Credit card issuers are taking unusual steps to protect their securitization vehicles as surging unemployment continues to hurt credit performance and a government program has reopened the ABS market to new issuance.
This month Bank of America Corp. issued to itself a class of securities, equal to 8% of its outstanding bonds, that will receive no interest payments and absorb losses ahead of all other investors.
The new notes are backed by a like amount of receivables that were not serving as collateral for the previously outstanding bonds. Citigroup said this month that it would create a similar, though smaller, buffer. Both companies also began temporarily treating significant amounts of principal collections as finance charges.
Doing so will boost excess spread, the amount by which income in the trust exceeds costs, which is a key measure of the health of a trust. The actions highlight the importance of securitization to the credit card business, despite the funding alternatives like deposits available to most big issuers. Issuance in the market was frozen for five months but has begun to thaw this month, thanks to the Federal Reserve Board's Term Asset-Backed Securities Loan Facility (TALF).
Analysts said the protections added by Citi and BofA should help them take advantage of Talf by bolstering investor confidence in their paper.
Daniel Castro, the chief risk officer at Huxley Capital Management, said the reason for such actions is "getting your investor base comfortable that you're going to be there, and that the next time you issue, your bonds will be well received."
Among the three largest credit card lenders, about 55% of $182 billion of receivables at BofA, 70% of Citi's $151 billion North American receivables and 45% of $190 billion at JPMorgan Chase were funded in the ABS market. Castro said the extra subordination and the reclassification of principal repayments tell the market: "'We're here, we're going to protect our trusts. If we need to create more protections through discount mechanisms or other mechanisms, we're going to do that.' "
Neither Citi nor BofA would comment on their actions. In securities filings, B of A said it was responding in part to rating agency actions and Citi cited their influence.
Myron Glucksman, a structured finance consultant and a former managing director in Citi's corporate and investment bank, said the issuers' actions were "very unusual" and had little precedent, but are "consistent with the times." "These are both key franchises for these banks," he said, and other issuers have a similar interest in protecting their trusts and maintaining the confidence of investors.A decline in excess spread to a certain level typically a negative average number for a three-month period could force a master trust to unwind.
Such an unwinding could shake credit card lenders badly, possibly creating strains on capital and forcing a scramble to fund accounts on the balance sheet and build loan-loss reserves. Analysts called that scenario a remote possibility for the major issuers in part because of the availability of measures like the ones taken by Citi and BofA. In a report published last week, analysts with Barclays' investment bank estimated that the BofA and Citi measures would keep their securitization vehicles from unwinding even if unemployment rose to about 12.5% and chargeoff rates climbed to 14%-15%. Unemployment hit 8.1% in February, while the chargeoff rate in BofA's trust was 9.1% and the excess spread was 4.8%. Citi's trust had a chargeoff rate of 9.3% and an excess spread of 5.5%.
The Barclays analysts also estimated that, with the new support, holders of senior credit card-backed bonds issued by BofA and Citi would be protected from credit losses at a chargeoff rate of more than 30% under some prepayment, yield and other assumptions.
Donald Fandetti, an equity analyst at Citi, called zero excess spreads for credit card issuers "the bear scenario." While it is possible, he said, he does not expect such a situation to unfold. "You'd have to have chargeoffs really spike pretty high and possibly even some dysfunction in Libor again," he said. Many credit card-backed bonds' yields are tied to the London interbank offered rate.
Last fall, at the height of the credit crunch, Libor spiked, squeezing excess spreads. In BofA's trust, excess spread fell so low that it triggered "cash trapping" a mechanism by which cash that would have flowed to the issuer is redirected into a reserve designed to protect bondholders from losses.
BofA's excess spread has since recovered, and the trapping has ceased, but more recently Citi and American Express Co. trusts have hit cash-trapping triggers. "It's going to be another quarter or two, if unemployment continues to go up, we'll probably be talking about cash trapping, and I guess, maybe early am" early amortization, the forced unwinding of the trusts "a little more frequently," Fandetti said. "But it's still pretty early."
Equity investors have continued to focus most of their attention on more conventional performance measures, like chargeoffs and earnings, Fandetti said, and they are not as "focused as much on these ABS issues as I think that they perhaps should be."
In another Barclays report last week, Joseph Astorina, an ABS analyst, wrote that current trading levels "do not fully reflect the extent of collateral deterioration that lies ahead owing to the weakening economy." Nor do current prices reflect the risk of proposed legislation that would expand the power of bankruptcy judges to modify mortgages, he wrote.
Such legislation could trigger an increase in filings, which in turn could increase card losses. In the first round of financing under TALF, announced last week, the largest amount of loans $2.8 billion financed investor purchases of $3 billion of new Citi credit card bonds. Some observers have predicted that credit card lenders, the largest of which are diversified banking companies, would not be major users of Talf because of funding alternatives including deposits and the Federal Deposit Insurance Corp.'s debt guarantee program.
But Glucksman said: "You don't necessarily want to abandon a market that works just because you have other alternatives. No one's going to abandon the market." Daniel Nigro, a portfolio manager for Dynamic Credit Partners, a New York investment management firm that specializes in structured finance, said that though banking companies have many sources of funding, "overdependence on one source gets dangerous as liquidity thins."
Large banking companies have tens of billions of dollars of credit card assets to re-fund each year, so it is important to diversify, he said.
