Credit Card Securitization

Yao-Min ChiangAssociate Professor, Department of Finance

Director, CNCCU Sinyi Center for Real EstateNational Chengchi University

A SHORT ARTICLE

• Credit card securities have been the cornerstone of the ABS market, although they are now second to home equity loans in terms of volume in the ABS sector. Credit card ABS has been a growing source of funding and balance sheet relief for lenders since 1987, when the first such security was brought to market.

• Credit card debt is known as revolving debt and is a key influence on the structure of credit card ABS. Credit cardholders are assigned a credit limit and can generally borrow funds up to that amount. They can repay some or all of their debt at any time, and can take on additional debt as long as the total debt is within their credit limit. Cardholders can repay as little or as much principal each month as they desire, subject to a small minimum payment. Thus, there is no true maturity for a credit card account and the amount of principal or loan may fluctuate over time.

• The collateral for a credit card security is the outstanding debt (the receivables) of a group, or pool, of individual credit card accounts. The cash flow available to pay interest to investors comes from the pool's gross revenues, which is made up of finance charges, annual fees, late charges, and interchange (the fee paid to the credit card issuer by a merchant who makes a sale charged to the card). Expenses for the pool consist of the ABS coupon, charge-offs, and a servicing fee.

• An issuer creates a credit card security by first setting up a trust. Then, the issuer sells the outstanding receivables (the current balances and the future cash flows produced by the current balances) of a designated group of credit card accounts to the trust. Additionally, the issuer transfers the right to purchase, at par, any future balances generated by the same group of accounts. The balance of receivables outstanding is collateralized into two types of securities, known as investor and seller certificates. The investor certificate is sold to ABS investors and the seller certificate is retained by the card issuer. The holder of the seller certificate receives all finance charge cash flows from the receivables that remain after payment of the investor certificate coupon, the collateral pool servicing fee, charge-offs, and trust expenses. The balance of the seller certificate fluctuates over time as cardholders pay off their balances and make new purchases. The cash flow available to pay the investor coupon depends on the amount of principal outstanding. If the pool's principal is paid down more quickly than new charges are added to the point where the balance falls below an established minimum, the seller must add more accounts to the pool.

• Credit card ABS can have fixed or floating rate coupons. Interest payments, based on the investor certificate's outstanding balance, are most often paid monthly, but are sometimes paid quarterly or semiannually. In contrast to automobile ABS, the principal is not amortized. Rather, for a specified period, the lockout period or revolving period, the investor certificate pays only interest, and principal payments are reinvested in new receivables generated by the pool. The lockout period can vary from 18 months to 10 years.

• After the lockout period ends, the principal is no longer reinvested but is instead returned to investors. This period is known as the principal-amortization period. Early credit card ABS structures repaid principal by passing proportional shares of all repayments to investors and sellers until the securities were retired. But because ABS investors wanted a more predictable repayment schedule, today the securities are usually retired in one of two ways — either through controlled amortization or by bullet payments.

• An ABS with controlled amortization repays, or amortizes, principal according to a set schedule, similar to a bond with a sinking fund. A scheduled principal is established and is set to a sufficiently low level so that the obligation can be satisfied even under stress scenarios.

• Bullet credit card structures are designed to pay interest on a periodic basis and, on the last scheduled interest payment date, to return all principal. In this type of structure, an accumulation period follows the revolving period. During this accumulation period, borrower repayments are held in a principal funding account that generates sufficient interest to make periodic interest payments and accumulate the principal to be repaid on the maturity date.

