Credit Card Asset-Backed Security Structure and Cash Flow Allocations
Although credit card receivables provide the income to pay investors of credit card asset-backed securities (ABSs), it is the trust that collects the receivables, issues the credit card ABSs, and pays each investor.
Master Trust Structure
Prior to 1991, stand-alone trusts were used for the creation of credit card ABS securities that used a single pool of credit card accounts and their receivables. Each new pool of credit card accounts required the creation of an additional trust.
Since 1991, the master trust was created to reduce costs for the issuers. The master trust can accept additional credit pools without creating new trusts. This basic master trust was not subdivided into tranches with varying cash flows, yields, and risks. The credit card accounts on which the trust is based are diversified according to the risk and the interest rate paid by the credit cardholder, and changes over time because of the competitiveness of the credit card market, the underwriting criteria, and changes in the prevailing interest rates.
The advantage of the master trust structure to the issuer is that it lowers costs and increases the flexibility of the structure, since the credit card account pool is not narrowly defined according to its risk and cash flow. Hence, the master structure can accept new credit card accounts even as the investment qualities of the underlying pool changes. For the investor, the generalized pool provides a diversified risk and competitive yields.
Master Owner Trust Structures (MOT)
In the 21st century, a new type of trust, known as the master owner trust (MOT) or master note trust has evolved, taking advantage of new technology and catering more precisely to market wants. The new trust structure is based on a collateral certificate issued by a master trust that is also owned and operated by the issuers of MOT securities.
The collateral certificate represents an undivided interest in the master trust, receiving apportioned principal and interest payments and paying its share of losses and servicing fees.
The main advantage of MOTs is that different classes of certificates with different risk profiles, cash flow payments, and different maturities can be issued to satisfy the needs of the market. In some cases, a particular certificate can be tailored to meet the specific needs of a major investor through a reverse inquiry, where the issuer inquires the investor as to its specific needs, then issues a certificate to the investor with those specific characteristics.
The MOT structure is generally divided into A, B, and C classes, or tranches, with the class A certificates having the highest credit rating. The lower classes provide credit enhancement to the upper classes. The ratings agency generally requires that there be a certain amount of subordinate certificates to support the senior certificates in order for each class to maintain its rating. Hence, the issuance of senior notes is limited by the number of subordinate certificates outstanding. This structure is sometimes referred to as a shared enhancement series. If subordinated notes mature before the senior notes, then additional subordinated notes must be issued before the maturity, or money from principal payments must be deposited into a custodial account to pay the principal of the senior notes.
To expand the market to institutional investors, credit card ABSs may be issued as notes rather than as pass-through securities, which satisfy ERISA (Employee Retirement Income Security Act) requirements, allowing such major buyers of fixed income securities, such as pension funds that are restricted by law to buying ERISA eligible securities, to purchase credit card ABSs.
Since it is the credit card issuers who are in the best position to judge the creditworthiness of the credit cardholders, and it is they who decide who qualifies for the cards, the credit rating agency requires that the issuer of the credit cards to maintain a minimum level of ownership in its issued credit card ABSs, to align the interests of the credit card issuers with that of the investors of the credit card ABSs. This seller interest must be at least 4% to 7% of the ABS. If the seller interest falls below this minimum level, then the credit card ABS issuer must provide more accounts to the ABS, enough to raise its ownership interest above the required minimum.
The seller interest requirement prevents the credit card issuers from transferring all of the risk to the investors, in which case, the issuer may have more incentive to issue more cards to the public to earn more servicing fees, with little concern for the creditworthiness of the cardholders. This scenario has just recently occurred with the massive defaults of mortgage-backed securities, and related securities based on them, such as CDOs. Because the mortgage lenders transferred most of the risk to investors, the lenders were focused on earning more servicing fees by approving more applicants, regardless of their creditworthiness, which has led to the massive defaults.
Part of the cash flow is retained by the sponsor of the credit card ABS. The sponsor continues to collect both servicing fees and much of the excess spread as a form of profit for providing credit. The sponsor continues to service each credit card account as if it were retained on its balance sheet. These services include mailing monthly statements to customers, collecting the money, collecting past due balances, and providing customer service.
Some credit card master trusts may use groups with differing characteristics. The master trust is divided into a seller's interest and the investors' interest. The investors interest may be divided into additional groups that correspond to specific pools of credit card receivables, and each group may issue different series of ABS securities. They may also be issued with different characteristics to appeal to different investors. For instance, 1 group may pay a fixed rate of interest, while another group may pay a floating rate. Hence, the different groups can be a different series of the same master trust.
Finance Charge Allocations
The portfolio yield is the total amount of finance charges collected as a percentage of the trust's receivables balance.
Finance charges collected by a master trust:
- monthly interest on account balance;
- other fees, such as an annual or late fee;
- interchange fees (fee charged to the merchant by the issuing bank for providing credit with a grace period to the consumer);
- recoveries of charged-off accounts;
- discounted receivables. The amount of the discount, which ranges from 1% to 5%, is added to the finance charges for that month, which can temporarily increase the portfolio yield.
Nonsocialized master trusts, the most common form of master trust, allocate finance charges based on the outstanding invested amount of each series. The allocation for a series is reduced as it receives principal payments in the amortization period. Hence, the main benefit of the nonsocialized master trust is that early amortization can be restricted to 1 or more series. As each series is amortized, more income from the underlying receivables goes to the remaining series.
The socialized master trust allocates finance charge according to the need of each series, which includes the coupon payment, allocated charge-offs and service fees. The main benefit of the socialized master trust is that it can support higher coupon rates, but an early amortization event will cause all series of the trust to enter early amortization.
Although principal is collected continually from the underlying portfolio, no principal is paid to groups still in the revolving period. When a group enters the amortization period, then the collected principal is allocated pro rata to groups based on the size of the group at the end of the revolving period. Generally, the amount of principal paid to each group will be a specific percentage of the original principal amount in each group. So if a group is amortized over a 1 year period, then the group will receive 1/12th of the principal each month. Any remaining principal will 1st be used to pay investors in other amortizing groups so that they can receive their full principal on schedule, while the remainder will be used to buy more receivables. If the group has an accumulation period, then the principal payments are paid into a fund until the day of maturity when the entire principal is paid to the investors.