Your SlideShare is downloading. ×
Structured Finance



Credit Card
Criteria
STANDARD & POOR’S RATINGS SERVICES
President Leo C. O’Neill
Executive Vice Presidents
Hendrik J. Kranenburg, Robert E. Mai...
Contents
Collateral Analysis And The Rating Process
For Credit Card Receivables . . . . . . . . . . . . . . . . . . . . . ...
Cash Flow and Structural Analysis For
    Credit Card Receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . ....
Collateral Analysis And
The Rating Process For
Credit Card Receivables

T
         his section describes the stages of the...
that affect transaction credit risk and examines a broad array of issues related to the
    originator’s operations.
     ...
Collateral Analysis And The Rating Process For Credit Card Receivables




distribution date. The information required inc...
and series ratios (see boxes for surveillance variables and ratios requirements).
    Monthly statistics are published by ...
Collateral Analysis And The Rating Process For Credit Card Receivables




now extend “prequalified” solicitations or “inv...
Issuers use credit scores in assessing a borrower’s risk of default. Cutoff points
    for acceptance can change depending...
Collateral Analysis And The Rating Process For Credit Card Receivables




dialing systems that queue delinquent accounts ...
vintage data is considered an important segmentation and is most often requested
     since it allows analysts to examine ...
Collateral Analysis And The Rating Process For Credit Card Receivables




spread in the trust. The payment rate assumptio...
oldest balances, this allocation method is more advantageous than a pro rata
     distribution.
       The purchase rates ...
Collateral Analysis And The Rating Process For Credit Card Receivables




  Competition naturally exerts downward pressur...
Certificate Rate
     The modeled certificate rate for ‘AAA’ ratings equals the actual rate for fixed-rate
     transactio...
Collateral Analysis And The Rating Process For Credit Card Receivables




Assessing The Value Of Servicer Interchange
Int...
typically promises to remit a pro rata share of interchange directly to the trust. At
     the trust level, such supplemen...
Collateral Analysis And The Rating Process For Credit Card Receivables




one of the assumptions used to support the redu...
‘BBB’ Ratings Criteria For
Credit Card Collateral
Invested Amounts

T
         his section describes the criteria underlyi...
Market Evolution
     The earlier credit card deals incorporated letters of credit (LOCs) from highly rated
     instituti...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




collateral account, if any. In contrast, the enhanc...
associated with account seasoning. Additionally, several issuers have increased
     excess spread by managing the composi...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




‘BBB’ Ratings Reflect Seller-Specific Consideration...
Table 2
                     General Guidelines for BBB Cash Flow Stress Test Scenarios
     Key Modeling            Combi...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




Three ‘BBB’ Stress Test Scenarios
When analyzing a ...
Table 3
                  3 Month Rolling Average Loss Returns per 18 Month Rolling Period
                               ...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




(a 50% increase or a 1.5x multiple). The issuer’s l...
In the past, legislative proposals have been introduced to cap the amount of interest
     a card issuer could charge. How...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




  In examining the three-month LIBOR rate and the F...
that show minimal error when compared to actual rate paths. The assumptions used
     in CIA credit card modeling are a su...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




to a series over a shorter period of time and, all ...
CIA Owner Trust Structure
     Each CIA structure is slightly different. Some CIA ratings require initial deposits in
    ...
‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts




   However, in transactions where a rating is reque...
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Credit Card Criteria
Upcoming SlideShare
Loading in...5
×

Credit Card Criteria

835

Published on

0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total Views
835
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
22
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Transcript of "Credit Card Criteria"