• The primary factors affecting credit quality of credit card receivables are card issuer underwriting standards and marketing methods; servicer quality; seasoning; geographic concentration; and economic conditions. Since credit card receivables are unsecured, the strength of an issuer's underwriting criteria is critical to default performance. The method of account generation is also important. For example, a bank soliciting its own customer base may be expected to produce a more creditworthy pool of accounts than a general direct-mail campaign. Servicing quality also has a substantial impact on defaults, as a servicer that aggressively handles delinquent accounts reduces the likelihood of default. Resolving delinquencies early is important, since recoveries on unsecured card receivables are generally fairly low. Seasoning typically leads to stable default rates. In terms of geographic concentration, the more localized a pool of loans, the greater the risk if the region experiences an economic downturn. Defaults are highly correlated with unemployment and bankruptcy filings, so general economic conditions are important as well.

• Most credit card ABS are rated AAA, which indicates that they have a high enough level of credit support to protect investors from all but the most traumatic economic events. Rating agencies apply a range of stress tests to each asset pool and transaction to establish a required level of credit enhancement. Thus, to create securities that withstand AAA-level stresses, issuers use credit enhancements for each credit card transaction. The most common of these credit enhancements are early amortization, letters of credit, and subordination.

• Early amortization is the most powerful safeguard for credit card ABS investors. An early amortization begins if certain characteristics of the collateral pool deteriorate to some preset trigger level. When an early amortization is triggered, the security's revolving period ends immediately and the investor certificate's share of all further repayments is passed through to investors until the certificate is retired. Early amortization is not reversible, so once the process begins improving conditions do not halt repayment. Most securities have early amortization triggers set to a specific minimum net portfolio yield level. Other triggers protect investors from various failures of the trustee, the servicer, or the card issuer. Additionally, a seller interest trigger is tripped if the seller cannot add enough accounts to maintain the minimum balance required.

• During the early years of the credit card market, the most common form of supplementary credit enhancement was a letter of credit from an AAA-rated bank. Letters of credit guarantee a specified amount of funds available to the issuer in the event of cash shortfalls from the collateral. However, letters of credit lost much of their appeal when the rating agencies downgraded the long-term debt of several letter of credit provider banks in the early 1990's. Since securities enhanced with letters of credit from these lenders faced possible downgrades as well, issuers began to issue cash collateral accounts instead of letters of credit in cases where external credit support was needed. In a cash collateral account, the issuer actually borrows the funds when the ABS are originated, instead of establishing a line of credit. These funds are available to make payments to investors, if needed.

• The event risk inherent in external credit enhancements such as letters of credit has resulted in structures being increasingly dependent on internal credit support. The most widely used is the senior/subordinated structure, where a portion of the investor certificate is designated as junior (subordinated) to the remaining (senior) portion. In this structure, the obligations of the senior class are honored first in the event of a cash flow shortfall from the collateral.

THE STRUCTURE OF THIS LECTURE NOTE

• The Market for Credit Card Asset-Backed Securities• Credit Card Securitization Process • Trust Structures • Cash Flow Structures • Cash Flow Calculation • Rating• Other Issues

THE BASIC PROPERTIES OF CREDIT CARDS

• Holders of credit cards may borrow funds, generally on an unsecured basis up to an assigned limit, and pay the principal and interest as they wish, as long as they make a small required minimum payment on a regular basis—generally once a month. Consumers may also borrow more money while paying off the old debt, if they do not exceed the credit limit. Because cardholders do not have to pay off the principal on a schedule, credit card debt has no actual maturity and is therefore a classic example of a nonamortizing loan.

THE MARKET FOR CREDIT CARD ASSET-BACKED SECURITIES

• Securities collateralized by credit card receivables are one of the oldest segments of the ABS market, representing 14.3% of ABS issuance in 2003.

• Issuance totaled $51 billion in 2004, substantially lower than 2003’s $65 billion.

• Bank One ($8 billion), Citi ($7 billion), MBNA ($6 billion), and Capital One ($6 billion) were the top four issuers in 2004.

• Of the total issuance, $42 billion was AAA rated and $5 billion was BBB rated. Upgrades dominated ratings migration in the credit card ABS sector, with a total of 38 upgrades, all due to MMT. There were two rating downgrades in 2004, both attributable to FCCT.

