With consumers under increasing stress, credit card ABS performance has weakened. In anticipation of a prolonged stressed environment for consumers, investors are asking the following questions: if performance continues to deteriorate, what will this mean for credit card ABS ratings?
More specifically, how will ratings change in a scenario where chargeoffs increase 50% from the index average, to 9%, yield declines 15%, and the monthly payment rate drops 20%, simultaneously, over the next 12 months? Also, what if only one or two of these variables worsened in a given scenario?
To answer these questions, Fitch Ratings conducted several stress scenarios on a hypothetical prime credit card receivable issuance trust over a 12-month period and simulated rating actions likely to be taken as a result. For the following simulation, Fitch assumes a prime trust using an issuance trust structure tranched as follows:
* Class A totals 87.50% of the trust. It has credit enhancement of 12.50% derived from the subordination of class B and class C. It is currently rated 'AAA'.
* Class B totals 6.00% of the trust. It has credit enhancement of 6.50% derived from the subordination of class C. It is currently rated 'A'.
* Class C is 6.50% of the trust. It is supported by a spread account established primarily for the benefit of class C noteholders. The spread account begins trapping when the three-month average excess spread falls below 4.50%. It is structured to trap its total 6.50% of the total invested amount, if available. This would equal 100% cash collateral for the class C notes. Fitch assumes there will be 12 months of trapping between the time the account begins to fund and the time when excess spread is depleted. Over this 12-month period, Fitch uses a linear decline scenario to evaluate the amount of credit enhancement, which could be provided by the spread account. It is currently rated 'BBB'.
Additional assumptions made for cash flow modeling include a spot LIBOR value of 3% and a weighted average coupon spread over LIBOR of 0.50%. Throughout the course of this analysis, these spot rates were used as inputs into Fitch's model used to run the breakeven analysis. This model incorporates Fitch's standard LIBOR forward curve and basis rate stresses, which are available on Fitch's web site at www.fitchratings.com.
Mild, Moderate, and Significant Stress Descriptions
Fitch analyzed several scenarios incorporating mild, moderate, and significant stresses that resulted in prolonged cash flow compression.
* Under the mild stress scenario, Fitch assumed chargeoffs would increase by 50%, to 9% from 6%, while yield and MPR would remain constant.
* Under the moderate stress scenario, chargeoffs would again increase by 50%, while yield would decrease by 15% and only MPR would hold constant.
* Under the significant stress scenario, stresses were applied simultaneously; chargeoffs would increase by 50%, yield would decrease by 15%, and MRP would be reduced by 20%.
Given the current weakened state of the economy and the forecast for increasing deterioration, the moderate stress scenario is not unrealistic. In fact, Fitch is predicting that credit card chargeoffs will exceed 8% by year-end 2009 as the economic downturn unfolds and the unemployment rate increases.
Since Fitch is simulating a protracted decline in performance in the significant scenario, Fitch assumes that 12 months pass between the steady state scenario and the stressed scenario. The time series below shows how the three-month average excess spread deteriorates as a result. However, it is unlikely that all three variables would experience such significant, simultaneous deterioration.
Likely Fitch Actions:
Each month, Fitch conducts a review of the performance of all credit card ABS ratings to determine if changes in performance are outside certain tolerance levels. If so, ratings on each transaction registering such an exception are reviewed in greater detail. Given the performance discussed above, Fitch would likely hold a committee for transactions issued by the hypothetical trust each month to discuss possible rating actions. While these committees are being held, it is Fitch's intention to communicate when research is being conducted to determine if rating action is warranted by using a SMARTView designation of Under Analysis until the rating has been affirmed, downgraded, or placed on Rating Watch.
If the performance discussed above was reviewed in isolation, then the following actions would likely be recommended to the committee:
* Stress at Outset. Fitch would likely have already revised the Rating Outlooks on the class B and C notes to Negative from Stable due to the trend toward lower break-even chargeoff multiples that the classes could withstand under a scenario including Fitch's projections for the next 12 to 24 months.
* Stress Month Four. Fitch may place the 'BBB' rating on class C notes on Rating Watch Negative due to continued deterioration and the measurably lower break-even chargeoff multiple that can be sustained by this class in particular.
* Stress Month Six. Fitch may downgrade the class C bonds by one to two notches, to somewhere in the 'BBB-' to 'BB+' threshold (from 'BBB') because excess spread is declining at a rapid pace, and spread account funding may be lagging Fitch's assumptions.
* Stress Month Six. Fitch may also revised the Rating Outlook for 'AAA' rated notes to Negative from Stable as the prior month's trends are factored into the projected scenario. The Outlook would indicate that, over the midterm, downgrade risk has increased.
* Stress Month Seven. Fitch may place the rating on the class B notes on Rating Watch Negative to reflect further impairment of the chargeoff multiples. Additionally, the class C bonds could be downgraded further by a one to two notches to 'BB+'/'BB'.
* Stress Month Nine. Fitch may downgrade the class B rating by one to two notches, to somewhere in the 'A-' or 'BBB+' threshold due to substantially lower chargeoff multiples.
As stress on the performance of the transaction increases, the multiple of current losses the bond can withstand will obviously become compressed. Compressed multiples do not automatically trigger a downgrade. Rather, when reviewing the performance of a transaction, Fitch considers the current and expected economic environment, actions and strength of the servicer, and structural features of the specific transaction. For example, if the usual chargeoff multiple associated with an 'AAA' rating is 4.50, it is possible that the chargeoff multiple could dip into the 3.0 to 4.0 range without a downgrade occurring if an economic downturn appears to be abating and the servicer appears to have taken actions to mitigate performance volatility. Fitch publishes chargeoff multiples regularly and will comment on situations in which multiple compression is evident.
As the spread account traps funds, the velocity of excess spread declines will be reviewed to determine the availability of future trappings relative to Fitch's original assumptions and whether the class C ratings remain appropriate.
Conclusion:
While downgrades would certainly result from certain levels of stress, the rated classes would not come close to approaching principal or interest shortfalls. Specifically, under the harshest scenario described above, Fitch would expect that by the seventh month of stress, subordinated classes would be downgraded by up to three notches while the 'AAA' rated class would be unaffected. Even by month 12, the 'AAA' class would not be downgraded, although its Rating Outlook would have been changed to Negative from Stable.
Potential Mitigating Actions:
Credit cards are revolving, rather than amortizing, financial instruments and are more dynamic than other consumer assets. To accommodate this collateral characteristic, trusts are structured such that the receivables and accounts are continuously replenished. If a credit issue occurs, the issuer may have flexibility to improve trust performance through various actions, including the execution of a large addition of better performing accounts. However, this is contingent on the existence of a large number of unsecuritized, high credit quality accounts on the balance sheet.
In addition, credit card issuers have historically possessed a significant ability to change terms of the credit card lending agreement to preserve their profit margins. In addition to risk mitigation activities such as credit line decreases, risk-based pricing initiatives are fluid and widely used in the industry. A byproduct of this flexibility is a fairly consistent level of excess spread over the past few years.
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