John N. McElravey, CFA

Director, Structured Debt Research Group Banc One Capital Markets, Inc.

Credit card asset backed securities (ABS) have been issued in the public debt market since 1987. Over the years, they have become the largest and most liquid sector in the ABS market. Average annual new issuance of credit card ABS since 1995 has been about $46 billion, with a peak amount of $58.2 billion in 2001. Because of its liquidity, transparency, and relatively high credit quality issuers, credit card ABS has become something of a safe haven in times of trouble for ABS investors. Indeed, investors making their first foray into ABS generally dip their toes into credit cards before diving in to the many other asset types available.

The size of the credit card ABS sector corresponds with the growth in the credit card market overall as consumers have come to rely on credit cards as a convenient method of payment for an expanding universe of goods and services, and as a means of accessing credit. In this chapter, we summarize the key structural features of credit card securitizations and provide an overview of the credit card ABS market.

SECURITIZATION OF CREDIT CARD RECEIVABLES

The earliest credit card securitizations in the late 1980s were executed as a means of diversifying the funding sources for banks active in the credit card market. In the early 1990s, the banking industry faced the imposition of stricter capital standards by regulators. Securitization provided a vehicle to help meet these new standards by reducing balance sheet assets and thereby improving regulatory capital ratios. Securitization also allowed for specialized credit card banks to enter the market and grow rapidly without having to rely heavily on customer deposit accounts as a funding source. These specialty banks, such as MBNA, First USA, and Capital One, were able to access the credit markets directly and achieve funding costs that were more comparable with established bankcard issuers. Much of the increased competition and innovation in the credit card market seen during the 1990s can be traced to these banks, which could not have grown as rapidly as they did without the benefits afforded by securitization.

Basic Master Trust Structure

The structure used for credit card securitization until 1991 was a standalone trust formed with a dedicated pool of credit card accounts and the receivables generated by those accounts. Each securitization required a new trust and a new pool of collateral. Since 1991, the master trust has become the predominant structure used in the credit card market (see Exhibit 18.1). As the name implies, the credit card issuer establishes a single trust that can accept numerous additions of accounts and receivables and issue additional securities. All of the securities issued by the master trust are supported by the cash flows from all of the receivables contributed to it. The collateral pool is not segregated to support any individual securities.

Step 1: Receivables from designated accounts are transferred to the master trust.

Step 2: Pro rata share of charge-offs and cash flows are allocated to investors.

Step 3: Pro rata share of charge-offs and cash flows are allocated to the seller.

For the credit card issuer, this structure lowers costs and provides greater flexibility because a new trust need not be established using a unique set of accounts each time additional securities are issued. From the investors’ point of view, assessing the credit quality of a new issue requires less effort because there is only one pool of collateral to review. As the collateral pool grows, it becomes more diversified. While the characteristics of the collateral pool can change over time due to changes in interest rates, underwriting criteria, industry competition, and so on, any change in a master trust would be more gradual than would the differences in stand alone pools.

Master Owner Trust Structures

The state of the art in credit card structures has evolved since 2000 to the master note trust or master owner trust (MOT) structure. The most prolific credit card ABS issuers have already adopted, or are in the process of readying, issuance vehicles that make use of the latest technology. The securities issued by the MOT are still backed by a revolving pool of credit card receivables, and the credit analysis required of the underlying collateral pool is not affected. However, there are important structural differences from previously issued credit card ABS using earlier master trust technology.

Most issuers adopting the MOT structure already have existing credit card master trusts, and some banks service more than one outstanding master trust because of the consolidation that has taken place in the credit card industry. Exhibit 18.2 presents an example of a MOT structured for an issuer currently active in the ABS market. The issuer’s existing credit card master trust issues a “collateral certificate,” which is treated like any other series issued by the master trust. The collateral certificate represents an undivided interest in the assets of the master trust, and is allocated its proportionate share of principal collections, finance charges, losses, and servicing fees. For credit card banks with more than one existing credit card master trust, it is conceivable that each one could issue a collateral certificate that could be used to back ABS. The cash flows allocated to the collateral certificate are passed through to the MOT. Securities are issued by the MOT to ABS investors.