PERFORMANCE

• In 2004, benchmark floating-rate 5-year credit card ABS spreads tightened 6 bps over the year to 1-mL +5 bps and subordinate spreads tightened 30 bps over the year to 1-mL + 20 bps. Benchmark BBB spreads tightened 110 bps over the last three quarters from 1-mL+155 bps to 1-mL + 45 bps. 2003,12,5 2004,1,16

Source: Asset-Backed Alert

THE BENEFITS OF SECURITIZATION

• Securitization has been the primary funding source for specialized credit card banks. Before the creation of credit card ABS, issuers had to fund their loans either by borrowing money from banks or taking deposits (e.g., offering consumers checking, savings, or money market accounts). Credit card ABS expand issuers' funding sources to include the broad base of fixed income investors allowing issuers to diversify their funding base and lower borrowing costs.

• Securitization also enables issuers to lower their regulatory capital. Banking regulators require that card issuers set aside a percentage of their assets in reserve for unexpected losses. By taking assets off a bank's balance sheet, securitization lowers card issuers' regulatory capital requirements and frees up capital to support other investments.

CREDIT CARD SECURITIZATION PROCEDURE

Essentially there are three key stages in a securitization:

1. Issue bonds; to ensure that there is no recourse to the card issuer, assets are transferred to a separate entity; this is normally through a special purpose vehicle (SPV). It is important to separate the interest in the trust into seller interest (the institution which originally issued the cards) and investor interest, although both parties have a claim on the income generated by the card receivables. Investors’ interest can be protected against default by cardholders, through a form of credit enhancement. A simple example is a senior/subordinated structure, where there is a priority allocation of the cash flow: Class A (priority); Class B (subordinated, therefore has a lower credit rating than class A).

2. Servicing the bonds (the revolving period): income received from securitized credit card receivables is two-fold:

(a) Interest and fees from cardholders (trust yield): this is used to pay for the administration of card accounts, to cover any defaults on cards and to pay the investor and sellers’ interest. Any residual income is the excess spread, which usually goes to the card issuer.

(b) Repayment of the principal by card holders: the revolving structure of credit card securitization has been established to offset those card holders who pay off their principal early. Instead, repayments are reinvested in purchasing new assets, until they get towards the end of the bond’s life and redemption occurs.

3. Redemption of the bonds: redemption typically occurs over a twelve month period, at the end of the revolving period. The cardholders’ repayments are not reinvested, but are retained to pay the investors’ principal. Redemption can either be through an accumulation method or through amortization.

(a) Accumulation: an amount of the cardholders’ repayments are placed in trust and accumulated until they are used to make a singe “bullet” payment of the investors’ principal.

(b) Amortization: a proportion of the cardholders’ repayment is used to pay off the investors’ principal over monthly payments.

THE TRUST STRUCTURE• In a securitization, a firm (the “seller”) transfers credit card receivable

s to a special-purpose vehicle (the “trust”) and pledges the cash flow from these assets to service debt securities (the “certificates”) issued by the trust. The balance of receivables outstanding is collateralized into two types of securities, known as investor and seller certificates.

• In addition to issuing investor securities, every seller is required to maintain an ownership interest in the trust. This participation performs several critical functions. It acts as a buffer to absorb seasonal fluctuations in credit card receivables balance, is allocated all dilutions (balances canceled due to returned goods) and fraudulently generated receivables that have been transferred to the trust, and ensures that the seller will maintain the credit quality of the pool since the seller owns a portion of it. To ensure that the certificateholders’ invested amount is always fully invested in credit card receivables, the size of the seller’s participation must remain at or above a minimum percentage of the trust receivables balance, usually 7%. The seller’s participation does not provide credit enhancement for the investors.

Stand-Alone vs. Master Trust• A vast majority of card securitizations have been

completed using two different vehicles — the stand-alone trust and the master trust.

