IMGCAP(1)]
From the September 2008 Issue
As the U.S. economic downturn persists, credit card issuers are facing new financial and political pressures that could rattle one of the industry's bedrocks: the market for credit card asset-backed securities.
No cause for panic yet, experts say, but the combination of rising credit card charge-offs and delinquencies, plus pending new credit card-industry regulations, could force issuers to rethink their heavy reliance on asset-backed securitization.
Through securitization, issuers sell packages of consumer credit card receivables to investors in secondary markets who earn interest based on the quality of the loan packages. While card issuers continue servicing the accounts and retain an interest in them, the sold-off loan pools temporarily are removed from their balance sheets until maturity, freeing issuers from some of the regulatory capital requirements associated with owning those loans.
Credit card securitization is the largest source of loan funding for card issuers, and it has been a relatively quiet, stable and profitable market for both investors and issuers for more than two decades. But this year, various forces are thrusting it into the spotlight.
The heaviest pressure is coming from consumer economic trends. U.S. unemployment hit a four-year high of 5.7% in July, and home values have declined across the U.S., particularly in California, Florida and Arizona, which is helping to drive up delinquency and charge-off rates (
Overall credit card charge-off rates could surpass historic highs of about 7% by the end of this year, says Gary Santo, managing director of asset-backed securities for Fitch Ratings in New York. "When charge-offs and delinquencies are creeping upward every month, it begins to weaken the health of credit card asset-backed securities," Santo says.
Fitch reported in July that excess spread, a key measure of the strength and profitability of the credit card asset-backed securities market, has fallen sharply this year. Three-month average excess spread–calculated by subtracting loan expenses, servicing fees and charge-offs from the yield–has fallen 111 basis points, to 7.08% at the end of June from a high of 8.19% at the end of January.
Excess spread in securitized transactions remains high enough to sustain further delinquencies and charge-offs, and Santo emphasizes that credit card securitization must not be confused with last year's meltdown in subprime mortgage securitization, which led to massive chaos in financial markets and the failure of some banks and credit unions, he says. Moreover, card issuers' continued management of securitized portfolios provides many levers for control.
No Connection
Indeed, there is little connection between credit card securitization and the market for so-called exotic asset-backed mortgage securities, which led to widespread write-offs within the last year, says Katie Reeves, director of securitization research for Deutche Bank in New York.
"Many subprime (mortgage) loans were originated and sold in securitizations with the assumption that the underlying real-estate values would only go up," Reeves says. "Credit card securitizations have always been backed by unsecured consumer credit, with no hard asset behind it, so the rating agencies, bankers and investors were never assuming an increase in a hard asset value."
Unlike mortgage asset-backed securities, prime credit card asset-backed securities are well-enhanced for economic ups and downs, Reeves says. "There are structural enhancements in the transactions that assume and protect against multiples of projected losses," she says.
Such enhancements include subordination, which assigns different tiers of investor ownership within a securitized trust so that shortfalls are covered first by the lowest tiers. Overcollateralizing, or allocating additional receivables to the issuer's position in sold-off loan pools, also provides a cushion from losses. The overcollateralized portion absorbs shortfalls first when delinquencies and charge-offs increase.
Many card issuers also purchase bond insurance from third parties to support securitizations, Rajiv Shah, a vice president within A.T. Kearney's financial practice for North America, tells Cards&Payments.
"Card issuers have a variety of tools to make credit card securitization more attractive to investors, but all of these things cost issuers more money," he says. "The tougher the economic environment we are in, the higher the funding costs are for issuers through securitization, and the more it cuts into their profits."
Regulation Effects
On top of recent negative economic trends, a raft of proposed new industry regulations and pending legislation to curb controversial card-issuer practices indirectly is threatening securitization. Many issuers say the proposals could endanger the securitization market by restricting their ability to raise card interest rates and fees to offset marketplace conditions.
The Federal Reserve, the Office of Thrift Supervision and the National Credit Union Administration in May proposed new Unfair or Deceptive Acts or Practices rules under the Federal Trade Commission Act that would prohibit many longstanding card-industry practices. Among the proposed rules are provisions that would prohibit issuers from raising interest rates on existing balances except in special circumstances and a requirement that issuers post payments first to cardholders' highest-interest balances.
Both rules, if implemented, likely would affect most major issuers' core business practices, observers say.
In their public comments to the Fed about the proposed rules, several issuers noted that investors in credit card asset-backed securities are reassured by existing card-industry underwriting practices, such as the ability to adjust pricing on consumer accounts for changes in consumers' risk profiles. Issuers typically raise cardholders' interest rates when evidence shows they are borrowing more heavily, or they are missing or being delinquent with monthly payments.
The proposed Fed rules "will affect securities that have been previously issued, as well as the willingness of investors to participate in future asset-backed securities offerings," JPMorgan Chase & Co. wrote in its comments. "Due to reduced revenue streams and higher risks caused by the (proposed rules), investors may pay less for (credit card asset-backed securities) or not purchase them at all."
The long-term effect of adopting the rules could be less liquidity available to issuers and higher borrowing costs for consumers, Chase contends.
Yet another pressure point on credit card asset-backed securities is a proposed new Financial Accounting Standards Board rule for credit securitization. If approved as proposed, the new rule would require credit card issuers in 2010 to bring securitizations back onto their balance sheets.
"A lot depends on regulators' response to the accounting board's rule change and what the requirements will be," Reeves says. "One question is, if card issuers bring all securitizations back on their balance sheets, will they get any regulatory relief at all for having sold them to investors, even though they are on the balance sheet for accounting purposes."
Despite these potential setbacks, issuers have enough leverage so that the credit card securitization should remain relatively stable for the foreseeable future, says Frank Bria, senior vice president of Response Analytics Inc., a U.S.-based financial institutions risk-management consultancy.
"Issuers have many options to tweak underwriting standards and to offset losses, and the most critical of these is improving their loss-forecasting models to make the securitization market more comfortable with their projections," Bria says. "If issuers provide very clear, accurate, short-term and long-term loss forecasts for their portfolios, the credit card-securitization market should be reassured, even during a downturn."
Economic uncertainties and potential regulatory changes likely will create challenges for issuers that rely heavily on securitization. But issuers have many tools at their disposal to weather immediate shocks. CP