Credit card ABS issuers may prefer the MOT structure for several different reasons. First, MOT structures can incorporate flexibility similar to that of a corporate medium-term-note program. For example, different classes of a series can be issued at different times, in varying sizes, and with different maturity profiles. Flexibility of this sort allows the issuer to be opportunistic with regard to the market timing of a new issue, and to tailor securities to a target investor base. This characteristic of the MOT is sometimes referred to as a “de-linked” issuance structure because the AAA securities can be issued separately from the A-rated or BBB-rated securities that provide credit enhancement for the senior notes. Most credit card ABS currently outstanding have been issued as a single series with senior and subordinate classes issued concurrently and having the same maturity. The subordinate classes support only the senior class with which they were issued.

In the MOT structure, all of the subordinate classes outstanding support all of the senior classes outstanding. These are known as “shared enhancement series” (see Exhibit 18.2). Senior securities can only be issued to the extent that there is a sufficient amount of subordinate notes already outstanding. For example, in order to issue Class B securities, there must be a sufficient amount of Class C notes outstanding to support them. A “sufficient amount” is that amount determined by the rating agencies to provide credit enhancement to maintain the desired ratings on the notes.

In turn, to issue Class A securities there must be the appropriate amount of Class B and Class C notes outstanding. The subordinate notes are allowed to have a different maturity date than the Class A notes. If a class of subordinate notes matures prior to the senior class, then a replacement subordinate note must be issued prior to the existing subordinate note’s maturity. To the extent that a replacement note is not issued before paying the maturing note, then principal collections will be deposited into an account that will be used to support the senior notes. Thus, the senior notes will always have the required amount of credit enhancement outstanding. Senior notes benefit from subordination up to and including the required amount. They do not have the benefit of subordinate notes issued in excess of the required amount. Even if de-linked series are issued, other securities issued by MOTs still can be structured to allow for the issuance of credit card ABS in a single series with “linked” subordinate classes that do not provide shared enhancement (classic credit card ABS). Series 2 and Series 3 in Exhibit 18.2 depict such a scenario.

Another reason for the MOT structure is that issuers can expand their potential investor base by structuring securities to be issued as notes rather than as passthrough certificates. By doing this, all classes of a series issued, including the subordinate classes, can achieve ERISA eligibility. This feature is important because pension funds, a significant source of fixed income investor funds, can only buy securities that meet ERISA guidelines. In this way, the total investor base for credit card ABS expands, especially for the subordinate bonds where liquidity has lagged the senior classes. In addition to expanding the investor base, the flexibility in the MOT structure allows for better and more timely execution of reverse-inquiry issuance.

Investor Interest/Seller Interest

Credit card master trusts allocate cash flow between the ABS investors and the credit card issuer. The “investor interest” is simply the principal amount owed to investors in the ABS. The “seller interest” is a residual ownership interest that the credit card issuer is required to maintain. This seller interest aligns the incentives of the seller with that of the investors because it has a pari passu claim on the cash flows. The minimum required seller interest for most master trusts tends to be in the 4% to 7% range of outstanding receivables. The seller interest in a master trust is likely to be higher in practice, in some cases much higher, than the minimum. For example, the average seller interest for trusts included in the Banc One Capital Markets Credit Card Performance Index tend to be in the 20% to 25% range. The actual level of seller interest will be driven by the issuer’s strategy with regard to its use of securitization for its funding needs.

The seller interest absorbs seasonal fluctuations in the amount of outstanding receivables, and is allocated dilutions from returned merchandise and ineligible receivables. The seller interest does not provide credit enhancement for the ABS. Credit enhancement for the ABS, discussed more fully later, is provided by subordinated securities, which are part of the investor interest, or by other means provided for in the structure of the series.

As an issuer’s credit card business grows, accounts that meet the eligibility criteria can be added to a master trust. An account addition normally requires rating agency approval unless it is a relatively small percentage of the current balance (usually 10% to 15%). Sellers are obligated to add accounts if the seller interest falls below its required minimum level. If the seller is unable to add accounts to the trust, then an early amortization event is triggered and investors begin receiving principal payments immediately. The risk of an early amortization gives the seller a powerful incentive to keep the seller interest above the minimum level.