  1. 1. Structured Finance Credit Card Criteria
  2. 2. STANDARD & POOR’S RATINGS SERVICES President Leo C. O’Neill Executive Vice Presidents Hendrik J. Kranenburg, Robert E. Maitner Executive Managing Directors Edward Z. Emmer, Corporate Ratings Clifford M. Griep, Financial Institutions Ratings Vladimir Stadnyk, Public Finance Ratings Roy N. Taub, Insurance Ratings Vickie A. Tillman, Structured Finance Ratings Sanford B. Bragg, Managing Director, Managed Funds Ratings Joanne W. Rose, Senior Managing Director, General Counsel RATINGS INFORMATION SERVICES Managing Director Jay S. Kilberg Vice Presidents Andrew Cursio, Product Management Robert Frump, Production & Electronic Distribution Paul Stanwick, Editorial David A. Collins, Director, Asia-Pacific Guy Hewitt, Director, Europe Susanne Barkan, Product Manager Sara Burris, Director, Design, Production, & Manufacturing Jean-Claude Bouis, Editor, Franchise Products Donald Shoultz, Editor, Policy & Operations Editorial Jennifer O’Brien, Managing Editor Ned Geeslin, Audrey Kennan, Suzanne Lorge, Donald Marleau (Tokyo), Cynthia Michelsen, Miriam Stickler, Lisa Tibbitts (Editorial Managers), Arlene Cullen (Melbourne) (Copy Editor) Design & Production Sandy Fong, Renee L. Mofrad, Beth Russo (Senior Managers), Elizabeth McCormack, Steve McLure (Senior Designers), Rosalia Bonanni, Theresa Moreno, Heidi Weinberg (Designers), Maura Gibbons (Junior Designer), John J. Hughes, Alicia E. Jones, Barry Ritz, Leonid Vilgorin (Managers), Dianne Henriques, Stephen Williams (Production Coordinators), Christopher Givler, Stan Kulp, Michelle McFarquhar (Senior Production Assistants) Subscription Information Hong Kong, (852) 2533-3535 London, (44) 171-826-3510 Melbourne, (61) 3-9631-2000 New York, (1) 212-208-8830 Tokyo, (81) 3-3593-8700 Subscriber Services New York (1) 212-208-1146 Web Site www.standardandpoors.com/ratings Published by Standard & Poor’s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, New York, N.Y. 10020. Editorial offices: 25 Broadway, New York, N.Y. 10004. Copyright 1999 by The McGraw-Hill Companies, Inc. All rights reserved. Officers of The McGraw-Hill Companies, Inc.: Joseph L. Dionne, Chairman; Harold W. McGraw, III, President and Chief Executive Officer; Kenneth M. Vittor, Senior Vice President and General Counsel; Frank Penglase, Senior Vice President, Treasury Operations. Information has been obtained by Standard & Poor’s from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, Standard & Poor’s, or others, Standard & Poor’s does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.
  3. 3. Contents Collateral Analysis And The Rating Process For Credit Card Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Review Of The Originator’s Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Legal, Collateral, And Structural Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Rating Committees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Rating Surveillance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Collateral Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Modeling Assumptions For Interchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 ‘BBB’ Ratings Criteria For Credit Card CIAs . . . . . . . . . . . 19 Collateral Invested Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Market Evolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Structural Credit Enhancement And Excess Spread . . . . . . . . . . . . . . . . . . . . 20 ‘BBB’ Ratings Reflect Seller-Specific Considerations. . . . . . . . . . . . . . . . . . . . 23 Three ‘BBB’ Stress Test Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Charge-offs/Loss-Spike Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Portfolio Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Certificate Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Interest Rate Assumptions And Spikes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Payment Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Purchase Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 CIA Owner Trust Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Legal Issues Related To Rating CIAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables . . . . . . . . . . . . . . . . 35 Structural Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 The Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Types Of Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Standard & Poor’s Structured Finance I Credit Card Criteria 1
  4. 4. Cash Flow and Structural Analysis For Credit Card Receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Cash Flow Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Subordination Of Interest Paid To The Collateral Interest Holder . . . . . . . . . 57 Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Series Termination And The Credit Rating . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Legal Considerations For Credit Card Receivables. . . . . . 65 General Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Bankruptcy-Remote Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Transfers, Ownership, And Security Interest . . . . . . . . . . . . . . . . . . . . . . . . . 68 Credit Enhancement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Selected Specific Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Pass-Through Certificates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Master Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Special Considerations For Private-Label Accounts For Credit Card Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Collateral Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Special Considerations For Unsecured Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Market Conditions Encourage Unsecured Lending . . . . . . . . . . . . . . . . . . . . 81 A Hybrid Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Three Categories Of Unsecured Consumer Lending . . . . . . . . . . . . . . . . . . . . 83 Unsecured Consumer Lending Versus Credit Card Lending . . . . . . . . . . . . . . 84 Characteristics Of Unsecured Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . 84 Analyzing Unsecured Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 2
  5. 5. Collateral Analysis And The Rating Process For Credit Card Receivables T his section describes the stages of the Standard & Poor’s rating process and focuses on the analysis of the credit card collateral being securitized. The collateral analysis includes examination of the originator’s operations and strategy and the analysis of the historical performance of the credit card portfolio. The section then discusses the stresses applied to each performance variable and the effect of each variable on the required credit enhancement for the transaction. Review Of The Originator’s Operations One of the most important aspects of any credit risk assessment is the review of the originator’s operations. In this review, emphasis is placed on the originator’s marketing, underwriting, and servicing operations. A rating is based on the representations of the parties to the transaction, but the scope of the review does not include an audit. A traditional Standard & Poor’s rating addresses the likelihood of full and timely payment of interest and principal to certificateholders. Therefore, it addresses the likelihood of the first dollar of default. Legal, Collateral, And Structural Analysis Standard & Poor’s analysis focuses primarily on the legal, collateral, and structural characteristics of the transaction. The legal criteria for structured finance ratings, which were developed for MBS, have evolved to cover other asset types in the ABS market. The fundamental tenet of the criteria is to isolate the assets from the credit risk of the seller. The collateral analysis involves an in-depth review of historical asset performance. Standard & Poor’s collects and analyzes years of data on the performance variables Standard & Poor’s Structured Finance I Credit Card Criteria 3
  6. 6. that affect transaction credit risk and examines a broad array of issues related to the originator’s operations. The structural review involves an examination of the disclosure and contractually binding documents for the transaction. These criteria cover many aspects of the structure, from the method of conveyance of receivables to the trust to the method of series termination. Rating Committees A team of analysts is assigned to each transaction. After the team of analysts has performed its review of the issuer’s operations and analyzed the collateral, a committee of analysts is assembled to determine whether the transaction has sufficient enhance- ment for the desired rating. The team leader is responsible for ensuring that all perti- nent information is presented to the rating committee. The committee presentation includes information gathered in the review process and information on the legal and structural characteristics of the transaction. The prospectus for publicly rated transactions is prepared by the issuer’s counsel before a transaction is priced. However, Standard & Poor’s relies on the binding agreements to determine whether the structure will provide timely payments. The most important of these agreements is the pooling and servicing agreement and its supplement. The supplement is usually drafted by the time a transaction is priced. Analysts ordinarily present the structure of a transaction to a rating committee after a transaction is priced, but in any event, as soon as practicable after the team receives a draft of the supplement. Once the rating committee process is completed, a rating letter is issued. Rating Surveillance After a rating is disseminated, it will be maintained by the asset-backed surveillance group, which works in conjunction with the Structured Finance Ratings Asset-Backed Group. The purpose of surveillance is to ensure that the rating continues to reflect the performance and structure of the transaction. The surveillance team is responsible for monitoring issue performance and identifying those issues that should be considered for either an upgrade or a downgrade. The goal of the surveillance group is to identify emerging risks in rated transactions. To that end, the asset-backed services surveillance group monitors and evaluates monthly changes in performance. Data is collected and analyzed from the individual master trusts and their component series on a monthly basis. To be able to analyze trust performance effectively, the asset-backed surveillance area requires that servicers send pertinent information no later than the monthly 4
