthly payment of interest and principal, divided by the total outstanding on the card in the prior month. Card issuers typically require a certain minimum payment to be paid; in addition, cardholders are entitled to either clear off the full balance or any part thereof. The payment rate is relevant to a securitization transaction as it determines the period it will take for a transaction to amortize once the amortization period starts.
Servicing Fee and Base Rate
It is typical of credit card securitizers to fix a servicing fee of 2%. A base rate implies the total of the servicing fee and the coupon payable to the investors, such that the portfolio yield, minus the charge-off rate, minus the base rate, is the excess spread.
The coupon itself may be a fixed or floating rate. Credit enhancement levels required for floating rate issuances are slightly higher than those for a fixed rate, as rating agencies stress the index rate also.
The analysis of all the factors affecting the excess spread—yield, charge off, and coupon—is important in a transaction, as the early amortization events are generally linked with the excess spread.
Early Amortization Triggers
Because a revolving transaction permits the issuer to keep the funding in the transaction and keep supplying further assets in lieu of those that pay off, the transaction maintains the funding level during the revolving period. However, this raises several questions: What if the quality of the asset pool deteriorates? What if the excess spread levels decline? What if there are other contingencies that require the leverage of the transaction to be reduced by paying down the funding?
As a result, all transactions with a revolving feature are coupled with an early amortization trigger (EAT). The EAT is akin to acceleration call in traditional bank finance—if the borrower’s financials suffer an adverse material change, the bank recalls the loan.
Hitting an early amortization trigger obviously spells a liquidity crisis for the originator, as the line of funding dries up as the trigger is hit. Hence, it is very important for the originator to avoid hitting the trigger. Early amortization is also obviously a prepayment risk for the investors.
One common trigger is based on the excess spread, computed based on a three-month rolling average. If this average spread falls to zero, the transaction enters an early payout. If the excess spread levels fall but do not hit the EAT, the transaction may commonly provide for trapping of the excess spread in a cash reserve.
The other EAT is the purchase rate; that is, the rate at which new receivables are originated by the originator for purchase by the trust. Decline in the seller’s interest is also commonly a trigger. Following is an example of the EATs in a typical credit card securitization deal:
Seller/Servicer Events
• Failure or inability to make required deposits or payments.
• Failure or inability to transfer receivables to the trust when necessary.
• False representations or warranties that are not remedied.
• Certain events of default, bankruptcy, insolvency, or receivership of the seller or servicer.
Legal Events
• Trust becomes classified as an investment company under the Investment Company Act of 1940 (relevant for U.S. transactions—in other cases, refer to other regulatory statements).
Performance Events
• Three-month average of excess spread falls below zero.
• Seller’s participation falls below the required level.
• Portfolio principal balance falls below the invested amount.
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