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Will credit card securities be the next financial mess?

The most important credit card maneuvers you probably don't know about

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Brace yourselves. Americans could be headed for another financial market implosion -- this time in a sector that few people are aware of, but which fuels the nearly $1 trillion credit card lending industry. Credit card securities may face rocky times in the coming months if Americans who are living off credit cards can't pay their debts.

Credit card securities
The ABCs on credit card ABS 

What's new: The economic downturn, rising credit card defaults and spillover from the subprime mortgage meltdown are making credit card securities more volatile.

Why it's important: Securitized credit card receivables are the fuel that drives credit card issuance for major banks. Without the money generated by these securities, interest rates would be higher and fewer people would be able to get credit cards.

Who is impacted: Potentially everyone with a credit card or who wants one.

What's next: As the economy slows and more people default on credit card accounts, many securitized credit card trusts may raise interest rates, cut credit limits and increase fees to offset losses. This has already started to happen.

See also: How credit card debt securities work, Rising credit card delinquencies vex card securitiesTreasury wants to jump start stalled credit card securities, Card issuers' bad earnings reshape credit card offers

Experts say a credit card industry blowup is highly unlikely, although some see signs of trouble for credit card-backed securities.

Credit card securitization is likely the most important credit card maneuver that you don't know about. Major credit card issuers -- such as Citi, Bank of America and JP Morgan Chase -- basically sell the future credit card payments of millions of credit cardholders to investors.

These so-called asset-backed securities (ABS) help fund rewards programs and cash back incentives. Securitization also makes it possible for the credit card banks to charge low or no annual fees and offer lower interest rates to prime customers.

Why it matters to consumers
A collapse of the credit card securities market would dry up a major funding source for banks and drive up bank funding costs. That could push interest rates through the roof and make getting a new credit card more difficult for everyone.

Asset-backed securities are complex, structured financing mechanisms that transfer the right to collect receivables of underlying assets -- such as mortgages, student loans, auto loans and credit cards -- to investors. (See How credit card debt securities work) The securities are sliced into classes (called tranches) and sold according to risk. If the performance of the underlying asset erodes, as was the case with defaulting subprime home mortgages, investors in the lower tranches (the higher-risk classes) could suffer losses on their investments.

Complex ABS deals were at the center of the 2007 subprime mortgage meltdown and spillover from that contagion has spread to credit card securities. However, several financial experts told CreditCards.com that credit card securities -- which rely on the promise of millions of American credit cardholders to faithfully pay their bills each month -- are a safe investment. Unlike subprime mortgage securities, credit card securities deals are structured in a way to minimize risk of collapse, they say.

"Any organization that continues to operate as a credit card originator and issuer in today's market has survived 20-plus years of credit card rate wars, has survived ongoing regulatory oversight, changes to accounting rules, updated consumer protection laws and numerous credit cycles. They are well-versed in securitization markets and well-positioned to weather the current storms," says Jim Ahearn, managing director in the U.S. securitization group at Société Générale, a Paris-based bank that specializes in structured financing and derivatives.

Ahearn is chairman of the communication and education committee of the American Securitization Forum, an industry group comprised of representatives from all aspects of securitization: bank issuers, underwriters, rating agencies, investors, trustees, attorneys and accountants. "Securitization is still a good product that continues to be an important funding source for credit card originators like Citi and Bank of America," Ahearn adds.

Worst-case meltdown?
Still, the worst-case scenario -- a major U.S. credit card bank shuttering its doors in the wake of a collapsing credit card securities portfolio -- could happen, according to at least one financial market expert.

"A lot of the banks that are involved in the securitization of credit card receivables have been weakened."
-- Eric Higgins  
Kansas State University  

"It's not a stretch to think that a minor economic downturn could lead to a problem in that market," says Eric Higgins, an associate finance professor at Kansas State University and a nationally recognized researcher on credit card ABS. "A lot of the banks that are involved in the securitization of credit card receivables have been weakened. They might not be able to absorb a dry up of the credit card market very well."

The reason: Credit card banks depend on a steady infusion of capital raised from notes and bonds secured by future cash flows from the millions of credit card payments Americans send in each month. Selling these credit card receivables allows banks to remove those loans from their balance sheets. Federal banking regulations require lending institutions to set aside a minimum amount of capital as a hedge against losses on loans and to maintain a ratio of capital to risky assets.

Moving the credit card accounts off their balance sheets through sales to securitized trusts allows banks to reduce that capital holding requirement and frees up money for lending additional credit card accounts. If defaults on credit card accounts rise so high that the trusts no longer have enough revenues to pay investors -- a rare but not unheard of occurrence -- the bank may have to take millions of credit card accounts back onto its balance sheets and hold sufficient capital against those loans to meet federal banking rules.

Adds Higgins: "The lesson of the subprime market is that finances based on probability in those worst case scenarios do happen. It's a low probability event, but even the low probability event will happen."