  7. 7. Collateral Analysis And The Rating Process For Credit Card Receivables distribution date. The information required includes absolute numbers on the total trust portfolio. This data enables the surveillance group to measure any collateral erosion and determine trust income and expenses, as well as calculate relevant trust Surveillance Variables Eligible principal outstandings: Principal eligible Delinquencies: Past due amounts not yet charged credit card receivables in trust pool net of finance off and segmented by month correlated with the charges, and other fees ineligibles, and so on, as various aging criteria prior to charge off. of the end of reporting period, which is used as Total income and its components: Income the analytical basis to determine minimum flowing into the trust (excluding recoveries), collateral required. specifically including cardholder interest payments Total gross principal outstandings: Net eligible and fees, interchange, discounted receivables principal outstandings plus other receivables such discounts, and other miscellaneous income. as finance charges, and fee interchange, and Principal collections: Cardholder aggregated other fees. principal payments collected from cardholders Prefunding account balance: Amount of cash on during reporting period to repay debt due. deposit in prefunding account available to purchase Purchases: New receivables generated during new receivables. the reporting period resulting from cardholder Gross losses: Losses on principal receivables. purchases and cash advances. Erosion of collateral recognized during the report- Credit support balance and changes: Period ing period resulting from delinquency criteria, end balance of each credit support class or bankruptcies, and so on, as specified in the account used to meet trust covenants and any trust documents. uses or repayments during the period. Recoveries: Income on receivables that were Outstanding invested amount: Balance of each charged off during any period, if applicable to rated and unrated investor certificate (including the trust structure. collateral interest amount). Net losses: Gross losses minus recoveries. Surveillance Ratios Seller’s interest: Principal eligible receivables Base rate: The addition of the certificate and minus total invested amount divided by principal servicing fee rates. receivables. Total payment rate: Total monthly collections Yield: Total trust income divided by total out- (obligor principal and finance charge payments) standing receivables; annualized. divided by the previous month’s total outstandings. Gross and net loss rate: Losses on principal Principal payment rate: Principal monthly col- receivables divided by principal outstandings; lections divided by the previous month’s eligible annualized. Net loss rate includes recoveries. principal outstandings. Certificate rate: Certificate interest paid to Delinquency rates: Past due amounts divided investors divided by outstanding invested amount; by principal outstandings, segmented by month; annualized. annualized. Servicing fee rate: Servicing fees paid from Purchase rate: Monthly purchases divided by trust divided by outstanding invested amount. the previous month’s eligible principal outstandings. Standard & Poor’s Structured Finance I Credit Card Criteria 5
  8. 8. and series ratios (see boxes for surveillance variables and ratios requirements). Monthly statistics are published by Standard & Poor’s in its Credit Card Quality Indexes so that industry participants can use the information as a way to track credit card performance trends. Performance information is disclosed in a report that is prepared monthly by the servicer of the transaction. Before a transaction’s closing date, the data that will be itemized in the servicing report is reviewed to ensure that all necessary information is included. The surveillance team also tracks the credit quality of all entities that support a rated security, such as credit or liquidity enhancers. Analysts review performance data monthly and contact the issuer if performance deviates beyond a reasonable band. If a committee vote results in a rating change, the issuer and trustee will be notified. For public ratings, a press release is normally disseminated. Collateral Analysis Review Of The Originator’s Operations An on-site review of an originator’s operations and management is one aspect of the rating process. The purpose of the review is to develop an issuer-specific profile in the areas of marketing, underwriting, servicing, and collections, and to assess other risk factors such as geographic concentrations and economic conditions. The review pro- vides analysts an opportunity to discuss with senior management competitive pres- sures, franchise value, strategic objectives, underwriting, account management poli- cies, and servicing and collections procedures. The diversity of marketing and under- writing practices among issuers may result in significant differences in performance. The review also enables analysts to evaluate the corporation’s organizational and technological infrastructure, and the quality of its resources, which are critical to effective servicing and collection of trust receivables. Marketing In the securitization process, the issuer retains the risk of maintaining its cardholder borrowing base. The scope and quality of an issuer’s marketing strategy are important determinants in an issuer’s ability to generate enough new receivables to support a securitization program and to effectively manage the performance of the receivables. Issuers market their credit card products through various distribution channels, including branch networks, “take-ones” at public locations, advertisements in maga- zines, toll-free telephone numbers, and direct mail solicitations. Traditionally, most direct mail offers were “preapproved,” offering lines of credit “up to” specified amounts. However, due to changes in the Fair Credit Reporting Act (FCRA), issuers 6
  9. 9. Collateral Analysis And The Rating Process For Credit Card Receivables now extend “prequalified” solicitations or “invitations to apply.” The net result is a benefit to issuers, which now have greater leverage to decline responders who no longer qualify. Issuers employ a broad range of marketing strategies. For example, many issuers focus on offering accounts to cardholders who are likely to revolve their balances because, if credit risk is kept in check, a portfolio of revolving cards is highly profitable compared with a portfolio of convenience users. There are many ways to attract revolvers. Many lenders use segmentation techniques that help identify cardholders who will be attracted to a specific offer and run small sample offers to test response rates, profitability, and performance. If successful, they roll out a full-scale direct mail program that targets cardholders with profiles that are similar to those of the test sample. Others may focus on price leadership and offer low “teaser” rates to entice cardholders to transfer balances. Responders with pristine credit profiles may receive permanently low rates. Each of these marketing strategies affects performance differently. In their review, analysts assess an issuer’s ability to identify, compete for, price, and maintain high-quality accounts. Underwriting Standard & Poor’s assesses the quality with which a particular underwriting methodol- ogy is developed, implemented, and practiced. Once a potential cardholder or group of cardholders has been identified, the issuer must determine which type of credit offer to extend. Issuers that extend similar credit offers (for example, APR and credit line amounts) to populations with vastly different credit and behavior profiles are called “mass marketers.” Until recently, mass-marketed offers were the predominant credit offer in the marketplace. Mass-market issuers maintain the spread between revenues and losses by subsidizing bad credits with good credits in their portfolio. In response to increased competition, some issuers turned to a more “targeted” approach, which involves segmenting their cardholder base and offering a range of products tailored to the risks and needs of particular groups of customers. For example, low-rate balance transfer offers are targeted to low-risk customers who revolve balances. A targeted approach involves additional analysis of credit bureau or third-party sta- tistical service data, or an issuer’s proprietary data warehouse. Statistical techniques are used to develop sophisticated credit scoring models to predict and assess the credit risk of potential cardholders, and to match an offer’s pricing to the risk profile of the potential cardholder. Credit scoring is a statistically based tool used to rank applicants by risk level given the information found on applications or credit bureau reports. Points for a variety of characteristics are added, producing a score that positions the applicant along a scale and quantifies the odds that the account will be paid as agreed. Standard & Poor’s Structured Finance I Credit Card Criteria 7
  10. 10. Issuers use credit scores in assessing a borrower’s risk of default. Cutoff points for acceptance can change depending on the degree of risk an issuer wants to accept. Despite their ability to provide relative rankings, credit scores do not correlate per- formance with specific scores. The probability of a negative performance at a certain score level will change with adverse selection in a pool of applications as well as over time. A targeted approach using scoring is expensive to develop and requires frequent testing to maintain. However, for those issuers that rely primarily on credit card accounts for corporate growth and earnings, the investment is essential to maintaining market share and profitability. Issuers that use proprietary statistical models to offer customized products are better able to maintain a consistent spread between revenue and losses for each cardholder or group of similar cardholders. Their primary marketing channel is direct mail, with limited amounts of preapproved underwriting. Servicing And Collections Once a new account is booked, the issuer’s ability to manage that account will determine its tenure and profitability. Timely and accurate monthly statements and friendly and efficient customer service generate goodwill and may increase card usage. With the increase in competition in the industry and the availability of other credit offers, cardholders demand better service. If an issuer cannot demonstrate an ability to address and meet valid customer needs, it will eventually lose market share and be left with a portfolio of cardholders with few other credit options available. At the same time, it is important to assess an issuer’s ability to keep operating costs in check. Over time, innovative technological techniques, such as image processing and artificial intelligence, enable an issuer to reduce expenses, providing additional flexibility in pricing and marketing strategies. Adverse selection from attrition will increase the risk profile of the issuer’s portfolio and may generate losses for certificateholders in securitized pools. Standard & Poor’s analyzes attrition rates and the issuer’s ability and strategy to retain cardholders. For example, some issuers have developed statistical models that help predict which cardholders are likely to be attracted to other offers and pay down in the coming months. Issuers can then offer these cardholders additional features such as upgrades to gold cards, lower finance charge rates, elimination of annual fees, and cash back features that do not impair the profitability of the account. Effective collection efforts maximize profits to the issuer. The interests of certificate- holders may be compromised if the issuer cannot demonstrate a prompt and effective means to collect delinquent balances. Analysts evaluate the quality of collections staff, collections strategy, and the timeliness of implementation when assessing loss levels on a portfolio. For example, many servicers leverage senior collection employees by having them focus on more seriously delinquent accounts. Many also use predictive 8