Stand-Alone• This is simply a single pool of receivables sold to a trust

and used as collateral for a single security, although there may be several classes within that security. When the issuer intends to issue another security, it must designate a new pool of card accounts and sell the receivables in those accounts to a separate trust. This structure was used from the first credit card securitization in 1987 until 1991, when the master trust became the preferred vehicle.

Master Trust• The master trust structure allows an issuer to sell multiple securities

from the same trust, all of which rely on the same pool of receivables as collateral. For example, an issuer could transfer the receivables from one million accounts (representing $1 billion of receivables) to a trust, then issue multiple securities in various denominations and sizes. When more financing is needed, the issuer transfers receivables from more accounts to the same trust. It can then issue more securities. The receivables are not segregated in any way to indicate which series of securities they support. Instead, all the accounts support all the securities.

This structure allows the issuer much more flexibility, • since the cost and effort involved with issuing a new series from a

master trust is lower than creating a new trust for every issue. • In addition, credit evaluation of each series in a master trust is easier

since the pool of receivables will be larger and not as subject to seasonal or demographic concentrations.

Master Trust Features• Master trusts may be set up with one or several

reallocation groups. For example, AT&T Universal Card Master Trust currently has two groups: Group I for series with fixed-rate coupons and Group II for series with floating-rate coupons. Most other trusts have only one group, in which all series are included. Depending on the structure of the trust, series within the same group may share principal and/or excess spread, have the ability to discount, or fix allocations of finance charges.

Principal Sharing• For all series in the same group, the trust allows

distribution of excess principal collections to any series in its accumulation or amortization period. Since a series in its revolving period has no principal payment requirements, principal collections allocated to that series are available for reallocation. In addition, principal collections in excess of a series’ controlled amount are available for reallocation. The principal reallocation feature provides investors with more assurance of timely principal repayment, with no additional risk to other series.

Excess Spread Sharing• There are several ways excess spread may be shared within series of a

group. Some groups may be set up as a “socialized” group, whereby finance charge collections are allocated to each series based on need. The interest expense for all series in the group will be the weighted average expense for each series. Thus, the highest coupon series will receive the largest allocation, and the lowest coupon will receive the smallest allocation. The excess spread for each series will be the same, since each has the same coupon expense. In effect, socialized groups share excess spread at the top of the cash flow waterfall. AT&T Universal Credit Card Master Trust, Household Affinity Credit Card Master Trust, and Citibank Credit Card Master Trust are examples of socialized trusts. Other trusts may allocate finance charge collections on a pro rata basis, based on size. Thus, each series will receive the same proportionate amount of finance charges, and the series with the lowest coupon expense will have the largest amount of excess spread. This amount will be available for reallocation to other series, particularly high coupon series, if their excess spread is reduced to zero.

CASH FLOW STRUCTURE

• The typical setup has three different cash flow periods: revolving, controlled amortization (in some cases, controlled accumulation), and early amortization. Each period performs a different function and allocates cash flows differently. This structure is designed to mimic a traditional bond, in which interest payments are made every month and principal is paid in a single “bullet” payment on the maturity date.

• Since the average life of a credit card receivable is a short five to 10 months, an amortizing structure, like the ones used in automobile and mortgage deals, does not work very well. In this type of structure, the principal and interest collections on the pool of loans are passed directly through to investors on a monthly basis. An amortizing structure for credit card-backed securities would result in a short average life and lumpy, unpredictable repayment to investors. Use of a revolving structure gives the issuer medium- to long-term financing, and it gives the investor a predictable schedule of principal and interest payments.

• All collections on the receivables are split into finance charge income and principal payments. Each of the three periods treats finance charge income in the same manner. Monthly finance charges are used to pay the investor coupon and servicing fees, as well as to cover any receivables that have been charged off in the month. Any income remaining after paying these expenses is usually called excess spread and is released to the seller. Principal collections, however, are allocated differently during each of the periods.

