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    Credit Card Criteria Credit Card Criteria Document Transcript

    • Structured Finance Credit Card Criteria
    • 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.
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • ‘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
    • 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
    • ‘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
    • 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
    • ‘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
    • 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
    • ‘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
    • 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
    • ‘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
    • 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
    • ‘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
    • 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
    • ‘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
    • 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
    • ‘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
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables T his section discusses the various structural and operational issues related to a master trust. These issues include the addition and removal of accounts, the purpose and sizing of the seller’s interest, and the importance and impact of payout events. The section concludes with descriptions of two master trust structures, socialized and nonsocialized, and a discussion of how principal and finance charge cash flows are allocated to investors. Structural Analysis The structure of each master trust transaction is governed by the terms of a pooling and servicing agreement and, for each series, its series supplement. The following is a discussion of some of the more important features found in the documents of a typical transaction. The Trust Account Conveyance And Additions And Removals When a trust is created, the seller conveys receivables to the trust for the benefit of certificateholders. The receivables conveyed are under the control of the seller and are from accounts designated by the seller. The receivables conveyed include those receivables generated from these designated accounts and from future receivables created following the transaction’s cutoff date. The trust accounts and receivables must conform to eligibility criteria and specific representations and warranties of the seller to ensure that additional credit risks are properly contained. Standard & Poor’s Structured Finance I Credit Card Criteria 35
    • Eligible Accounts, Eligible Receivables, And Representations And Warranties Standard & Poor’s evaluates asset performance based on historical data provided by the seller and by comparing the seller with peer issuers. In addition, it relies on representations and warranties made by the seller of the assets. One of the most important seller’s representations concerns the quality and eligibility of the assets in the trust. Each account and receivable must be eligible under the transaction documents; otherwise, the account or receivable is removed from the trust. Appendix A lists the common eligibility requirements for credit card transactions and should be used as a guideline for sellers and issuers, although Standard & Poor’s will review deals that don’t conform to the standard representations and warranties listed. Representations made regarding the assets should apply to both the initial pool of accounts and related receivables and those subsequently added to the trust. As delineated in the governing documents, any breached representation or warranty must be cured within a specified grace period. Receivables that are deemed ineligible are usually reduced to a zero balance for trust-related calculations and for payment allocation purposes. Any reduction to the receivables balance due to ineligibility reduces the seller’s interest. Although accounts are typically selected randomly, designated accounts may be selected. However, in this case, the transaction documents will include a representation and warranty stating that the nonrandom selection procedures will not materially and adversely affect the interests of the certificateholders. The seller is also responsible for protecting the trust’s interest in the receivables by filing Uniform Commercial Code (UCC) financing statements and by perfecting the trust’s interest in the receivables that are transferred or assigned to it. The trust agreement permits the seller to remove receivables and related designated accounts from the trust or to add new receivables by designating additional accounts from another receivable pool. Because receivables may be added to and removed from the trust, credit risk could arise as a result of changes to the composition of the trust after closing. There are risks associated with adding recently originated accounts because new accounts have not had sufficient time to season and reach their peak default phase. The addition of new accounts, therefore, potentially skews performance for the overall trust by making the performance of the receivables from the existing accounts appear more favorable. Standard & Poor’s estimates that new accounts are not likely to reach their peak charge-off until between month 18 and month 24. Therefore, receivables from new accounts may dilute the trust’s charge-off statistics until the new accounts are seasoned. Adding a large percentage of new accounts could delay a base rate pay- out event, since losses are temporarily masked. Moreover, the new accounts that are added may have been originated under more relaxed underwriting standards compared 36