Higgins co-authored a 2003 study on credit card securities that looked at how these financial instruments can unravel (called early amortization) and potentially force a bank into receivership, as it did in February 2002 when NextBank failed. Under the right circumstances, a credit card securities collapse could have a domino effect that rocks the entire economy, Higgins contends.

Credit card securities: how they work
How credit card securities work

Today, 20 percent to 50 percent of credit card accounts for the major issuers may be sold into special trusts set up by the credit card banks. Credit cardholders never realize the bank has sold their accounts (more).

"Oh yeah, that would be huge," he says. "In the credit card securities scenario, it would definitely kill the financial market if one of those big banks were to go down because of that. The Fed wouldn't let that happen. Let's be clear on that. Just like Bear Stearns, the Fed viewed that as devastating for the financial sector and for the economy."               

'Small potatoes'
Darrell Duffie, a finance professor at Stanford University's Graduate School of Business, says it's highly unlikely that the unraveling of a credit card securitization deal -- even in the midst of an economic recession -- would topple a U.S. bank. "I sincerely doubt it. The Fed is certainly not going to allow any of these huge, large banks to go bankrupt."

Could there be a downside to securitized credit cards that no one today can imagine? "There's always something that you haven't thought about that could go wrong," says Duffie, who is also president-elect of the 8,000-member American Finance Association, a group that promotes better knowledge and understanding of finance and economics.

Another reason credit card securities aren't likely to impact the economy to the same degree as mortgages: Securitized credit card pools are much smaller in comparison to mortgage pools. A home mortgage may average $200,000 while the average credit card balance may be only $8,000 -- a big difference.

"It's not a stretch to think that a minor economic downturn could lead to a problem in that market."
-- Darrell Duffie  
Stanford University's Graduate School of Business  

Credit cards are "small potatoes compared to the mortgage industry," Duffie says. "It's not likely this is going to be another mortgage blowup."

He adds: "For most people, the home mortgage is much larger than their credit card debt. When the mortgage market goes south it's a huge deal. When the credit card market goes south, it's important but it's not like this subprime crisis."

Charles Morris, a lawyer, former banker and author of "The Trillion Dollar Meltdown," a new book about the 2007 credit crash, agrees that the coming months will prove more challenging for consumers facing credit restrictions than for investors. "I'm not worried about credit card debt from the standpoint of investors the way that I'm worried about mortgages. From the standpoint of households, it's going to be tough times." 

Signs of trouble ahead?
First-quarter 2008 earnings statements released recently by the major credit card issuing banks refer to deteriorating credit card markets. The banks are boosting their reserves for losses on credit card loans expected in the coming months. Industry observers point to several signs that credit card ABS are in for rough times ahead. Among them:

Top 5 credit card
asset-backed securities issuers
 
Top 5 credit card asset-backed securities issuers
Source: Moody's Investors Service, Jan. 31, 2008 

•  The rate at which credit cardholders are defaulting on their accounts is creeping upward and expected to go higher as the economy continues to stall. These payments are the linchpin of credit card securities.

• 
In recent years, consumers drowning in credit card debt could tap into home equity lines of credit to pay off their balances. Now, many homeowners no longer have that safety net due to declining home values and the general credit crunch.

• 
Investors -- burned by the subprime mortgage mess -- are shying away from putting their money into the kind of structured financing deals associated with asset-backed securities. Those who are buying credit card securities are demanding higher returns for the perceived greater risk. The banks' "cost of raising capital is higher," says Bob Mura, managing editor of the "Asset-Backed Alert," a weekly industry newsletter that tracks ABS deals worldwide. "The funding costs are higher because of the overall lack of liquidity in the market. You have to offer investors higher returns when there are fewer investors willing to buy."

• 
Moody's Investors Service Inc., one of the top three credit rating services, recently issued a "negative" outlook for 2008 largely related to future uncertainty about how long the credit contagion will last.

• 
The Federal Reserve and bank regulators are paying closer attention to all asset-backed securities with a new eye toward assessing and managing potential risk in light of what happened to securities backed by subprime mortgages.

• 
The Securities and Exchange Commission (SEC) is drafting rules to oversee Moody's and the other rating agencies, which have previously been unregulated but were at the heart of the subprime meltdown. The rating agencies gave subprime mortgage-backed securities ratings that didn't reflect the risk inherent in the home loans underlying the investments.

New scrutiny for all ABS securities
What the 2007 mortgage fiasco has done is shine a brighter light on all asset-backed securities.  Federal regulators are scrutinizing all securities more closely, including credit cards, and calling for less complex deals that clearly state the potential risks.

Securitized credit card assets on the rise 

The largest credit card banks routinely issue credit card asset-backed securities -- selling future credit card payments of customers to investors who provide upfront cash (capital) to banks. The amounts have been rapidly rising.