1. Revolving Period

• During the revolving period, monthly principal collections are used to purchase new receivables generated in the designated accounts or to purchase a portion of the seller’s participation if there are no new receivables. If there are not enough new receivables to reinvest in, an early amortization will be triggered because the seller’s participation has fallen below the required minimum, or, in some cases, the excess principal collections will be deposited in an excess funding account and held until the seller can generate more credit card receivables. The risk of early amortization gives the seller adequate incentive to maintain the seller’s participation at a level well above the minimum. The revolving period continues for a predetermined length of time, which has ranged from two to 11 years. Investors will receive only interest payments during this period.

2. Amortization Period

• Controlled Amortization• At the end of the revolving period, the controlled

amortization or controlled accumulation period begins. In the case of controlled amortization, which typically runs for 12 months, principal collections are no longer reinvested but are paid to investors in 12 equal controlled amortization payments. The payments are sized at exactly one-twelfth of the invested amount so investors can be repaid on a predetermined schedule. (Some series may have longer or shorter controlled periods and, thus, will have smaller or larger controlled amortization payments.) Any principal collected in excess of the controlled amount will be reinvested in new receivables, as in the revolving period. Interest will be paid only on the outstanding amount of securities as of the beginning of the monthly period.

• Controlled Accumulation• Controlled accumulation follows a similar procedure,

except that the controlled payments are deposited into a trust account, or principal funding account (PFA), every month and held until the expected maturity date. At the end of the accumulation period, the full invested amount will have been deposited into the PFA and investors will be repaid their principal in a single payment (see chart below). Of course, interest payments will be made each month on the total invested amount. With this structure, investors will not see any difference in monthly payments when the deal converts from revolving to accumulation.

Soft/Hard Bullet

• “Bullet” structures, which are also used with revolving assets, are designed to return principal to investors in a single payment. These ABS also feature two separate cash flow management periods: the revolving period, during which any principal repaid is used to buy more receivables, and the accumulation period (analogous to the amortization period in a controlled-amortization structure), during which principal payments build up in an escrow account to fund the bullet payment to investors.

• The most common bullet structure is the soft bullet, so labeled because the bullet payment is not guaranteed on the expected maturity date (although most such ABS do pay off on time). The potential for a shortfall exists during the accumulation period, in which case investors may receive the remaining principal payments over an additional period (usually one to three years) until what is known as the final maturity date.

• In contrast, a hard-bullet structure ensures that the principal is paid on the expected maturity date and does this with a longer accumulation period, a third-party guarantee or both. In a hard bullet, rating agencies evaluate the timeliness of principal payments. Hard bullets are rare, because investors are comfortable with soft bullets and are unwilling to pay extra (in the form of a lower yield) for a guarantee. As with controlled-amortization structures, soft- or hard-bullet structures are also subject to early amortization risk.

3. Early Amortization

• The seller is obligated to add credit card accounts to the trust if the amount of its participation falls below the required minimum. If the seller cannot provide additional accounts, an amortization event will occur (see Amortization Triggers, page 5). In most circumstances, the seller must receive rating agency approval before any accounts can be added. Sellers do not need approval when the addition is a small percentage of the trust (10%–15%) or when the minimum seller’s participation level has been breached. Of course, rating agencies will receive notification of these events.

• Severe asset deterioration, problems with the seller or servicer, or certain legal troubles can trigger early amortization at any point in the deal, whether it is revolving, amortizing, or accumulating. The box on page 5 shows common amortization triggers. In such cases, the deal automatically enters the early amortization period and begins to repay investors immediately. This feature helps protect investors from a long exposure to a deteriorating transaction.

• Several topics should be considered when evaluating early amortization risk, including:

— Variability of charge offs.— APR pricing position (competitive or not).— Fixed- or floating-rate investor coupon.— Seller/servicer strength.— Ability to discount new receivables into trust.— Sharing of excess spread.— Percentage of total bank receivables that have been securit

ized.—Existence of variable funding, extendible, or commercial p

aper series.

