Credit Card Asset-Backed Securities (ABS)

Credit card asset-backed securities (ABSs) are fixed-income bonds based on the cash flow stream from pooled credit card accounts. First issued in 1987, credit card ABSs are mostly high quality, pay good yields, and are liquid, with transparent prices. The number of credit card ABSs increase as the use of credit increases. However, like most asset-backed securities and unlike most corporate or government bonds, credit card ABSs have only an average maturity rather than a specified maturity because the underlying cash flow is highly variable. Credit card ABSs are structured so as to mimic the cash flow of a typical bond, but the timing of the cash flow is usually not guaranteed.

Securitization of Credit Card Receivables

The process of securitizing credit card receivables is like securitizing mortgages and other loan obligations. A card issuer sells a group of accounts to a trust, which issues securities backed by those receivables. The card issuer still services the account, but the assets are removed from its balance sheet. This allows the card issuer to issue more accounts and to reduce its capital reserve requirements, the amount of money banks are required by law to hold to do business. This money doesn't earn interest, so, naturally, the card issuer wants to reduce its required reserves as much as possible. As the cardholders pay on their accounts monthly, most of the money is sent to the trust, which pays the holders of the credit card ABSs interest and principal. The card issuer retains a servicing fee and part of the finance charge as profit, and includes part of the principal — the seller's interest.

Securitization allows more rapid growth of banks specializing in credit card issuances by providing a source of funding and a way to transfer risk. Before the securitization of credit card receivables, card issuers borrowed money from a bank or relied on bank deposits to fund credit card loans. Securitization greatly expanded funding for credit card issuers, including monoline issuers, and issuers whose main business is not banking or issuing credit cards, such as Target.

Credit Card ABS Yields

Most credit card ABSs pay a floating rate coupon that is a specified number of basis points above a specified interest rate index. Like the yield of most fixed income securities, the number of basis points is inversely proportional to the credit rating of the security.

Credit Card ABS Life Cycle

Most credit cardholders pay both principal and interest every month. This income is used to pay bondholders, but whether interest or principal is paid depends on the life cycle period of the ABS. Because the payment stream is highly variable, most credit card ABSs have a revolving period and amortization period, so that an average maturity and an expected maturity date can be specified — though not guaranteed.

During the revolving period, investors receive interest payments only. Collections of principal are used to buy more receivables or to add to the seller interest. Although the principal and interest payments are highly variable over the term length of the ABS, the seller interest grows or shrinks to keep the ABS payments steady.

During the amortization period, principal collections from cardholders are used to repay the ABS investors their invested principal during this final period. The length of this period depends on the monthly payment rate from the cardholders in the underlying portfolio. If the cardholders are paying less each month, then the amortization period may be extended. If payment rates are high, then excess principal collections are used to buy more receivables.

Some credit card ABSs use controlled amortization — making equal principal payments to investors over a specified time, usually 1 year. The amount of interest earned during the amortization period declines with the principal. Although the receivables vary over time, the seller interest absorbs varying amounts to maintain a steady cash flow to the ABS investors.

Some ABS issues are structured so that the payments to investors are like bond payments, where during the life of the ABS, investors received equal interest payments with a final payment of interest and principal at maturity. This is accomplished by the use of a controlled accumulation period, when principal collections are paid into and held in a trust account until maturity, then the entire principal is paid to the investors.

Early amortization results when the credit profile of the ABS security deteriorates because of problems with the seller or servicer, or the collateral falls below an amount specified to maintain the credit rating of the security. These problems constitute early amortization triggers, which divert principal payments from the seller to the investors, to repay them faster, lessening their risk.

Credit Enhancements

The credit enhancements used for other asset-backed securities are used for credit card ABSs. These include the use of senior and subordinated tranches, excess spread, cash collateral accounts and collateral invested amounts.

In a typical $750 million deal with an A, B, and C tranche, the senior A tranche will consist of bonds totaling $650 million and have a AAA rating, so that it can be sold to institutional investors that require investment-grade securities. The subordinate B and C tranches will consist of bonds totaling $50 million each, with the B tranche having a credit rating of A and the C tranche having a credit rating of BBB. The C tranche pays the highest yields, but is the 1st to receive any losses. When losses reach a threshold, then the losses are allocated to the B tranche. If the losses are greater than anticipated, then they will be allocated to the investors of the A tranche.

Excess spread is the amount of the monthly finance charge left after paying all investors their monthly payment, and paying for all related monthly expenses. Although the excess spread is often used as a credit enhancement, in the case of credit card ABSs, the issuer retains the right to the excess spread as a part of its profit in issuing credit cards.

Example Excess Spread Calculation
Portfolio Yield = 18%
Coupon Rate - 6%
Servicing Fee for Portfolio - 1%
Losses on Defaults - 6%
Excess Spread = 5%

Credit Card ABS Market

The main issuers of credit card ABSs can be categorized as commercial banks; consumer finance companies; independent networks, such as Discover or American Express, and retailers, which includes Sears, Penny's, and Target.

The credit card ABS market is considered the largest and most liquid of all asset-backed securities, which does not include mortgage-backed securities, which is considered a separate investment category. Virtually all ABSs are traded by special dealers in the over-the-counter market. Most of the investors are institutional investors.

Credit Ratings

Credit ratings of credit card ABSs depends on many of the same variables that determine the credit ratings of other asset-backed securities. Part of the credit rating depends on the qualitative factors of the issuer: new account underwriting standards; marketing; cardholders' credit scores; credit card interest rates; servicing and collections; whether it is a general credit card such as MasterCard or VISA, or a private-label card, such as Sears; the competitive rank of the issuer; and account seasoning. The other main factor is the structure of the credit card ABS and what credit enhancements are being used.

A main tool used to evaluate the credit rating of a credit card ABS is stress testing, which is devised by the credit rating agency that gives the credit rating. These stress tests are what-if financial models where critical variables are varied to see if the trust can withstand the stresses, and if so, by how much. The ranges of the variables are generally determined from the past 3 to 5 years of pertinent historical data. The variables for credit card ABSs include the following:

Portfolio yield, which depends not only on the annual percentage rate charged on the cards, but also on the proportion of users carrying credit card debt over convenience users, who pay their balance in full each month, avoiding the finance charge.

Purchase rate. The more the credit card is used, the more receivables it generates, which helps to pay interest and principal. A main risk with this variable is if the card issuer goes bankrupt, in which case, the cardholders stop using the credit card, which will greatly decrease the cash flow and trigger early amortization.

Monthly payment rates. The higher the rates, the more money available to repay balances.

Charge-offs. Obviously, the greater the number of charge-offs, the greater the risk for ABS holders. Most credit card issuers charge off accounts after 180 days have elapsed since the missed payment. Charge-offs generally increase during the 1st 24 months, then level off.

Example: Stress Testing a Credit Card Asset-Backed Security

Variables Normal 1 2 3 4
Chargeoffs Normal
Payment Rate Normal Normal
Yield Normal Normal Normal
Pool Size Normal Normal Normal Normal
Result Normal
Not Fully

Floating rate ABSBS requires greater credit enhancements, since 1 of the stress tests for a floating rate ABS assumes that interest rates rise significantly, which would reduce available excess spread.