  11. 11. Collateral Analysis And The Rating Process For Credit Card Receivables dialing systems that queue delinquent accounts based on a statistical behavioral score that identifies the riskiest cardholders. The systems also use other ranking criteria, such as size of outstanding balances, and they incorporate legal criteria regarding when collections staff are allowed to call delinquent cardholders. The dialer systems calculate the optimal time of day to reach a cardholder. These systems have a positive impact on the efficiency of collections. Finally, an issuer’s ability to manage fraud losses is examined in a review. Most issuers combat fraud with neural network systems that detect such activity in the authorization process. For example, systems are typically programmed to detect authorizations at gasoline stations for as little as one dollar. Criminals frequently use gas pumps to test their ability to use a stolen card. Other fraud prevention measures include mailing deactivated cards that can only be activated by the cardholder with certain security information or mixing mass mailings of credit cards with mail that does not contain cards. Also, issuers often stay in contact with the law enforcement community to discuss the latest card-theft techniques used by organized crime. Geographic Concentrations And Other Risks Portfolios can contain additional risk factors that Standard & Poor’s evaluates during a review. For example, the portfolio could be geographically concentrated, subjecting it to regional economic or industrial downturns that would be diluted in a more diversified pool. The portfolio could be heavily biased toward a particular type of cardholder whose performance may skew the portfolio. Cardholders with similar interests or affiliations, known as affinity groups, behave differently than consumers who carry cards that offer rewards, such as airline miles or cash rebates. Economic and industry trends may also affect the performance of an issuer’s port- folio. For example, the local employment pool may be stressed due to new corporate entrants in the region, which may reduce servicing quality or increase wage costs. Stronger competition in an increasingly saturated market may cause an issuer to be more lax in its underwriting standards to increase revenue. Changes in consumer behavior, such as a greater willingness to build up excess credit or declare bankruptcy, may cause credit quality to deteriorate. Analysis Of Historical Collateral Performance Before analyzing stressed cash flow scenarios, analysts examine the historical perfor- mance of the issuer’s portfolio. Typically, the issuer’s entire portfolio is reviewed, as master trust structures allow for account additions after a rated series closes, which may affect the trust’s performance. In most cases, Standard & Poor’s looks for three to five years of data from first-time securitizers, since a track record is extremely important. Standard & Poor’s asks for a range of portfolio data and data is usually provided in a variety of ways. However, Standard & Poor’s Structured Finance I Credit Card Criteria 9
  12. 12. vintage data is considered an important segmentation and is most often requested since it allows analysts to examine how originations from different years or campaigns have performed. Analysts can then examine the trends in performance and match them to changes in underwriting or servicing strategies. Vintage data can also be used to gauge the issuer’s loss curve, and determine the ultimate level of charge-offs by removing the effects of growth. Analysts can then infer how the issuer’s current strategy may unfold in terms of performance. Cash Flow Stress Tests And Their Relationship With Payout Triggers After assessing the seller and servicer’s operations and analyzing the performance of the issuer’s receivables, the analytical team runs cash flow scenarios that stress five key performance variables: payment rate, purchase rate, losses, portfolio yield, and certificate rate. Implicit in the cash flow runs is the assumption that a base rate payout event will cause the transaction to amortize. A base rate amortization will occur when the three-month average portfolio yield, net of losses, is insufficient to cover the certificate interest and servicing fees averaged for the same period. At that point, all principal payments collected from cardholders are passed through to investors. The guidelines that follow encompass many of the parameters used to model a typical transaction, but these are not all-inclusive. A variety of cash flow runs are presented to a rating committee for deliberation. Also, as the market for credit card- backed certificates is dominated by ‘AAA’ and ‘A’ rated paper, the discussion focuses on the stress levels for those rating categories. A separate discussion of Standard & Poor’s ‘BBB’ cash flow modeling will be discussed in a later section. Payment Rate The payment rate is one of the most important variables in the model because a higher payment rate ensures that investors are paid out quickly in adverse scenarios. In a base rate amortization, reductions in enhancement can accumulate rapidly, exposing investors to potential default losses. Enhancement reductions, or write-downs of the certificate, will occur when the portfolio yield is unable to cover charge-offs plus the certificate rate and servicing fee. That is, draws on credit enhancement occur when the excess spread is negative. Therefore, transactions that pay principal at faster rates (i.e., those with higher payment rates) are exposed to losses over a shorter period of time and, therefore, need less enhancement. For a transaction with a standard base rate trigger and a typical mix of fixed- and floating-rate assets, analysts usually assume that a transaction will enter rapid amor- tization with a 5% annualized negative spread rate. In the first month of the rapid amortization stress period, increases in charge-offs are the main reason excess spread is negative. In subsequent months, charge-offs and floating-rate certificate rates, if applicable, are assumed to rise to their ultimate levels, which raise the total negative 10
  13. 13. Collateral Analysis And The Rating Process For Credit Card Receivables spread in the trust. The payment rate assumption in an ‘AAA’ stress scenario is usually 45%-55% of the issuer’s steady-state portfolio payment rate. The discount percentage applied to the steady-state payment rate depends on the level of payment rates, pay- ment rate trends, servicing practices, and payment-rate volatility. The ‘A’ scenario typically is 10% faster than the ‘AAA’ assumption (that is, 50%-60% of the steady-state assumption). Purchase Rate The pooling and servicing agreement governing credit card receivables-backed trans- actions calls for the continued transfer to the trust of all receivables arising in the designated accounts. Therefore, purchases keep the amount of principal receivables in the trust from declining. Higher purchase rates increase the pace of the repayment of principal to investors. For example, assume that the monthly principal payment rate equals 10% of the outstanding principal amount in the trust. If the purchase rate was less than 10%, the amount of principal receivables in the trust would decline each month, leaving a lower amount of principal collections to retire old receivables. A steady payment rate on a declining trust balance would result in fewer dollars of principal payments in subsequent months. However, if the purchase rate equaled the 10% payment rate, the principal receivables in the trust would remain at their initial level, and the portfolio would not decline. Thus, monthly principal collections would also be maintained. If the purchase rate exceeded the 10% payment rate, principal collections would be greater than payments received and the portfolio would continue to grow. The purchase rates used in the model vary based on the seller’s business and per- formance characteristics, the seller’s credit rating, and the certificate rating that the issuer is trying to achieve. But the chief risk associated with a purchase rate assumption is the risk of seller bankruptcy or insolvency. Therefore, higher-rated lenders are usually given more purchase-rate credit because they are more likely to survive adverse business conditions and fund purchases in the future. Also, bank card issuers that are part of the VISA or MasterCard associations have franchise value that would make it more likely for other originators to bid for their accounts if they were to disengage from the business. Insolvency is the chief risk because if the originator becomes insolvent, the trust may not have ownership of, or a first perfected security interest in, receivables origi- nated after insolvency. In the event of an insolvency, the documents generally require the servicer to allocate collections to the trust as if the trust owned all the receivables. Further, if the servicer is legally prevented from doing so, the documents call for the allocation of all collections from each account to be used first to pay off the oldest balances (as in first in, first out accounting). Since the trust has an interest in the Standard & Poor’s Structured Finance I Credit Card Criteria 11
  14. 14. oldest balances, this allocation method is more advantageous than a pro rata distribution. The purchase rates modeled for bank cards range from 2% to 5%. In contrast, most retail lenders are given no purchase rate credit because retailers are typically unrated and because of low franchise value, whereby retailer cards are assumed to have little utility in a U.S. Bankruptcy Code Chapter 7 liquidation. Charge-offs The risk of volatility in the charge-off rate, portfolio yield, and certificate rate is par- tially captured by the base rate trigger. Therefore, there is only slight variation from transaction to transaction in the stress scenario’s negative spread at the start of the modeled rapid amortization period. As previously mentioned, rapid amortization cash flow modeling for a ‘AAA’ case begins with excess cash flow starting at a negative 5% annualized rate. That negative rate usually results in a charge-off level that is 1.5 to two times the steady-state assumption at the start of a rapid amortization before reaching an ultimate ‘AAA’ stress loss case within 12 months. However, cumulative negative spread will be affected by the ultimate charge-off level and the rate of deterioration of each performance variable, which is determined through portfolio-specific analysis. In a ‘AAA’ scenario, the ultimate charge-off level is typically increased by three to five times the issuer’s steady-state charge-off level. The steady-state level is determined by examining historical portfolio statistics and by incorporating an assessment of underwriting and servicing quality. For ‘A’, ultimate charge-offs are assumed to reach two to three times the steady-state level. Portfolio Yield Portfolio yield generally consists of three types of payments: finance charges, fees, and interchange. Periodic finance charges are the interest cost associated with an unpaid balance at the end of a grace period. Fees include annual membership fees, late payment fees, and overlimit fees. Interchange is the fee paid to originators by VISA or MasterCard for absorbing risk and funding receivables during grace periods. Although some issuers do not include all of these sources in portfolio yield, others include these and more. For example, recoveries from previously charged-off accounts can be included, as can the proceeds from “receivable discounting.” A dis- counted receivable arises when a portion (usually 1%-5%) of principal receivables is designated as finance charge receivables. Collections of discounted principal receivables are then treated as finance charges. Several bank card master trusts incorporated discounting before a bulletin from the Office of the Comptroller of the Currency stated that discounting could not be considered recourse. 12
  15. 15. Collateral Analysis And The Rating Process For Credit Card Receivables Competition naturally exerts downward pressure on portfolio yield, but external pressures, such as macroeconomic influences and the legislated interest rate cap, also exist. In the past, legislation has been introduced in the U.S. Congress to place a cap on the amount of interest that an issuer can charge a credit card holder. Resolution S. 1922 would have limited credit card interest rate payments to four percentage points above the rate used by the IRS to assess penalties on late tax payments. Resolution S. 1603 would have capped credit card interest rates at five percentage points above the average six-month Treasury bill rate, adjusted annually. Finally, resolution H.R. 3860 would have capped rates at the six-month Treasury bill rate plus 10 percentage points, adjusted semiannually (see chart 1). Although none of these proposals became law, similar resolutions could become law in the future. For this reason and the others stated above, in most cases, Standard & Poor’s compresses yield to 11% or 12% in ‘AAA’ scenarios and about 12% in ‘A’ scenarios for most bank card portfolios. However, for high yield portfolios, the standard stress yield case as described above may not be applied. Rather, for high yield portfolios, the stress yield will likely not be as compressed because portfolio yield may be composed largely of fee income rather than finance charge income, and the impact of a legislative case would be less severe. In addition, such issuers are targeting higher-risk customers who are less likely to have the ability to switch to a lower-priced card. Higher-yielding portfolios will be analyzed on a case-by-case basis. Following an examination of historical yield data and any yield volatility, an appropriate yield stress will be determined for each rating category. Chart 1 Proposed Legislative Caps (Not Enacted) (%) S.1603 Rate S.1922 Rate H.R.3860 Rate 25 20 15 10 5 Jun-91 Jun-81 Jun-75 Jun-92 Jun-95 Jun-73 Jun-82 Jun-76 Jun-85 Jun-93 Jun-96 Jun-74 Jun-77 Jun-83 Jun-94 Jun-78 Jun-79 Jun-86 Jun-88 Jun-84 Jun-87 Jun-90 Jun-89 Jun-80 Month Standard & Poor’s Structured Finance I Credit Card Criteria 13