Amortization Triggers*

Seller/Servicer1. Failure or inability to make required deposits or payments. 2. Failure or inability to transfer receivables to the trust when necessary.3. False representations or warranties that remain unremedied.4. Certain events of default, bankruptcy, insolvency, or receivership of the seller

or servicer.

Legal5. Trust becomes classified as an “investment company” under the Investment Co

mpany Act of 1940.

Performance6. Three-month average of excess spread falls below zero.7. Seller’s participation falls below the required level.8. Portfolio principal balance falls below the invested amount.

Fast Pay Allocation• In the event that an early amortization is triggered and not cured, the i

nvestors will begin to be repaid immediately on a fast pay, or uncontrolled, basis. All principal collections and any amounts in the PFA will be distributed to investors, with senior certificates being paid off first. Principal distributions will be made to subordinate investors only after senior investors are fully repaid. To help speed repayment to investors, a portion of principal collections that would normally be allocated to the seller’s participation will be reallocated to the investors.

• In the history of credit card securitization, the only three deals that have triggered early amortization events were issued by RepublicBank, Delaware, Southeast Bank, and Chevy Chase FSB. None was rated by Fitch. In the Chevy Chase deal, investors voted to waive the trigger event, and the transaction continued to operate as normal. The securities were repaid as originally scheduled, and no investor suffered a loss. In both the Southeast Bank and RepublicBank deals, early amortization was commenced and investors were repaid without a loss, but earlier than they had expected.

CASH FLOW CALCULATION

Cash Flow modelling for different time frames • revolving period • accumulation period • amortisation period • early termination scenario

Rules:1.All collections on the receivables are split into finance char

ge income and principal payments.2.Each of the three periods treats finance charge income in th

e same manner.3.Monthly finance charges are used to pay the investor coupo

n and servicing fees, as well as to cover any receivables that have been charged off in the month.

4.Any income remaining after paying these expenses is usually called excess spread and is released to the seller.

5.During the revolving period, monthly principal collections are used to purchase new receivables generated in the designated accounts.

6.If there are not enough new receivables to reinvest in, an early amortization will be triggered because the seller’s participation has fallen below the required minimum.

7.Investors will receive only interest payments during the revolving period.

8.controlled amortization, which typically runs for 12 months.

9.Principal collections are no longer reinvested but are paid to Investors in 12 equal controlled amortization payments.

10.Any principal collected in excess of the controlled amount will be reinvested in new receivables, as in the revolving period.

11.Interest will be paid only on the outstanding amount of securities as of the beginning of the monthly period.

12.Controlled accumulation follows a similar procedure, except that the controlled payments are deposited into a trust account, or principal funding account (PFA), every month and held until the expected maturity date.

13.Controlled accumulation: At the end of the accumulation period, the full invested amount will have been deposited into the PFA and investors will be repaid their principal in a single payment.

14.Controlled accumulation: Interest payments will be made each month on the total invested amount. With this structure, investors will not see any difference in monthly payments when the deal converts from revolving to accumulation.

Cash Flow Terms

Portfolio Yield• Yield is made up of periodic APR charges, annual fees, late pa

yment fees, overlimit fees, and, in some cases, recoveries on charged-off accounts and interchange. Interchange is income from the card associations (Visa, MasterCard, and Novus, among others) that is paid to the issuing bank as compensation for taking credit risk and funding receivables, the amount of which varies from 1%–2% annually.

Monthly Payment Rate • The MPR includes monthly collections of principal, finance ch

arges, and fees paid by the cardholder and is stated as a percentage of the outstanding balance as of the beginning of the month.

Chargeoffs• Credit cards are unique among loans in that the credit quality o

f each cardholder is reflected in the cardholder’s credit limit and annual percentage rate (APR), which are based on the cardholder’s ability to meet debt payments. chargeoffs which are composed by delinquencies and bankruptcies

Investor Coupon• fixed-rate ABS, vs. floating-rate ABS, For example, the ABS

investor’s coupon floats off the one-month London Interbank Offered Rate (LIBOR).