The Credit Card ABS Life Cycle

Under normal circumstances, the life cycle of credit card ABS is divided into two periods: the revolving period and the amortization period. We discuss each period below.

Revolving Period

During the revolving period, investors receive interest payments only. Principal collections on the receivables are used to purchase new receivables or to purchase a portion of the seller interest if there are not enough new receivables generated by the designated accounts. The revolving period is used by an issuer to finance short-term credit card loans over a longer time period. The revolving period is used to maintain a stable average life and to create more certainty for the expected maturity date.

Amortization Period

After the end of the revolving period, the amortization period begins and principal collections are used to repay ABS investors. The amortization period may be longer or shorter depending on the monthly payment rate of the accounts in the master trust. The payment rate is the percentage of the outstanding receivables balance paid each month. Trusts with lower monthly payment rates will require longer amortization periods. For example, credit card ABS with a 5-year expected maturity might revolve for 48 months, and then enter amortization for the final 12 months of its life. This part of the credit card ABS life cycle is usually accomplished through one of two mechanisms: controlled amortization or controlled accumulation.

In a controlled amortization, principal is paid to the ABS investors in equal payments (see Exhibit 18.3). The example assumes one series issued out of the master trust with two classes, a Class A senior certificate and a Class B subordinated certificate. During the 4-year revolving period, investors receive only interest payments. Principal collections are used to purchase new receivables. The total amount of receivables varies over time, and these fluctuations are absorbed by the seller interest. At the beginning of year five, the revolving period ends and a controlled amortization begins. Investors receive principal payments in 12 equal installments. Principal collections not needed to repay ABS investors are used to purchase new receivables. Interest payments continue based on the declining principal balance of the ABS. The Class B amount remains fixed during Class A amortization, and the seller interest grows proportionately until the ABS investors are repaid.

In a controlled accumulation, principal collections needed to repay ABS investors are deposited into a trust account each month and held until maturity after the end of the revolving period (see Exhibit 18.4). This example again assumes a simple senior/subordinated structure and a 4-year revolving period. After the end of the revolving period, principal collections are trapped in an account in 12 equal installments to be used to repay the Class A investors. Excess principal collections are used to purchase new receivables. Interest payments to investors during the accumulation period are made based on the original outstanding invested amount. A single “bullet” payment of principal is made at maturity to the ABS investors. This structural device developed as a way to emulate the cash flow characteristics of a corporate bond.

Early Amortization

Under certain circumstances, such as poor credit performance or a financially troubled servicer, an early amortization of the ABS could occur. Trigger events are put in place to reduce the length of time that investors would be exposed to a troubled transaction. Exhibit 18.5 lists common early amortization trigger events found in credit card master trusts. If an early amortization trigger is hit, then a transaction that is in its revolving period stops revolving and immediately begins to pass principal collections through to the ABS investors. One structural enhancement available to protect investors allows for principal to be passed through on an uncontrolled, or rapid amortization, basis. This mechanism diverts principal due to the seller toward payment of the ABS in order to get investors repaid more quickly.

Cash Flow Allocations

Credit card master trusts may have a large number of series outstanding at any one time. As a result, the allocation of cash flows can become complex. This section discusses the key elements of master trust cash flows.

Groups

A credit card master trust may utilize the concept of a “group,” which is a structural device used to help allocate cash flow. Within the hierarchy of the master trust, one or more groups may be established, and each series of securities issued to investors will be assigned to a group. At its highest level, the master trust allocates cash on a pro rata basis between the investor interest and seller interest. The investor interest is subdivided further on a pro rata basis at the group level. While many trusts have only one group that encompasses all of the series issued, other trusts may have two or more. In trusts with more than one group, series with similar characteristics could be grouped together. For example, a master trust with two groups could place all of the fixed-rate coupon series in one group and all of the floating-rate coupon series in a second group. The sharing of excess principal or finance charge collections, if called for in the master trust structure, will be determined at the group level.

Finance Charge Allocations

The components of the finance charge collected by a master trust include the monthly interest on the account balance, annual or late fees, recoveries on charged-off receivables, interchange,¹ and discounted receivables.² When expressed as a percentage of the trust’s receivables balance, finance charges are called the portfolio yield.

