In May, the Federal Reserve Board, the Office of Thrift Supervision and the National Credit Union Administration proposed new rules that restrict the pricing and collection of credit card accounts. More recently, the House Financial Services Committee approved a bill by Rep. Carolyn Maloney (D-NY) that would rein in common credit card practices.

The Federal Reserve Board has received more than 27,000 form letters as responses to these proposals, according to its Web site. As of ASR's press time, the Board did not issue its own response to the comments.

One of the dangers of the proposed regulations is that they will not allow credit card companies to capture default risk over the life of a revolving line of credit. In other words, these issuers need to, in essence, periodically reevaluate such risk over time and not just at the time of the borrower's account opening by charging interest rates according to the borrowers' changing risk characteristics.

"The proposed rules are going to prohibit the re-pricing of credit card receivables in ‘real time' by making card companies unable to make rate increase on existing balances," said Glenn Schultz, a managing director at Wachovia Securities. He added that this will have the most impact compared with the other changes that include allowing borrowers enough time to make payments and regulating where payments will be allocated.

Fitch Ratings, in its July edition of Credit Card Movers & Shakers, said that it is closely watching these proposed rules from the Federal Reserve relating to credit card issuers.

The rating agency said that as currently drafted, these proposals could "represent the most sweeping rules changes for the credit card industry in recent history."

Gary Santo, a managing director at Fitch Ratings, said that the rules could prohibit credit card issuers from managing their card portfolios on an ongoing basis. "Issuers react to borrower behavior and manage risk in a fluid environment, and these regulations could hamper their ability to do so," Santo said.

Aside from hindering credit card companies from actively managing their accounts, market players said that the regulation might decrease yields on existing card portfolios. However, Santo added that it is difficult to assess the impact of the pending legislation on credit enhancement levels for credit card ABS.

"When we consider credit enhancement levels on deals, we look at three main components: the gross yield, the monthly payment rate and charge-offs," Santo said. "Although there is no one-to-one correspondence on these factors, they are not isolated from one another. In this case, even though charge-off rates are rising and are expected to reach 7% or more by year-end, the monthly payment rate and gross yields remain strong on credit card ABS, which could serve as an offset."

Wachovia analysts, in a recent research report, said that these new rules appear to potentially reduce the portfolio yield on most credit card master trusts. This is happening in conjunction with charge-offs rising, which in turn will likely limit the excess spread on credit card transactions.

"What you are seeing now is charge-off rates rising, which is not surprising," Schultz said. He explained that charge-off rates went down to just below 3% following the bankruptcy reform act. However, charge-off rates are now rising to the 6% range, which is close to historical averages. According to Schultz, charge-off rates going into a recession usually run in the 7% to 8% range. "Our thesis has always been that underwriting in the consumer space is much more disciplined compared with mortgages, although delinquencies and defaults naturally rise during an economic slowdown."

Despite charge-off rates keeping within historical averages, the dual effect of these rates rising and portfolio yields decreasing could reduce the amount of excess spread that credit card deals have, although Shultz believes that even if portfolio yields drop down to the 5% or 6% range, there is still sufficient cushion there for investors, as current excess spread has remained robust at 7% on average.

He added that even though spreads in the sector are historically wide, the market has built the residential subprime disaster and credit crunch into these levels. The wide spreads, Wachovia believes, present a value opportunity.

Appetite Is Still There

Credit card deals continue to be well received by investors as long as there is performance and liquidity to back them up, said Craig Leonard, co-head of U.S. syndicate at Barclays Capital. The bank was one of the underwriters on the American Express Issuance Trust 2008-2 transaction that priced in early August.

The deal was well received considering the negative news surrounding the company's earnings release, which was coupled with similar news from other credit card issuers such as Citibank.

This is because despite the negative headlines, credit card metrics and structures have held up, Leonard said. "Portfolio yields have come down a little bit, but they remain sound compared with historical rates for the major issuers. These credit card trusts still have sufficient excess spreads." Leonard added that they've seen some market tiering for credit card issuers but only based on seller servicer ratings.

Leonard said that the widening seen in credit cards is not, for the most part, due to the negative headlines surrounding the sector, but that "it's across the board, in the entire consumer space, companies are seeing a downturn that, in turn, has caused spreads to widen," he said. "In terms of fundamentals, the pricing on card deals is too wide and these bonds currently look cheap. Even though performance has deteriorated, we think structures are sound. But unfortunately this is a market driven by technicals, and that has had a negative impact on spreads."

Investor Perspective

Credit card investors are not bullish on the product not only because of the increase in charge-offs, but also because of economic indicators that don't bode well for the sector.

James Grady, managing director and fixed-income portfolio manager specializing in structured finance securities at Deutsche Insurance Asset Management, cited the negative impact of the most recent employment numbers that showed an elevated number of initial claims, even though there was apparently some noise in the numbers.

These numbers, which come on top of the banks' increasing unwillingness to extend credit, could have a detrimental impact on the growth of credit card receivables and will further drive up spreads.

"Spreads are getting banged up pretty hard, and it's been getting worse in the last couple of months," Grady said. "The stuff that's getting well bid is on the front end and very short stuff."

Not helping the sector is the possible impact of current credit card legislation. What causes investor concern is when the Federal Reserve, which is charged with both the safety and soundness of financial institutions and ensuring adequate consumer protections, takes the side of consumer advocacy instead of focusing more on the safety and soundness issue.

"Investors would prefer that the Fed focused primarily on protecting the banks' interests," Grady said. He acknowledged that the regulation might mitigate losses down the line, but he said that it's essentially a "mixed bag on the impact that this will have."

Not allowing credit card companies to re-price risk might dry up access to credit, which is not good for everyone involved, Grady said. Regulation changes might ultimately cause investors to shy away from the market even more.

"When you know that political winds might change legislation and adversely impact investors, there's not much for investors to do and this may force them to pull back from the sector," he said. "You don't want that right now, as the market already has the banks and Wall Street shying away from extending credit."

Issuance Projections

Credit card issuance has been keeping the ABS pipeline busy in the absence of activity in other sectors, specifically the mortgage market. But will this continue with everything that's happening on the legislative front?

Although the sector's issuance in July was down compared with the average in 1H08, Barclays' Leonard said that the current summer slowdown is not indicative of volume for the remainder of the year. "I think issuers will be opportunistic," he said. "Whether they do a fixed- or floating-rate or long- or short-dated transaction will depend on market conditions. A reverse inquiry deal might also be an option when the opportunity presents itself."

In terms of Fitch's outlook for volume in the second half of the year, Santo said that while the rating agency does not typically comment on volume, the common consensus in the industry is that credit card issuers may have been front loading their issuance, as evidenced by the steady volume in the sector year to date.

"Historically, you could look to the maturity schedules for these trusts and get a sense of the issuance calendar; however, portfolio management practices may also become a factor," Santo said.

An example of a practice that could affect issuance is the reduction of credit being offered by lenders in the form of new credit or existing line management, effectively reducing the inventory available for securitization.

Wachovia's Schultz believes that despite the fact that current spreads are wide versus the asset, this is not going to dramatically reduce ABS issuance in the credit card sector. For one, even if more restrictive regulation is implemented, Schultz doesn't think this will reduce the overall profitability of the credit card sector, as there are many ways in which credit card companies could work within the rules and maintain their profits, such as raising initial interest rates for new customers.

He added that stricter underwriting standards are not as much of an issue with credit card companies because they've always had a different paradigm compared with the mortgage market, which is based on unsecured lending.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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