Receivables Balance• Pool’s receivables balance. If the outstanding principal receiva

bles of the portfolio decline, especially during early amortization.

Excess Spread• The yield on credit cards, which is high relative to other types

of consumer loans, should cover the payment of investor interest in addition to the servicing fees and still be sufficient to reimburse the trust for any receivables charged off during the month. The remaining yield, or excess spread, provides a rough indication of the financial health of a transaction.

CREDIT ENHANCEMENT

Internal Credit Enhancement• Subordination: A popular type of internal credit support is the senior/subordinated

(or A/B) structure, which is technically a form of “overcollateralization.” It is characterized by a senior (or A) class of securities and one or more subordinated (B, C, etc.) classes that function as the protective layers for the A tranche. If a loan in the pool defaults, any loss thus incurred is absorbed by the subordinated securities. The A tranche is unaffected unless losses exceed the amount of the subordinated tranches. The senior securities are the portion of the ABS issue that is typically rated triple-A, while the lower-quality (but presumably higher-yielding) subordinated classes receive a lower rating or are unrated.

• Overcollateralization: In this case, the face amount of the loan portfolio is larger than the security it backs.

• Excess Spread is the net amount of interest payments from the underlying assets after bondholders and expenses have been paid. The monthly excess spread is used to cover current-period losses and may be paid into a reserve fund to increase credit enhancement.

External Credit Enhancement

• Cash Collateral Account A CCA is simply a segregated trust account, funded at the

outset of the deal, that can be drawn on to cover shortfalls in interest, principal, or servicing expense for a particular series if excess spread is reduced to zero. The account is funded by a loan from a third-party bank, which will be repaid only after all classes of certificates of that series have been repaid in full. Cash in the account will be invested in the highest rated short-term securities, all of which will mature on or before the next distribution date. Draws on the CCA may be reimbursed from future excess spread.

Collateral Invested Amount• The CIA represents an uncertificated, privately placed ownership interest i

n the trust, subordinate in payment rights to all investor certificates. Acting like a layer of subordination, the CIA serves the same purpose as the CCA; it makes up for deficiencies if excess spread is reduced to zero. The CIA is traditionally placed with banks, which may require investment-grade ratings on the CIA as a condition to purchase. The CIA itself is protected by a spread account (not available to any other investors) and available monthly excess spread. If the CIA is drawn on, it can be reimbursed from future excess spread.

• This class of enhancement also goes by other names — CA investor interest, collateral interest, enhancement invested amount, or “C” tranche. A senior/subordinate structure offers two different types of investor ownership in the trust — senior participation in the form of class A certificates and subordinate participation in the form of class B certificates. Class B will absorb losses allocated to class A that are not already covered by excess spread, the CCA, or the CIA. Like the CCA and CIA, draws on the subordinate certificates may be reimbursed from future excess spread. Principal collections will be allocated to the subordinate investors only after the senior certificates are fully repaid.

Letter of Credit• From the inception of credit card securitization until 1991,

the letter of credit (LOC) was a common form of enhancement. It is an unconditional, irrevocable commitment from a bank to provide cash payments, up to the face amount of the LOC, to the trustee in the event that there is a shortfall in cash needed to pay interest, principal, or servicing. Usage as a form of enhancement was discontinued when a number of banks providing LOCs were downgraded and the transactions they enhanced were downgraded as a result. The CCA was developed to remove downgrade risk caused by enhancer credit quality, and this marked the end of the use of LOCs in credit card transactions.

SENSITIVITY ANALYSIS AND SCENARIO ANALYSIS

STRESS TEST• Under the most severe depression scenarios, properly structured ‘AAA’ cre

dit card asset-backed securities (ABS) should repay investors 100% of their original investment plus interest. Securities rated in the ‘A’ category (subordinated certificates) are subject to less severe recessionary scenarios than those used for ‘AAA’; however, they are considered to be investment grade and of high credit quality. The trust’s ability to pay interest and repay principal to class B is strong, but it may be more vulnerable to adverse changes in economic conditions and circumstances than class A.