Finance charge collections are allocated by most master trusts pro rata based on the outstanding invested amount of each series. This “floating” allocation adjusts as a series amortizes or accumulates principal collections in a principal funding account. Excess finance charge collections may or may not be shared by series in the same group depending on the structure of the master trust. Some master trusts, such as Discover Card Master Trust, utilize a “fixed” allocation of finance charges. In this structure, the proportion to be allocated to a particular series is fixed at the end of the revolving period and is based on the original principal balance of the series. This structure allows for a greater relative proportion of finance charge collections to go to amortizing series. In an early amortization, a portion of the seller’s finance charges can be reallocated to investors to cover any potential shortfall when the portfolio is under stress.

Master trusts that allocate finance charges pro rata based on the size of the series invested amount are known as “nonsocialized” master trusts. Finance charges are available to each series to cover its allocated charge-offs, servicing fees, and to pay the coupon to the ABS investors each month. Some nonsocialized master trusts do not share excess finance charges. In other nonsocialized trusts, once all of the expenses are covered, the series included in the same group may share excess finance charges. If excess finance charges are shared by the series in a group, then they are distributed to the other series based on need. Any excess finance charges left over are considered excess spread.

The advantage of a nonsocialized master trust is that the risk of early amortization can be isolated at the series level. The disadvantage is that high coupon series are at a relatively greater risk of early amortization if there is a shortfall in finance charge collections. The sharing of excess finance charges helps mitigate, but does not eliminate, this risk. Most master trusts, such as the Sears Credit Card Master Trust II, are structured as nonsocialized trusts that allow for sharing excess finance charges.

An alternative structure, used by a small number of credit card ABS issuers, is a “socialized” master trust. In such a structure, finance charges are allocated to series within a group based on need. Need is determined by the costs of each series—the coupon, servicing fees, and allocated charge-offs. Charge-offs are allocated to a series pro rata based on its size within the group. The expenses for the group are the weighted average of the expenses for each series. Series with higher coupon costs will receive a larger allocation of finance charge collections. The advantage of socialization is that finance charge collections are combined to help support higher cost series, and thus help avoid an early amortization. However, the fates of all series are linked. All series in a group will make payments as expected, or they will all enter early amortization together. Citibank Credit Card Master Trust I and Household Affinity Master Trust I are two examples of socialized master trusts.

Principal Collections

Principal collections are allocated on a pro rata basis to each series in the same group based on the size of its invested amount. The allocation of principal to each series is determined by where it is in the ABS life cycle. Series that are in their revolving period receive no principal collections. Their principal collections can be reallocated, and may be shared with other series that are amortizing. Sharing principal collections is a structural enhancement that helps to ensure the timely payment of principal to ABS investors. Principal that is not needed to repay investors is reinvested in new receivables.

For a series in its amortization or accumulation period, principal collections allocated to it will be used to repay investors. The allocation of principal is determined by the size of the invested amount of the series at the end of its revolving period. Even though the certificates are amortizing, the allocation percentage to the series will be fixed based on its original invested amount. If the credit card ABS accumulate principal or amortize over 12 months, then 1/12 of the principal amount of that series will be paid to it. Principal collections in excess of what is necessary for amortization, depending on the structure of the trust, may be shared with other series in the same group as needed to meet their amortization schedules. Otherwise, excess principal is used to purchase additional receivables.

Credit Enhancement

In order to establish an investment grade rating on credit card ABS, credit enhancement is necessary to absorb losses. The amount of credit enhancement needed will vary from one master trust to another based on the desired rating level and the credit performance of an issuer’s credit card portfolio. Early credit card transactions carried letters-of-credit from commercial banks as credit enhancement. However, downgrades of a number of credit enhancers exposed ABS investors to downgrades on their investments. While some issuers still rely on surety bonds, internal forms of credit enhancement have become the norm.