  16. 16. Certificate Rate The modeled certificate rate for ‘AAA’ ratings equals the actual rate for fixed-rate transactions, but rises in floating-rate transactions to the capped rate when interest rate caps are provided, or to a level that exceeds the yield on the portfolio in uncapped deals. That ultimate uncapped level usually peaks at a rate of 15% under the ‘AAA’ stress case and 14% under the ‘A’ stress case. The rate of increase to these ultimate levels can vary, however. In determining the ultimate level of increase on floating-rate transactions, analysts will take into consideration other factors, including the issuer’s ability to manage and reprice its portfolio and the rating on the certificates. Additionally, analysts recognize that the relationship between portfolio yield and the variable cost of funds is an important factor in determining the level of excess spread for floating- rate certificates. Principal Allocation Assumptions The method used to allocate principal between the seller and the investor certificates during amortization is yet another cash flow aspect to consider. The transactions are usually structured to pay investor certificates based on a fixed/floating ratio allocation. The fixed/floating allocation freezes the numerator for the series payment ratio at an amount equal to the series investor interest at the end of the revolving period, but the denominator floats to equal the current principal receivables in the trust. The principal allocation percentage (PAP) for investor certificates in amortization will equal the lesser of 100% and the following percentage: Investor interest at the end of the revolving period divided by the greater of: (1) principal in the trust plus cash in the excess funding account, and (2) the sum of the numerators for all series’ PAP. Standard & Poor’s assumes that the seller’s interest would quickly reach zero in amortization due to dilution and fixes both the numerator and denominator in the cash flow assumption so that the ratio is equivalent to 100%. This results in a slower payout of rated classes than if the seller’s interest were assumed to be positive under a fixed/floating allocation. As mentioned above, series with slower principal payments require more enhancement to cover losses. Also, during amortization, the cash flow allocation sections of the documents provide that certificateholders receive the benefit of principal collections from other principal- sharing series in their revolving period. However, analysts assume that such amounts will not be available, as many factors could cause a disruption in such cash flow. One example of such a disruption is a seller insolvency that would cause a trustwide rapid amortization event in which all series would amortize at the same time. 14
  17. 17. Collateral Analysis And The Rating Process For Credit Card Receivables Assessing The Value Of Servicer Interchange Interchange income paid to an issuing bank is part of its overall compensation for assuming credit risk and offering a grace period on finance charge accrual. Interchange income is generated when merchant banks discount the amount they pay to merchants for credit card charges. This discount amount is ultimately shared among the merchant bank, the issuing bank, and VISA or MasterCard as compensation for their clearing- house function. The issuing bank’s share of interchange income is actually generated during the settlement process between VISA or MasterCard and the issuing bank (see chart 2). In the context of credit card receivable securitization, the issuing bank’s share of interchange income can affect the performance of the trust portfolio because the issuer Chart 2 Interchange Cash Flow Payment Step 3 Step 7 Charge Merchant bank VISA or MasterCard forward reimburses the payment of $98.70 to the merchant for the merchant bank. They also purchase minus a collect fixed processing fees fixed "discount fee"; from the merchant bank and e.g., 1.9% of the the issuing bank. Merchant total $100 purchase Bank nets $0.60 ($98.70- $98.10) price (the merchant prior to paying VISA or receives $98.10). MasterCard fees. Merchant Cardholder Merchant Bank ® Step 1 Step 2 Step 4 ® Cardholder uses At the end of the Merchant bank a VISA or MasterCard business day, the submits the credit card to make merchant submits charge to VISA a $100 purchase the charge to the or MasterCard. merchant establishment. merchant bank. Step 6 Card-issuing bank submits payment Step 5 to VISA or MasterCard VISA or minus a fixed MasterCard "interchange fee"; forwards the e.g., 1.3% of $100 charge the total $100 to the bank purchase price. that issued The total payment Step 8 the credit made is $98.70 Card-issuing bank bills the cardholder card to the for the $100 purchase. customer. Card-Issuing Bank Step 9 Cardholder pays the issuing bank the $100 or at least the minimum amount with the remaining balance paid over time. Card-issuing bank nets $1.30 in interchange ($100 cardholder payment - $98.70 payment to VISA or MasterCard). The trust's pro rata share of this $1.30 is usually included as finance charge collections. Standard & Poor’s Structured Finance I Credit Card Criteria 15
  18. 18. typically promises to remit a pro rata share of interchange directly to the trust. At the trust level, such supplemental cash flow is then recharacterized and applied as additional finance charge collections to pay for transaction expenses such as certificate interest, servicing fees and trustee fees, and defaulted amounts. If structured this way, interchange income can provide extra loss coverage by creating a greater level of excess spread. However, because of legal considerations, Standard & Poor’s will not assign any credit to interchange unless certain conditions are met. Legal Analysis Of Interchange Income Standard & Poor’s historically has felt that the benefit of receiving interchange income 10 could evaporate upon a seller insolvency. This view was predicated on legal analysis that suggested that perfecting interchange fees would be problematic because of the following issues: I The property rights of the issuing bank in interchange fees are not clearly defined in the membership agreements with VISA and MasterCard, and I Interchange fees are subject to setoff by VISA and MasterCard. As VISA and MasterCard are not parties to the transaction, they provide no representations, warranties, or covenants related to interchange fees. Additionally, interchange rates are revised annually by VISA and MasterCard. Servicing Fee Requirements And Interchange Dependency As a means of reducing required credit enhancement levels, some servicers have offered to have a portion of their servicing fee paid from interchange, if it is available. This arrangement can reduce the required level of credit enhancement by contractually limiting a portion of the required servicing fee to the actual level of monthly interchange income allocated to the trust. For example, the servicer may require a 2% annual servicing fee but contractually agree to accept 1% of the servicing fee from interchange income to the extent it is available. If interchange did not exist, the servicer would only be paid a 1% servicing fee from trust cash flows. The implication of this structural provision is a 1% reduction in the servicing fee expense assumption for cash flow modeling purposes, but this is only possible if the conditions below are met. Modeling Assumptions For Interchange Standard & Poor’s normally assumes no benefit is derived from interchange due to perfection issues associated with these fees. Because of the legal analysis discussed previously and the fact that interchange income is generated during the settlement process between VISA and MasterCard and the issuing bank, analysts assume that interchange income will not exist in a worst-case early amortization scenario. This is 16
  19. 19. Collateral Analysis And The Rating Process For Credit Card Receivables one of the assumptions used to support the reduction in portfolio yield for cash flow modeling purposes. However, if certain conditions are met, credit will be applied in the analysis for servicer interchange. Analysts will run stressed cash flow scenarios with full credit to servicer interchange only if the transaction meets the following criteria: I For investment-grade certificate ratings, the trust must have a servicer and a trustee (as successor servicer) willing to be paid a portion of its servicing fee from servicer interchange. Both must have high long-term senior unsecured debt ratings, and both must accept a reduced servicing fee if interchange is not avail- able in the future. The rationale is that one of the highly rated entities should be available to service the portfolio at the lower servicing fee. I The trustee must have credit card-servicing capabilities. The trustee is obligated to service or find a replacement servicer if the current servicer is no longer able to service the trust. Standard & Poor’s assumes that the trustee will not be able to find a replacement servicer that will service the trust at the contracted fee and will be required to assume that role itself. For this reason, the trustee must have experience with servicing a credit card portfolio. If these provisions are incorporated into the structure of the transaction, analysts assign value to interchange income. Otherwise, interchange is viewed as an unperfected source of income that would disappear upon the seller’s insolvency. However, if interchange credit is given, the certificate ratings will be dependent on the servicer and trustee’s ratings and may be affected by a downgrade of either party’s ratings. Standard & Poor’s Structured Finance I Credit Card Criteria 17
  20. 20. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts T his section describes the criteria underlying Standard & Poor’s ‘BBB’ ratings. It begins with a brief description of the collateral invested amount (CIA) and the evolution of the CIA market. Then the section summarizes the stresses applied to key performance variables under three separate cash flow scenarios: the combined-stress case, the loss-spike test, and the interest rate-spike test before concluding with a discussion of the legal aspects unique to rating CIA pieces. Collateral Invested Amount A popular form of credit enhancement to the more senior classes, class A and class B, is a subordinated interest known as the collateral invested amount (CIA). The most subordinated interest is referred to by a number of different names, including the enhancement invested amount, the C class, and the collateral interest. For purposes of this section, it will be called the collateral invested amount or CIA. All references are to securities issued by a master trust and backed by bank credit card receivables. As the market has matured, issuers have placed a greater interest in expanding the universe of buyers for the CIA to diversify funding sources. This is especially important because many traditional CIA buyers reached their lending limits for selected names. In addition, many investors that traditionally purchase more senior classes of credit card-backed securities have taken an interest in purchasing the most subordinated class to increase yield in exchange for incremental risk. These factors, along with heightened investor concerns over consumer credit quality, have helped drive the demand for Standard & Poor’s ratings on CIA interests. Standard & Poor’s Structured Finance I Credit Card Criteria 19