• Credit card ABS performance can be influenced by many variables, The major variables influencing credit enhancement levels are chargeoffs, portfolio yield, monthly payment rate (MPR), and investor coupon.

CREDIT RATINGS

• Before the assets in the trust are put into security form and sold to investors, the card issuer contracts with a credit rating agency to establish a bond rating for the issue. A bond rating is an opinion from a rating agency of the credit quality of the subject security. Bond ratings are typically expressed by a series of letters (e.g., AAA, AA, BBB, C). Triple-A rated securities, which have the lowest risk of default, must be structured to withstand severe economic stresses and still pay investors 100 percent of their principal with interest. Lower rated securities (e.g., AA, BBB, B) have a relatively higher risk of default and may not be able to repay investors under severe economic conditions. Differences in default risk are reflected in a bond's coupon. As such, a bond with a triple-B rating pays a higher coupon than one with a triple-A rating. In credit card ABS, issuers typically structure an ABS deal so that it has more than one rated "class" of bonds. For example, an issuer may structure a $750 million deal such that it issues $650 million in bonds with a triple-A rating, $50 million in bonds with a single-A rating, and $50 million in bonds with a triple-B rating. In such a case, an issuer will have to pay a higher coupon to investors in the lower-rated classes than to investors in the triple-A class, since investors in the lower-rated classes are exposed to a higher risk of default.

• Subordinating the claims of some classes of bondholders to the triple-A bondholders serves the purpose of "enhancing" the credit quality of the most senior class. Such enhancements are discussed in more detail at the end of this section.

• In determining a bond's rating, credit rating agencies examine performance variables such as the issuer's underwriting standards, cardholders' credit scores, and loan interest rates. They also perform a variety of "stress tests" on the underlying credit card portfolio assets. Using computer models, the rating agencies simulate the effects of economic "shocks" on a card portfolio's performance. They observe the conditions and circumstances under which a credit card ABS deal can no longer pay investors back their full principal and interest.

TAX

• Generally, only the interest portion of payments to ABS investors is subject to income tax—state and local (if applicable), as well as federal. The portion of the payments that represents return of principal or original cost is not taxable.

WHY INVEST

• When investors are considering whether to buy an asset-backed security, they consider the security's "convenience." Specifically, investors examine the security's structure in relation to their own investment goals. Some bond structures are more "convenient" and better positioned to meet a particular investor's needs. In determining a bond's convenience, investors examine the frequency of cash flows associated with the bond, the way that the bond pays back principal (all at once or incrementally over time), and the complexity of the bond's terms. Spreads are wider for bonds that have structures or repayment terms that are unusual, difficult to model, or hard to understand.

THE OAS MODEL

• In a given month portfolio yield, charge-off and monthly payment rates along with any coupons determine cash flows for a given trust. Given a projected sequence for each of these rates, we can determine trust performance for the entire life of the bonds. Our approach utilizes Monte Carlo simulation to captures the optimality that is embedded in these tranched securities. Each simulation results in a series of cash flows for (say) the Apiece. A treasury spot curve, plus an appropriate option-adjusted spread will determine the present value of this resulting cash flow.

• To get an option-adjusted spread one starts by running many simulations and recording the resulting cash flows. By choosing a spread level, we are able to take the present value of each of these cash flows. We are also able to find the average of all of these resulting present values. The option-adjusted spread is the spread level for which the average of all of the prices is equal to the price of the bond. The often quoted Nominal spread is simply the spread that prices the bond based on only its expected cash flows.

SWAP

• When a trust backed by US$ collateral issues bonds denominated in currencies other than US dollar, the currency risks are hedged by means of currency swaps. Interest swap contracts are also entered into in order to minimize market basis risks.