Excess Spread

Excess spread is perhaps the most important measure of the health of a credit card master trust, is a key early amortization trigger, and is the first line of defense against losses. Excess spread is simply the cash flow left over each month after the investor coupon, servicing fees, and charge-offs have been allocated to each series. The calculation of excess spread is fairly straightforward, as shown in Exhibit 18.6, with the values expressed as an annualized percentage of the outstanding receivables balance. If the 3-month moving average of excess spread for a particular series in a non-socialized master trust falls below zero, then an early amortization event with regard to that series has occurred. In socialized master trusts, the excess spread for all series in the same group will be equal because they share finance charge collections based on the weighted-average cost of the group. An early amortization trigger based on a decline in excess spread will, therefore, affect all series in the group.

Cash Collateral Account

A cash collateral account (CCA) is a cash reserve account funded at closing and held by the trust. The cash to fund the CCA is usually lent by a third party and invested in high-grade, short-term securities. The CCA is used to protect against shortfalls in cash flow due to rising charge-offs, and any draws on it are reimbursed from future excess spread.

Collateral Invested Amount

An alternative to a cash reserve is a collateral invested amount (CIA), which is a privately placed subordinated tranche of a series. The CIA is placed with a third-party investor, and the investor may or may not require a rating on the CIA. The CIA is an improvement for the issuer over the CCA because this tranche is backed by collateral from the master trust rather than cash. Like the CCA, the CIA is available to protect against shortfalls in cash flow due to declining excess spread. The CIA tranche has the benefit of a spread account, which is not available as credit enhancement to other investors. Draws on the CIA also are reimbursed through excess spread.

Subordination

As credit card ABS have evolved, structures have become more complex. Letters-of-credit have given way to CCAs or CIAs, which in turn have been replaced with rated subordinated securities. The subordinated classes also are placed with public ABS investors and tend to be rated in the single-A or triple-B categories. A typical structure might include AAA-rated Class A senior certificates, a single-A rated Class B subordinated tranche, and a Class C tranche issued to investors rated at triple-B level (see Exhibit 18.7). The Class C tranche is credit enhanced by a spread account that can trap additional cash out of excess spread if certain credit performance triggers are tripped. Using subordinated tranches allows the issuer to monetize a larger portion of its collateral portfolio, and allows it to reach a wider investor audience. As noted above, the development of the master owner trust is the latest step toward a liquid, ERISA-eligible, subordinated credit card ABS market sector.

Rating Agency Considerations

Rating agency criteria have evolved over time as new structures, such as rated C-pieces or the master owner trust, have been introduced. In general, the rating criteria from the agencies are not substantially different for the MOT structure than it was for the classic credit card master trusts. Stressing the historical performance of critical variables related to the cash flows tests the structural integrity of credit card ABS. The rating agencies generally require three to five years of historical data, and will examine vintage data in order to estimate loss curves and the ultimate level of charge-offs. Once baseline performance is determined, then different cash flow stresses are used depending on the desired rating. The key quantitative variables for analyzing credit card securitizations include portfolio yield, charge-offs, monthly payment rate, monthly purchase rate, and the investor coupon.³ Each is discussed below.

• Portfolio yield, as noted above, is a measure of the income generated by the credit card receivables. While portfolio yield is driven largely by the APR on accounts and fees, usage by account holders also plays an important role. All else being equal, a portfolio with proportionately more revolving accounts relative to convenience users will translate into a higher portfolio yield.
• Charge-offs are the credit losses experienced by the portfolio, and are taken by most issuers at 180 days past due. Peak losses on a static pool basis for credit card accounts have been observed at about 24 months of seasoning.
• The monthly payment rate is an important variable in the analysis because high payment rates can be a source of strength and implied credit enhancement. A large proportion of convenience users, while depressing portfolio yield, can sharply increase payment rates. A higher payment rate means that investors can be repaid more quickly during an early amortization.
• Related to the payment rate is the purchase rate, which is the generation of new receivables by the designated accounts. Higher purchase rates mean more receivables are being generated to support outstanding ABS. Bankruptcy of the seller of the receivables, such as a department store chain, is the main risk with regard to the purchase rate because cardholders may stop using the card. As the amount of receivables declines, the credit quality of the portfolio may deteriorate.
• Floating-rate ABS generally require more credit enhancement than fixed-rate transactions because the rating agencies assume in their stress scenarios that market interest rates increase dramatically. Higher funding costs for the ABS reduce the available excess spread.