  21. 21. Market Evolution The earlier credit card deals incorporated letters of credit (LOCs) from highly rated institutions to protect investors against the risk of default. To avoid a rating depen- dency on the credit quality of the LOC provider, the market moved to cash collateral accounts funded by the same institutions that formerly provided the LOCs. Since CIAs were introduced in the early 1990s they have become the most common form of credit enhancement. When CIA structures were first introduced, issuers had their CIAs rated mainly for tax purposes, rather than to allay investors’ credit concerns. Issuers understood that an investment-grade debt rating was viewed favorably by tax lawyers opining whether the IRS would deem the CIA as debt for tax purposes. The former LOC and cash collateral account providers were, and have continued to be, the primary investors in the CIA market, having built their expertise for evaluating the credit risks well before the enhancement was a ratable subordinated debt interest. As the traditional investor market for CIAs has become saturated, issuers have become more interested in having their CIAs rated by Standard & Poor’s to gain greater acceptance from potential new investors and to reduce their reliance on existing sources of finance. Additionally, traditional buyers began to express interest in having CIAs rated to increase their ability to syndicate their positions, which would free up capacity to invest in future transactions and create a more liquid market. Across the board, investors have become more sensitive to credit risks and price volatility due to credit spreads. Structural Credit Enhancement And Excess Spread All credit card structures incorporate a series of amortization events that, if triggered, cause principal collections allocated to investors to be passed through immediately and before the scheduled payment date. Among other things, amortization events include insolvency of the originator of the receivables, breaches of representations or warranties, a servicer default, failure to add receivables as required, and asset performance-related events. Additionally, a transaction will generally amortize early if the three-month average excess spread falls below zero annualized. Excess spread is generally defined as finance charge collections minus certificate interest, servicing fees, and charge-offs allocated to the series. Early amortization is a powerful form of structural credit enhancement for all certificateholders, including the CIA holders, who are generally in the first loss position. In a typical credit card structure, credit enhancement for the A and B classes is fully funded at closing. For example, the class A certificate relies on the credit enhancement provided by the subordination of class B and the CIA and/or a cash 20
  22. 22. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts collateral account, if any. In contrast, the enhancement for the CIA is dynamic and typically in the form of a reserve account. The reserve account is funded from excess spread plus an initial deposit, if necessary. The amount of excess spread deposited into a reserve account is dictated by the terms of the CIA loan agreement. Generally, if excess spread falls below specified levels, excess finance charge collections are trapped in a reserve account for the CIA’s benefit. A typical loan agreement will require a targeted reserve fund balance based on the current level of excess spread. Table 1 shows one example of a reserve account structure and the required trigger levels. In this example, if the three-month average excess spread is above 4.5%, no deposit is required. Should excess spread fall between 4% and 4.5%, excess spread will be trapped in the reserve account until the reserve account balance is equal to 1.5% of the initial series invested amount. As excess spread falls, the targeted reserve fund balance increases. At less than 3% excess spread, the targeted reserve account will be 4%. In an adverse scenario, this structural credit enhancement is designed to build the reserve account before the excess spread falls below zero. Similarly, amounts held in the reserve account can be released if excess spread increases above a specified level. Reserve account structures vary and affect the amount of excess spread that can be trapped under an adverse scenario. Average bank card excess spread remained positive from 1992 through 1997 (see chart 1). Although performance varies significantly by issuer and a number of issuers have supported their transactions, since credit card securitization began, the situations in which a deterioration in portfolio credit quality has caused excess spread to fall below zero are infrequent. In fact, many of the incidents of negative excess spread were a result of policy changes or a particularly high fixed-rate coupon on the certificates. Others have occurred from changes in charge-off policies causing temporary and short-lived blips in charge-off rates. Incidents of negative excess spread are more likely in discrete trust structures. In contrast, the more common master trusts are generally larger, more diversified, and less prone to any loss spikes Table 1 Sample Reserve Account Trapping Mechanism Reserve Fund Target % of Initial Three Month Average Excess Spread Series Invested Amount 4.5% 0.0% 4.0% - 4.5% 1.5% 3.5% - 4.0% 2.0% 3.0% - 3.5% 3.0% 3.0% 4.0% Standard & Poor’s Structured Finance I Credit Card Criteria 21
  23. 23. associated with account seasoning. Additionally, several issuers have increased excess spread by managing the composition of the securitized portfolio to reduce loss rates or discounted receivables to boost yield. Cash flow models are used to measure the effect of a deterioration in excess spread on a transaction and how this deterioration affects the amount of cash that can be trapped in a spread account to cover defaults. The cash flow model formulas reflect the payment allocation provisions in the pooling and servicing agreements, as well as the CIA loan agreement. For cash flow modeling purposes, excess spread is assumed to be the lower of either the current level or the first trigger level (4.5% in the example above) when simulating a stress test. Excess spread is not a cash flow model input; rather, it is a model output. Once an excess spread trigger level is breached, the reserve account builds from monthly excess spread, if any, up to the targeted balance. If finance charge collections are insufficient to cover certificate interest, servicing fees, and receivable charge-offs, excess spread is negative and amounts in the reserve account will be reduced. To achieve an investment-grade rating on a CIA, a sufficient amount of excess spread must be available to fund a reserve account to avoid a default under various ‘BBB’ stress tests. Chart 1 Bank Card Trusts Excess Spread Bank Card Loss Rate Bank Card Spread (%) Bank Card Wtd Base Rate 20 15 10 5 0 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 22
  24. 24. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts ‘BBB’ Ratings Reflect Seller-Specific Considerations When moving down the ratings spectrum, greater reliance can be placed on the card issuer’s ability to originate and effectively manage its credit card business. In addition, compared with the ‘AAA’ and ‘A’ stress cases discussed in the section Collateral Analysis And The Rating Process, when evaluating CIA pieces, less-conservative portfolio-stress scenarios are assumed for cash flow modeling purposes. The ratings on the more senior classes are typically above the unsecured debt rating of the bank that originates and services the credit card receivables that have been transferred to the issuer. The senior class can be rated above the unsecured rating of the bank because the senior class ratings are based primarily on the creditworthiness of isolated pools of assets, without regard to the creditworthiness of the bank. The probability and potential impact of the bank’s insolvency are factored into the rating assigned to the senior certificates. Therefore, in assigning a rating to the more senior classes, the transaction’s structure must provide the means by which the assets’ cash flow would be available to pay debt service in a timely manner notwithstanding the insolvency, receivership, or bankruptcy of the issuer. In contrast, the CIA ratings are often at or below the rating of the originator/servicer. Therefore, greater reliance can be placed on the bank’s ability to effectively service the portfolio during the life of the transaction and to originate and transfer receivables to the issuer. When the bank’s rating is at least as high as that of the credit card-backed security, the bank’s credit card business can be viewed as an ongoing concern for purposes of the CIA analysis, and performance is modeled accordingly. In rating the CIA, the analysis incorporates many of the same factors Standard & Poor’s considers when assigning an unsecured rating to the bank. These include quantitative factors such as loss rates, bankruptcy data, payment rates, the mix of variable- and fixed-rate accounts, and repricing information. More qualitative factors are also included, such as marketing, pricing and account-retention strategies, underwriting and account-management policies, the use of technology, the strategic importance of the securitization program as a source of funding, and management expertise. Additionally, Standard & Poor’s assesses macroeconomic conditions, con- sumer behavior, geographic concentrations, competitive pressures, and franchise value. All of these factors are critical in determining the appropriate ‘BBB’ enhancement level for CIA classes. The links between secured and unsecured ratings at the invest- ment-grade rating level imply the possibility that a ‘BBB’ structured rating may be downgraded in conjunction with the downgrade of an issuer’s unsecured rating to below investment grade. Standard & Poor’s Structured Finance I Credit Card Criteria 23
  25. 25. Table 2 General Guidelines for BBB Cash Flow Stress Test Scenarios Key Modeling Combined Loss Spike Interest Rate Variable Stress Scenario Scenario Spike Scenario Yield Decrease to 75% of Expected steady state. Expected steady state. expected case over an 18 month period. Charge-offs Increase to 1.5 to 2 Increase to 2 to 3 times Expected steady state. times Portfolio the the expected case over expected case over an an 18 month period. 18 month period. Absolute increase for Absolute increase for most portfolios should most portfolios should be 5% to 10%. be 2.5% to 5%. Payment Rate 75% of expected case. Same as combined Same as combined stress scenario. stress scenario. Purchase Rate Assumes a flat portfolio Same as combined Same as combined for investment grade stress scenario. stress scenario. originator/servicers and a declining portfolio for non-investment grade originators/servicers. Certificate Rate Actual rate for fixed Actual rate for fixed Assumptions based on rate securities in series. rate securities in series. the stochastic modeling Increase to 75% of Start and remain at the of interest rates, using worst case portfolio higher of current level Markov chain Monte yield over 18 months or certificate rate which Carlo techniques. for floating rate would first first excess securities in a series. spread to be trapped for floating rate securities in a series. Excess Spread Starts at lower of Same as combined Same as combined current level and high- stress scenario. stress scenario. est excess spread trig- ger (if current is above trigger level, portfolio yield and/ or loss rate is adjusted). Excess Spread is a model out- put for future periods. 24
