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Rising credit card bill delinquencies vex card securities

Poor payment records expected to continue into 2009, analysts say

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Mounting job losses and rising credit card delinquencies and defaults are placing a strain on a key capital-generating arm of the credit card industry -- credit card asset-backed securities. Nervous investors in credit card-backed bonds shied away from the investments in October. But experts say the credit card securities are resilient and won't likely implode like mortgage-backed investments.

Still, special trusts set up by most credit card issuers to manage investment portfolios totalling nearly half a trillion dollars are reporting rising charge-off and delinquency rates.

Charge-offs rising
"Those things are going up. At some point in time, that could be a problem," warns Eric Higgins, a noted researcher on asset-backed securities (ABS) and a Kansas State University finance professor. Credit card securities bundle millions of credit card accounts into bonds backed by the future payments of cardholders. Banks use the proceeds of these investments to generate capital that helps finance credit card loans to other customers. 

Charge-offs are the amount of uncollected credit card balances removed from a bank's books and charged against its loss reserve. The charge-off rate is the amount of charge-offs divided by the average outstanding credit card balances owed to the issuer.

Credit card securities

Charge-off and delinquency rates on credit card debt have inched upward in recent months, but have not reached historically high levels. Analysts say credit card securities are suffering losses, but aren't likely to implode.

Credit card charge-off rates increase

Note: Credit cards make up about 98 percent of revolving debt as reported by the Federal Reserve.

Although not at historically high levels, the charge-off rate has climbed in recent months as Americans struggle to pay their bills during an economic downturn and Wall Street crisis. Industrywide, the Federal Reserve reported a 5.47 percent charge-off rate during the second quarter of 2008 (see chart). A Moody's analysis of payment data for credit card loans pooled into securities found rates at 6.82 percent during August 2008. Moody's predicts the rate could push toward 8.5 percent by the end of 2009 -- well above the 7.1 percent noted in analysis from May 2003. The Fed's highest credit card charge-off rate was 7.85 percent in the first quarter of 2002. 

In filings to the Securities and Exchange Commission, Citi reported losing $1.44 billion during the third quarter of 2008 from securitization of credit card receivables, compared to a $169 million gain during the same quarter in 2007. Fitch Ratings and Moody's Investors Service -- two top securities ratings firms -- have signaled warnings about credit card-backed securities' future performance. "Although the balance sheet strength and liquidity of the sector's largest credit card issuers remains quite strong, the uncertainty and tempo of the turmoil will test even the stalwarts' ability to adapt," according to Moody's.  

The fundamentals are strong. Really
Despite recent losses logged by credit card asset-backed security trusts, analysts and financial experts maintain that the investments are still sound vehicles for generating billions in capital to help fuel credit card lending.

"All financing markets are experiencing difficulty. This is one of the better asset markets," Moshe Orenbuch, a research analyst for Credit Suisse investment bank, says about credit card-backed securities. Unlike student loans, mortgage or auto loan payments -- which are also securitized and sold to investors -- credit card portfolios are shorter-term investments. 

The credit crunch has frozen the ABS markets and "at the moment it's difficult if not impossible to do anything. At the moment, there are no deals getting done," Orenbuch says, adding when the credit crunch eases and investor confidence is restored, "This is probably going to be the first asset class to come back."

Frozen ABS markets mean credit card issuers that do not have access to cash from depositors are shut out of a key capital-generating source. This limits their ability to make new credit card loans to customers, deepening the effects of the credit crunch. American Express had this problem until federal regulators approved its application to become a bank holding company on Nov. 11, 2008.

Mortgage similarities
The meltdown of the mortgage market -- which became mired in similar kinds of complex asset-backed securities -- has shined more attention on securities backed by credit card receivables. Some analysts watching rising job losses and loan defaults have warned a credit card meltdown may be on the horizon because Americans are carrying nearly a trillion dollars in outstanding credit card debt. They argue banks already weakened by the mortgage crisis could fall were a credit card meltdown to occur.

However, financial experts and observers say there are significant differences between how the mortgage securities were structured and how credit card securities operate.

The first and perhaps most important is that mortgage deals relied on physical assets -- homes -- as the basis for future cash flows into investments. When housing values plunged and homeowners began to default on mortgages, the foreclosure process took months or years to complete. During that time, cash flows to the securities declined -- endangering payouts to investors.

With credit cards, banks have more flexibility to react to changing market conditions. They continually monitor customers' payment records, card usage and credit scores. When credit card users are considered greater risks for potential default, issuers can cut credit limits, increase interest rates or constrict the pool of those eligible for credit. Lending institutions have been tightening credit since early 2008 (See: Banks tighten lending standards even more).

Some credit card companies have tightened credit for good-paying, creditworthy customers, too. The reason cited: Overall market and economic conditions such as job losses and the rising cost of living have made it more risky to lend money. Issuers have also cut credit limits or increased interest rates on customers living in states hard hit by mortgage foreclosures (such as Florida, Nevada and California) and even on customers who shop in the same places where other risky customers shop. 

Higgins, the Kansas State finance expert, says the growing rates of charge-offs and delinquencies on credit card bills are a concern as the economy falters. However, Higgins said he is "impressed with the resiliency of the credit card asset-backed securities market given the absolute lack of a market for a lot of other securitized products."

Controlling for risk
Credit card securities also are less complex than their mortgage counterparts and issuers have a stake in making sure the securities succeed. Higgins says the ability to re-price and adjust is what keeps credit card securities viable: "You're just better able to control risk," he says.

Added Orenbuch: "There's more financial flexibility than you have in auto, student loans and mortgages."
How credit card securities 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).

The banking industry has warned that one of the unintended consequences of proposed credit card industry regulations and laws could be diminished returns on credit card backed securities. The Credit Cardholders' Bill of Rights (H.R. 5244), for instance, could limit the ability of banks to price for risk, according to the American Bankers Association, a major industry trade group. 

"Investors in asset-backed securities -- which are responsible for funding over 50 percent of all credit card loans made by banks and thrifts and total in the hundreds of billions of dollars -- are likely to view H.R. 5244 as placing their returns on these securities in peril," according to the ABA. "This could cause a serious contraction in that marketplace as investors shy away from buying these securities, forcing card companies to pull back significantly on their lending."

Higgins said credit card issuers who offered credit cards to riskier subprime customers may experience greater losses in their securitized portfolios. "Those riskier types of lenders, their pools aren't doing as well," he said, citing Washington Mutual Bank's securitized portfolio. "WaMu is experiencing deterioration a little faster."

JP Morgan Chase announced a deal in September to buy WaMu after the thrift was closed by federal regulators. It was the largest bank failure in U.S. history. Higgins says WaMu's securitized portfolios, which were not a part of the Chase acquisition, were placed on negative watch and may be most at risk of failure. He noted, however, "One bad deal from a bank that failed is not going to be a problem. That in no way is a reflection on the whole market."

Higgins cautioned that even with the built-in safety measures, credit card asset-backed securities markets are not foolproof. A lot depends on the economy.

"If it continues to deteriorate and we have a prolonged recession, then we're going to have a problem," he says. "That's going to be felt by a lot of sectors -- not just credit cards."

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

See related: How credit card securities work, Treasury wants to jump start stalled credit card securities, Will credit card securities be the next financial mess?, Fed report: Banks tighten lending standards even more

Published: November 5, 2008


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