The stress tests run by the rating agencies force portfolio yields, payment rates, and purchase rates down sharply at the same time that charge-offs rise. This combination compresses excess spread and causes an early amortization of the transaction. Exhibit 18.8 shows generic stress scenarios for credit card ABS transactions for Standard & Poor’s. The rating agencies may deviate from these benchmark levels depending on the qualitative factors of a seller’s business. Some of the key qualitative elements that go into the rating analysis are new account underwriting, servicing and collections, marketing, card type (private label versus general purpose), geographic diversification, strategic objectives of the firm, account seasoning, and the competitive position of issuer. These qualitative factors, among others, determine how the generic stress factors will be modified and applied to an individual issuer’s credit card portfolio.

¹ Based on proposed legislative caps.

² Coupon for uncapped floaters.

THE CREDIT CARD ABS MARKET

Credit card ABS is the largest and most liquid part of the ABS market. In 2001, total new public issuance of credit card ABS reached $58.2 billion, and we expect issuance to remain at high levels in the near future. In addition, there are about $270 billion of credit card ABS outstanding. The large number of issuers and dollar amount outstanding makes this sector particularly active for secondary trading. Consequently, pricing spreads for credit card ABS tend to be used as a benchmark for comparison to other ABS sectors.

During the past decade, the credit card industry has experienced rapid growth and increasing competition. That dynamic culminated in sharp increases in outstanding receivables in 1995 and 1996, and was reflected in the amount of new credit card ABS issued during that period. However, rapid growth and intense competition also led to problems with asset quality (see Exhibit 18.9). Charge-offs rose steadily and excess spreads dropped from the middle of 1995 through the middle of 1997 as consumer bankruptcy rates reached record levels. It has been generally acknowledged that competition for new accounts, the use of introductory “teaser rates,” and weaker underwriting led to many of the credit problems seen in the credit card sector.

Credit performance stabilized in the late 1990s as credit card companies re-examined their marketing strategies and underwriting procedures. Charge-off rates slowly fell back to about 5% by the summer of 2000, but excess spreads remained relatively high as banks instituted more thorough risk-based pricing of customer accounts (see Exhibit 18.9). As the economy slowed and the recession took hold, charge-off rates began to climb again, and peaked at about 6% by year-end 2001. Nevertheless, excess spreads have increased sharply due to dramatically lower interest rates. The majority of ABS are issued as floating-rate notes. As LIBOR rates fell, funding costs dropped, and margins on credit card master trusts soared to record levels.

Industry Consolidation

To better meet their credit underwriting and customer service needs, stronger credit card companies invested heavily in technology, and increased their scale of operations to spread the costs of that investment over more accounts. Many smaller or weaker firms have been unable or unwilling to meet the challenge of the new competitive environment, and have decided to exit the business. As a result, consolidation has been one of the key themes in the credit card business for the past few years. To illustrate, at the start of 1987 there were slightly more than $80 billion of credit card receivables outstanding in the United States, and the top ten credit card companies had a combined market share of about 40%. By the end of 2000, there were about $700 billion of outstanding credit card receivables, and the top ten credit card companies had a combined market share of 68% (see Exhibit 18.10).

As the credit card industry has consolidated, so has the market for credit card ABS. The three largest credit card issuers accounted for about 45% of credit card ABS outstanding as of year-end 2001, and the top five were responsible for approximately 63%. While consolidation has reduced the number of issuers in the market, the overall credit quality of those that remain has improved. Seven of the top ten sponsors have corporate debt ratings of A2/A or better. From the standpoint of liquidity and issuer quality, this sector is the strongest in the ABS market.