  26. 26. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts Three ‘BBB’ Stress Test Scenarios When analyzing a CIA, Standard & Poor’s will evaluate the impact of a deterioration in pool performance or an increase in the deal’s certificate rate, or both, using three separate cash flow scenarios. The three ‘BBB’ scenarios include a combined-stress, a loss-spike, and an interest rate-spike scenario. Under the combined-stress scenario, all key variables are stressed simultaneously. This combined worse case approach is similar to the ‘AAA’ and ‘A’ stress cases, in which various performance variables are stressed at the same time. For the loss-spike stress test, the certificate rate and portfolio yield are held constant at the steady state and the loss rate is stressed more severely. The interest rate-spike scenario incorporates a sharp increase in the coupon for floating-rate securities in a series and holds loss rates and portfolio yield constant at their expected steady states. The portfolio purchase rate and payment rate assumptions are the same for all three scenarios. There is no strict formula for specific stress levels applied to each modeling variable. Instead, the level of stress is portfolio specific and is based on an analysis of the pool characteristics and an evaluation of the originator/servicer. Charge-offs/Loss-Spike Analysis In a ‘AAA’ scenario, the peak annualized loss percentage is typically three to five times the expected steady state for the portfolio. This peak is reached in 12 months. In contrast, in a ‘BBB’ combined-stress scenario, loss rates are increased to 1.5 to two times the expected steady state. The peak is reached in 18 months and the absolute level of increase typically does not exceed 500 basis points for the combined-stress scenario. For a ‘BBB’ rating, a transaction should also be able to survive an increase in losses of two to three times the expected steady state under a loss-spike scenario. Standard & Poor’s uses ‘BBB’ loss guidelines that examine the historic performance of securitized portfolios. Table 3 shows in basis points the absolute level of increase for nine frequent issuers. This compares monthly loss data for each master trust for 18 months beginning in 1992 or since the trust’s inception if it was created after 1992. The table shows the maximum increase in the three-month average charge-off rate over the 18-month period. In examining issuer-specific portfolio loss volatility, Standard & Poor’s evaluates pool performance in a variety of ways. For example, one-month and three-month average loss rate changes over rolling 12-, 18-, and 24-month periods were analyzed for all bank card issuers. Table 3 shows each trust’s monthly loss rate percentages compared on an 18-month rolling basis. Assume a master trust had an annualized loss rate of 5% in January 1994 and an annualized loss rate of 7.5% in June 1995; the absolute level of increase would be 250 basis points for that 18-month period Standard & Poor’s Structured Finance I Credit Card Criteria 25
  27. 27. Table 3 3 Month Rolling Average Loss Returns per 18 Month Rolling Period Absolute Change Rank Trust Name 1 2 3 4 5 Fleet abs. chg* 508 503 502 484 450 min - max 2.58%-7.66% 2.72%-7.75% 2.47%-7.49% 2.85%-7.69% 3.10%-7.61% multiple 2.97 2.85 3.03 2.70 2.45 Capital One abs. chg 490 478 463 462 448 min-max 3.02%-7.91% 3.37%-8.15% 2.96%-7.60% 2.79%-7.41% 3.79%-8.28% multiple 2.62 2.42 2.57 2.66 2.18 Citibank Standard abs. chg 302 284 276 249 247 min-max 3.70%-6.72% 3.72%-6.57% 3.65%-6.41% 3.65%-6.14% 3.97%-6.44% multiple 1.82 1.77 1.76 1.68 1.62 Discover abs. chg 330 314 305 303 283 min-max 4.13%-7.43% 4.35%-7.49% 4.63%-7.68% 4.31%-7.34% 4.21%-7.04% multiple 1.80 1.72 1.66 1.70 1.67 First Chicago abs. chg 310 307 300 278 264 min-max 6.52%-9.62% 6.26%-9.33% 6.72%-9.72% 6.19%-8.97% 6.09%-8.73% multiple 1.48 1.49 1.45 1.45 1.43 First USA abs. chg 262 259 255 255 252 min-max 2.38%-4.99% 2.82%-5.41% 2.95%-5.50% 2.37%-4.92% 3.97%-6.49% multiple 2.10 1.92 1.86 2.08 1.63 Household AFFNY abs. chg 304 297 297 266 259 min-max 4.59%-7.12% 4.30%-7.27% 2.85%-5.82% 3.53%-6.19% 2.96%-5.55% multiple 1.55 1.69 2.04 1.75 1.88 MBNA II abs. chg 245 236 228 201 189 min-max 1.61%-4.06% 1.72%-4.08% 1.94%-4.22% 2.16%-4.16% 2.32%-4.21% multiple 2.52 2.37 2.18 1.93 1.81 Providian abs. chg 293 274 267 255 253 min-max 5.44%-8.37% 4.98%-7.72% 5.62%-8.29% 5.36%-7.91% 5.71%-8.24% multiple 1.54 1.55 1.48 1.48 1.44 Minimum Abs. Chg. abs. chg 245 236 228 201 189 multiple 1.48 1.49 1.45 1.45 1.43 Maximum Abs. Chg. abs. chg 508 503 502 484 450 multiple 2.97 2.85 3.03 2.70 2.45 Average Abs. Chg. abs. chg 338 328 321 306 294 multiple 2.04 1.98 2.00 1.94 1.79 *Absolute Change is measured in basis points. 26
  28. 28. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts (a 50% increase or a 1.5x multiple). The issuer’s loss performance for other 18-month periods, such as from February 1994 through July 1995, would be compared, and so on. For each issuer in table 3, this 18-month rolling test was applied and the top-five most volatile loss periods for each issuer are displayed. In addition to the monthly loss rate history, Standard & Poor’s bases its expected case steady-state loss rate on delinquency roll rate, vintage loss performance, and lagged loss rate analysis. These analytical techniques help mitigate any distortions due to recent account growth and provide insights into expected future performance. In many cases, the expected steady-state loss rates are well above the historical average. As a result, stressed loss rates are at considerably higher multiples compared with historic averages. Portfolio Yield Portfolio yield is affected by the terms of the cardholder agreement, the percentage of convenience users in the portfolio, and the absolute level of charge-offs and delin- quencies. Portfolio yield consists of cardholder finance charges and fees. It may also include interchange income and recoveries from charged-off receivables. For modeling purposes, the yield assumption is important, because yield dictates how much income will be available to cover expenses (defaults, certificate rate interest, and servicing fees). Chart 2 Three-Month LIBOR & Federal Reserve Credit Card Interest Rates (sample period) (%) Fed Reserve Rates 3-mo. LIBOR (avg.) 20 18 16 14 12 10 8 6 4 2 0 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 Year Note: The Federal Reserve Credit Card Interest Rates include data collected by the Federal Reserve on outstanding credit card receivables for 65% of the commercial banks, but do not include interchange. Standard & Poor’s Structured Finance I Credit Card Criteria 27
  29. 29. In the past, legislative proposals have been introduced to cap the amount of interest a card issuer could charge. However, movement toward competitive floating-rate products has mitigated the risk of a legislative cap. Nonetheless, due to the remote possibility of a regulatory cap, as well as market competition that naturally exerts downward pressure on portfolio yield, the yield on a portfolio is assumed to decline in a stress scenario. In a ‘AAA’ scenario, the decline in yield is simultaneous with an increase in losses. Although not always the case, yield in a ‘AAA’ case is typically lowered to 11% or 12% and little credit is given to an issuer’s ability to reprice its portfolio in this environment. However, at the ‘BBB’ level, analysts assume that if the portfolio is well managed and nationally diverse, there would be less pressure on price in a rising loss environment. The entire credit card industry would likely suffer and price competition would abate, allowing issuers to raise APRs to offset higher losses. For this reason, in a ‘BBB’ combined-stress scenario, yield is reduced to 75% of its expected steady state over an 18-month period. Chart 2 illustrates the industry-average credit card interest rates for a sample period. Although the gap between credit card interest rates and three-month LIBOR has remained quite healthy, there is a wide variance among issuers in their pricing, product mix, and account solicitation strategies. As a result, portfolio yield differences among issuers are significant. Analysts factor issuer-specific portfolio management strategies into the assumptions used for cash flow modeling purposes. Certificate Rate For fixed-rate transactions, the modeled input for the certificate rate is the actual rate payable to certificateholders. For floating-rate transactions, however, the certificate rate is assumed to increase over time. In floating-rate deals in which interest rate caps are provided, interest rates are increased to the level of the cap. The relationship between portfolio yield and the variable cost of funds is an important factor in determining the level of excess spread for series with floating-rate certificates. Since banks can reprice credit card accounts and the vast majority of cards issued in recent years have had floating rates, the differential between portfolio yield and certificate rate is assumed to be positive in a ‘BBB’ combined-stress scenario. Standard & Poor’s arrived at its positive 3% to 5% net margin relationship by comparing the relationship between the three-month London Interbank (LIBOR) rate and the Federal Reserve credit card interest rates for one extended period (see chart 2). Over this 15-year period, the greatest positive differential between the credit card rate and LIBOR was 14.36% in September 1992, and the average difference was 10.82%. Over this period, the gap between credit card yield and LIBOR never dropped below 5%, with 6.52% in July 1984 as the lowest point. 28
  30. 30. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts In examining the three-month LIBOR rate and the Federal Reserve credit card interest rate between June 1973 and August 1982, there are instances when the net interest margin dipped below 5%. For much of the period of September 1979 through July 1982, the net interest margin was less than 5%, averaging just under 2.25%. During that time, there were nine months in which the indexes inverted. Standard & Poor’s assumes that the likelihood of an inversion during a period of rapidly rising loss rates and a declining portfolio yield (the ‘BBB’ combined-stress scenario) is remote. The early 1980s was an unusual period when interest rates sky- rocketed in reaction to the oil crisis. It is unlikely that the low level of net interest margin observed then will be repeated. In addition, the credit card market and the way it funds itself have evolved. LIBOR was not a widely traded index in the early 1980s and, consequently, was less liquid and more volatile. Furthermore, during that time period, most bank card issuers did not borrow at the LIBOR rate. Instead, since most issuers were full-service consumer banks, they relied primarily on consumer deposits to fund their credit card businesses. The cost of borrowing based on the federal rate for deposits was arguably lower than LIBOR during the early 1980s. Since lenders did not borrow based on LIBOR, they did not need to adjust yield and reprice portfolios to compensate for a rising LIBOR-rate environment. At that time, virtually all credit card issuers offered the same price to consumers: 19.8%. If the events of the early 1980s were repeated, it would be reasonable to assume that originators would reprice their portfolios and avoid a negative relationship between yield and certificate rate. Although Standard & Poor’s thinks that it is unlikely that LIBOR and credit card rates will invert in the future, it does not ignore that possibility when analyzing CIAs. For this reason, a ‘BBB’ rated CIA must pass an interest rate-spike stress, which incorporates the interest rate environment experienced between 1979 and 1981. This interest rate-stress scenario does not incorporate a simultaneous rise in loss rates and decline in portfolio yield. Interest Rate Assumptions And Spikes Standard & Poor’s approach to interest rate modeling is based on the stochastic modeling of interest rates, using Markov chain Monte Carlo techniques. This technique involves the use of a probability transition matrix that allows the volatility to vary from period to period. The rates are generated via an autoregressive time series model, and the volatility represents the random error at each point in the simulation. Besides using a transition matrix to govern the jumps among volatility states, the modeling uses a probability transition matrix for the levels of rates, thereby eliminating very unlikely jumps in rates from period to period. The results are interest rate scenarios Standard & Poor’s Structured Finance I Credit Card Criteria 29