Securitized credit card assets

Note: Credit cards represent about 98 percent of all pools of securitized assets.
Source: Federal Reserve
 

"What we need to do better in the regulatory side is to make sure these banks are capturing these risks in their economic capital models. Do they have reserves for potential losses?" says Todd Vermilyea, assistant vice president for supervision, regulation and credit at the Federal Reserve Bank of Philadelphia.

Fed Governor Donald L. Kohn said in an April 17 speech that structured credit products like asset-backed securities will need to be "simpler and more transparent" in the future. They must also "avoid relying so heavily on credit rating agencies to do all their homework for them."

In the mortgage deals, portfolios that contained subprime mortgages and other collateral destined to go belly-up were packaged and re-packaged into portfolios and given investment-grade ratings even though they were essentially junk. Now, those rating agencies are under fire and targets of more scrutiny. Top executives from Moody's, Standard & Poor's and Fitch Ratings -- the top three rating agencies -- testified at an April 22 congressional hearing about measures they are taking to restore confidence in their ratings.

SEC Chairman Christopher Cox told members of the Senate Banking, Housing and Urban Affairs Committee that his agency would at least spot-check the underlying assets of future structured financing deals. Prior to September 2007, when the Credit Rating Agency Reform Act of 2006 took effect, the agencies were unregulated. The SEC is currently drafting rules that would strengthen accountability, require transparency and disclosure and promote more competition among rating agencies. A report is expected to be released by the summer of 2008.

Alabama Sen. Richard Shelby, the committee's ranking Republican, says the SEC should treat credit rating agencies the same way physicians are treated: "If they're incompetent, they jerk their licenses. Why not something like this that goes to the heart of our financial system?"

Shelby calls the situation a "crisis of trust for the entire market."

"There's no trust out there in the market today," he says. "I don't know very many people who trust the rating agencies ... Today, would I buy bonds that Moody's or Standard & Poor's rated AAA without having someone else look at them? No. I would be foolish if I did."

Countermeasures already under way
Supporters of credit card securities point to an important difference between those structured deals and mortgage-backed securities. Credit cards are unsecured debts and are not tied to any collateral -- such as a house -- that could take many months or years to legally seize and then sell off. Banks can react more quickly to missed or late credit card payments, writing them off as uncollectable after only three to six months or sending them to debt collection agencies to recover overdue debts.

Still, others note that the credit card industry's long history of dealing with nonpaying credit cardholders and adjusting their terms to match prevailing market forces (called re-pricing) are another positive sign for credit card securities.

If defaults begin to rise, the trusts have a number of options at their disposal to recoup losses. They include: raising interest rates, lowering credit limits, raising late fees and over-the-limit fees, tightening restrictions on new credit applicants and stepping up aggressive collection efforts on overdue accounts. All of these measures have already kicked in over the past several months among the top credit card issuers (See Card issuers' bad earnings reshape credit card offers).

Although rules governing securitized trusts specify that credit card issuing banks and their trusts are to operate separately, the reality is that they often work in concert. If the trust is experiencing rising defaults and charge-offs among its credit card accounts, the originating bank can transfer new accounts to the trust to help offset the bad accounts. Financial experts say this revolving pool of borrowers can be a steady source of new fuel for a faltering securitized trust.

Rising credit card defaults
Defaults or charge-offs are the value of uncollected credit card balances removed from the books and charged against loss reserves. The rate is the amount of charge-offs divided by the average outstanding credit card balances owed to the trust. Although those default rates are not yet near historic highs, they have been inching up in recent months. 

Citi reported a 5.83 percent credit card loss rate for the first quarter of 2008, up from 5.11 percent and 4.53 percent during the two preceding quarters. Other lenders such as Bank of America are reporting similar spikes in defaults -- attributed to job losses and the rising cost of living in a stalling economy.

Credit card performance indexes

Performance measure (%)
Feb. 2008
Feb. 2007
% change

Charge-off rate

5.59
4.51
23.92

Delinquency rate

4.53
3.89
16.48

Principal payment rate

17.27
17.72
(2.52)

Aggregate yield

18.95
18.33
3.39

One-month excess spread

8.12
7.42
9.46

Source: Moody's Investors Service April 14, 2008

Historically, Citi's loss rates are not as high as the 7.07 percent from 2003. The company points out in a chart how loss rates rose during the economic recessions of 2001 and 1990, but fell afterward. The message in the chart: They survived other economic speed bumps and this will be no different.

Says Higgins, the Kansas State finance professor: "The defaults haven't been tremendous. We're not necessarily at a breaking point yet. We kind of need to see what happens with the economy."

To comment on this article, write to Editors@creditcards.com.

See also: How credit card debt securities work, Rising credit card delinquencies vex card securitiesTreasury wants to jump start stalled credit card securities, Card issuers' bad earnings reshape credit card offers 

Published: April 29, 2008


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