Credit Card Market Segments

The major issuers of credit card ABS fall into four major categories: commercial banks, consumer finance companies, independent networks, and retailers. Some examples of the issuers in each of these categories follow:

General Purpose Cards

The credit card ABS market is divided into two major segments: general-purpose cards and private label cards. The larger of these two segments includes transactions sponsored by issuers of general-purpose credit cards. General-purpose credit cards include both Visa and MasterCard cards issued by commercial banks and consumer finance companies, as well as the independent networks of merchants built by Discover Card and American Express. This group of issuers represents the vast majority of the credit card ABS market. Issuers of general-purpose cards tend to price new ABS at tighter spreads relative to private label issuers. Tiering in that market favors the largest, most frequent issuers with stable credit performance. Nevertheless, most issuers price new credit card ABS transactions within a very tight range of only a few basis points. At this point in time, Citibank and MBNA are generally considered to be the benchmark issuers in this market segment.

Teaser Rate Cards

In an attempt to gain market share in the face of fierce competition, credit card issuers devised a number of innovations to establish brand loyalty with new customers. Low-price cards, with no annual fee and up-front “teaser” rates, have been used to lure customers away from competitors. These accounts often allow the new customer to transfer existing balances from other, higher interest rate cards. The teaser rate usually is in effect for 6 to 12 months, and then steps up to a higher rate based on the borrower’s credit risk. Balance transfers have been used to great effect by card issuers, though many borrowers have become adept at rolling balances from one card to another at the end of the teaser rate period. One of the problems with this approach is the potential for adverse selection in the account base. Borrowers with poor credit are more likely to respond to a teaser rate, and may be less likely to roll balances to a new card in the future because they have less credit options. Most credit card banks have moved away from the blanket marketing of teaser rate accounts to concentrate on other ways to establish brand loyalty among cardholders.

Affinity and Co-Branded Programs

One of the uses of the technological investment made by credit card issuers has been in the customer retention effort. A package of interest rates, credit limits, and other services can be offered to entice customers to stay once the teaser period ends. These packages may come in thousands of possible combinations, and are offered based on the credit profile and card usage patterns of the cardholder. The method of “mass customization” is made possible by the sophisticated computer systems that search for new customers in huge databases, and track the credit performance and profitability of existing customers. One of the most successful issuers practicing a mass customization strategy is Capital One.

Two popular products created by issuers to differentiate themselves in the minds of cardholders and retain them as customers are affinity and co-branded programs. Affinity cards are issued by a bank in association with a special interest group, such as a college alumni association, professional group, or sports team. The group receives a fee from the bank, and the bank uses its affinity program to attract a certain demographic group to use its card. Co-branded cards are programs that associate a bank’s credit card with a particular commercial firm. Customers can earn certain rewards from the commercial firm for making purchases with the card, such as mileage awards toward free tickets on airlines, which is probably the most popular of the bank co-brand programs.

Private Label Credit Cards

The other, much smaller segment of the credit card market includes private label credit cards, which are sponsored by retailers for use in their own stores. This segment has been dominated by issuance from Sears, which represents about one-third of the private label market. Retail credit card accounts are most often viewed by the sponsor as a means to increase sales, and credit underwriting may not be as stringent as it is for general-purpose credit cards. As a result, charge-offs tend to be higher on private label credit card master trusts than they are for general-purpose card master trusts. On the other hand, APRs and portfolio yields do tend to be higher to compensate for the greater risk in the private label portfolio. Private label credit card ABS transactions tend to be less frequent and somewhat smaller, and as result they tend to price at a concession to ABS transactions sponsored by general-purpose card issuers. Nevertheless, good value can be found among private label issuers by investors willing to investigate them.

CONCLUSION

The credit card ABS market currently is the largest and most liquid asset-backed sector. For this reason, it is viewed by many as a safe haven for ABS investors in stressful market times. Indeed, spreads on credit card ABS are usually the first to recover from market dislocations. Over the past several years, a growing economy, healthy consumer balance sheets, and greater acceptance of credit cards for non-traditional uses led to a sharp increase in outstanding receivables. Meanwhile, the market weathered a deteriorating credit situation from 1995 through 1997. Nevertheless, a growing need for technology and intense competition led to consolidation in the industry, though competition still appears to be quite strong. Increasing issuance in the European market should produce a more global credit card ABS market in coming years, and additional innovations are sure to follow. Given the commitment most credit card issuers have made to the ABS market, it seems likely that the credit card ABS market should continue to be a benchmark sector for the foreseeable future.