  31. 31. that show minimal error when compared to actual rate paths. The assumptions used in CIA credit card modeling are a subset of the simulation results. Interest rate data from 1973 through the present are modeled via autoregressive time series models. An autoregressive model gives the estimate of the next period’s rate as a linear combination of one or more past values plus some random error. The random error is the volatility of the interest rate data, which includes the periods of high volatility, such as the 1973-1974 oil crisis and the early 1980s. Simulating rates via this approach with a constant volatility yields excessively volatile results. Therefore, three volatility assumptions are used in the simulations: low, moderate, and high, corresponding to different periods in history. Using a transition matrix based on the historical data, the volatility may vary from period to period based on the likelihood of moving among the states. For example, if the current period is one of low volatility, it is most likely that the next period will be one of low volatility. However, there is some probability that the next period will be one of moderate volatility, and some smaller probability that the next period will be one of high volatility. The transition probabilities weight the historical periods so that the experiences of the early 1970s and early 1980s are not overrepresented. Similarly, a transition matrix for the level of rates governs the period-to-period jumps, pre- venting jumps from 5% to 12% in one period, for example, if such a jump is very unlikely. When applying the model to credit card C class ratings, Standard & Poor’s is concerned with the interest rate risk over an 18-month period or a 25-month period. A total of 1,000 10-year interest rate paths are simulated. For each of these paths, the rates during each 18-month rolling period are averaged. That is, the periods 1-18, 2-19, 3-20, ..., 103-120, each represent an 18-month period. Each 10-year path gives 103 18-month periods, so for the entire simulation, there are 103,000 18-month periods. The results are rank ordered and the results for the 18-month period corresponding to the 95th percentile are selected. In addition, the 18-month period with the steepest slope is also selected. Similarly, for the 25-month scenario, the same 1,000 10-year periods are grouped into rolling windows of months 1-25, 2-26, and so on, yielding 96 25-month periods for each 10-year path. In either case, the 95th percentile and the steepest slope scenarios are then used in the interest rate-stress modeling for the C class rating. The results determine the sufficiency of the spread in the deal to protect CIA investors. Payment Rate The principal payment rate is one of the most important cash flow variables because it determines how long certificateholders are subjected to the credit risk of a deterio- rating pool of assets. Portfolios with fast principal payment rates will allocate losses 30
  32. 32. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts to a series over a shorter period of time and, all else being equal, require less enhance- ment than portfolios with slow principal payment rates. The payment rate assump- tion in a ‘AAA’ stress scenario is usually 45%-55% of the issuer’s steady-state portfolio principal payment rate. The payment rate assumption for ‘BBB’ stress scenarios is between 70%-75% of the issuer’s steady-state portfolio principal payment rate. The actual percentage used depends on the historical average payment rate for the portfolio, the minimum payment rate and whether it has changed over time, the existence of any cobranded products, the quality of servicing, and the historical volatility of payment rates. Purchase Rate Trust agreements call for any purchases arising on designated accounts to be contin- ually transferred to the trust. The bank’s ability to continue to generate and transfer receivables to the trust is an important consideration when rating the CIAs. Purchases affect the level of principal receivables in the trust. Higher purchase rates accelerate the repayment of principal to investors and lower the enhancement levels required. Purchase rate assumptions vary based on pool characteristics, past performance, and account management strategies used by the servicer. There are also legal consid- erations when determining purchase rate assumptions for cash flow modeling purposes. If the originator of the receivables becomes insolvent, the master trust may not have an ownership or a first perfected security interest in receivables originated after the insolvency. In the event of an insolvency, the documents generally stipulate that the servicer allocate collections to the trust as if the trust owned all the receivables origi- nated from the designated accounts. Further, if the servicer is legally prevented from doing so, the documents normally call for the allocation of all collections from each of the designated accounts to be used first to pay down the oldest balances. Since the trust has an interest in the oldest balance, this allocation is more advantageous than a pro rata distribution. Since an insolvency of the originator could adversely affect its ability to originate and transfer receivables to the trust and, consequently, cause a slowdown in the rate of principal repayment to investors, Standard & Poor’s varies purchase rate assumptions based on the unsecured credit rating of the originator for purposes of the CIA rating analysis. For cash flow modeling purposes, an investment-grade bank is assumed to be able to originate and transfer sufficient receivables to maintain the principal balance of the portfolio. For noninvestment-grade originators, the master trust portfolio is assumed to be declining and, as a result, the rate of principal return to investors will be slower. Standard & Poor’s Structured Finance I Credit Card Criteria 31
  33. 33. CIA Owner Trust Structure Each CIA structure is slightly different. Some CIA ratings require initial deposits in a reserve account at closing, others are protected by a fully funded cash collateral account. Still other CIA pieces rely solely on dynamic credit enhancement based on current excess spread levels. The earlier credit card deals utilize a three class tranche structure: class A, class B, and the CIA, with all three classes issued out of a master trust. Subsequently, however, several of the major issuers began using a new owner trust structure. In this second type of structure, issuers take the interest and principal entitlement to the CIA class together with the rights to all remaining excess cash flow after covering all of the class A and class B costs available at the master trust level, and transfer the cash into an owner trust. The ‘BBB’ notes are then issued out of this second-tier owner trust and these notes are collateralized and payable only from the cash flows allocated to them at the owner trust level. All cash received at the owner trust level is pooled together and used to pay ‘BBB’ noteholders interest first, and principal as due second. Issuing notes from an owner trust structure is intended to take advantage of accounting regulations changes and allow issuers to structure first loss C pieces as notes. These notes are then treated as debt (rather than equity) for tax purposes. Classification as debt eliminates both the transfer restriction, which requires, under the tax code, that holders of equity pieces receive permission from the issuer before selling their C piece, and the sale restriction under the Employment Retirement Security Act (ERISA). Legal Issues Related To Rating CIAs In transactions where Standard & Poor’s is requested to rate collateral interests issued by a master trust in a variety of structures, certain tax issues arise that must be addressed in addition to the bankruptcy issues. These new owner trust structures are generally intended to enable the sponsor to enhance the liquidity of the collateral interests (including permitting sales to non-U.S. investors) without triggering entity-level taxation for the master trust. In transactions in which the collateral interests are not rated, Standard & Poor’s typically receives an opinion from counsel for each transaction that: I The class A and class B certificates of a particular series will be treated as debt for federal income tax purposes, and I The master trust will not be subject to entity-level taxation as an association taxable as a corporation or as a “publicly traded partnership” treated as a corporation. 32
  34. 34. ‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts However, in transactions where a rating is requested for the collateral interests, there is an increased risk that the master trust could become a publicly traded part- nership taxable as a corporation through the transfer of the collateral interest to a large number of holders, thereby subjecting such holders to double taxation. The risk to investors in the collateral interests is that, although it is generally believed that such interests constitute debt for federal tax purposes (as is the case with class A and class B certificates), it is possible that such interests could be treated as equity because they have fewer debt-like characteristics than the other, more senior classes, including a lower level of credit support. In some cases, counsel is sufficiently sure of the debt characterization of the collateral interest that it is willing to deliver an opinion stating that the collateral interests are debt for federal income tax purposes. If such an opinion is delivered from counsel familiar with the issues, Standard & Poor’s would be reasonable in assuming in its analysis that: I The master trust has only a single class of equity interest (the seller’s interest) and thus, is a mere security device and not a separate entity for tax purposes, and I Investors in the collateral interests are (as are investors in the other certificate classes) treated as holders of debt issued by the sponsor. However, in the event that counsel is unable or unwilling to provide such an opinion, it would be necessary for Standard & Poor’s to assume that such collateral interests are not debt for federal income tax purposes. In such a case, the risk that the master trust may be viewed not as a mere security device but, rather, as a distinct entity potentially subject to entity-level tax as an association taxable as a publicly traded partnership treated as a corporation must be taken into account. Therefore, additional assurances either in the form of: I An opinion of counsel that the collateral interests are debt for federal income tax purposes, or I An undertaking from the sponsor that it will use its best efforts to prevent the master trust (or any applicable trust) from becoming a publicly traded partnership taxable as a corporation are required. Such an undertaking will, in general, include a covenant from the sponsor that it will limit to 100 the number of holders of such collateral interests and any other interests issued by the relevant trust that may not be treated as debt for federal tax purposes as defined by federal tax regulations. For owner trust structures, opinions stating that the secured notes are characterized as debt and that the owner trust is not taxable as a corporation are also reviewed. Standard & Poor’s Structured Finance I Credit Card Criteria 33

×