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables with those of existing accounts. This may result in higher-than-anticipated charge-off rates for the trust in subsequent months, when these riskier accounts mature and enter their peak charge-off period. Even given these risks, since most credit card issuers originate receivables daily as part of their normal course of business, Standard & Poor’s allows limited additions to the trust subsequent to the transaction’s closing. Account Additions Account additions subject to certain limitations are allowed without Standard & Poor’s confirmation that the ratings will not be lowered or withdrawn as a result of account additions. Such additions are classified as automatic account additions. Still, these additions must meet account and receivable eligibility criteria and are subject to representations and warranties as required. Automatic account additions are permitted as long as the number of cumulative accounts added in any three-month period does not exceed 15% of the trust portfolio at the beginning of the quarter, and if the number of accounts added during any 12-month period does not exceed 20% of the trust portfolio at the beginning of the 12-month period. In the case of all other account addition proposals, Standard & Poor’s evaluates the characteristics of the added accounts and monitors the effects of these lump-sum additions on the credit quality of the trust. In addition to voluntary automatic additions and lump-sum additions, the seller is required to add accounts whenever the interest falls below the minimum seller’s interest, or when the principal receivables in the trust fall below the minimum aggregate principal receivables requirement. Such account additions are classified as required account additions. In most transactions, if the minimum seller’s interest or the minimum aggregate principal receivables requirement is breached, to correct the imbalance and to ensure the deal is sufficiently supported, principal collections are deposited in an excess or special funding account. These deposits are made from the point of infraction until the seller is able to convey the necessary additional receivables from newly designated accounts, or until sufficient receivables are generated in the accounts already designated to the trust. Because of the revolving nature of credit card accounts and the monthly sale of newly charged receivables to the trust, legal opinions regarding the receivables conveyed after the cutoff date are delivered periodically by the issuer’s counsel. The opinions address the nature of the sale of the newly conveyed receivables and the trustee’s perfected interest in these receivables. The frequency with which these opinions need to be reviewed is based on the seller’s rating as follows: I For sellers rated ‘AA’ or higher: seminannully; I For sellers rated ‘A+’ to ‘A’: quarterly; and I For sellers rated ‘BBB+’ or lower: monthly. Standard & Poor’s Structured Finance I Credit Card Criteria 37
    • Risks are also associated with account removals, because the seller may elect to remove the better-performing accounts, causing the overall quality of the trust portfolio to deteriorate. Additionally, removal may cause the seller’s interest to fall below the required minimum seller’s interest, or cause the principal receivables in the trust to fail the minimum aggregate principal receivables requirement. Failure of either require- ment would reduce the size of the trust portfolio to such a level that the collateral would be insufficient to support the outstanding certificates at their required enhance- ment levels. To protect the securities from these risks, before most removals, the trustee is required to receive notification from Standard & Poor’s that the proposed removal will not adversely affect any outstanding ratings. Automatic removal of accounts without Standard & Poor’s written affirmation is allowed, provided certain criteria are met. One requirement is that the account selection process must be random to prevent biased removals from the trust. Another requirement may be that removals are allowed, but subject to monthly, quarterly, and annual limits. Additionally, removals may only occur if the minimum seller’s interest and the minimum aggregate principal receivable requirements are not breached. The seller also agrees to deliver an officer’s certificate stating that the proposed removal will not adversely affect certificateholders. Seller’s Interest Each series of securities issued from a master trust has an undivided interest in the assets and an allocable interest in the collections on the receivables in the master trust based on the aggregate invested amount of the series. Trust assets that have not been allocated to any series of securities are known as the seller’s or transferor’s interest. Seller’s interest represents the remaining ownership interest in the trust assets; that is, trust assets that not allocated to certificateholders’ interest. The size of the seller’s interest is equal to the difference between the aggregate principal receivable balance of the trust portfolio and the principal balance of all outstanding securities in the trust. Seller’s interest fluctuates as the amount of securities issued by the trust changes or as the balance of principal receivables in the trust assets increases or decrease. In the absence of dilutions, which reduce the receivables balance, when account purchases exceed account payments during the revolving period, the seller’s interest increases. Conversely, when account payments exceed account purchases, the seller’s interest declines. The seller’s interest also declines as a result of any noncash reductions in the receivable portfolio. These noncash reductions are receivable dilution (see chart 1). The Purpose Of A Seller’s Interest. The seller’s interest serves two key purposes. First, it provides a collateralization buffer in instances when account payments exceed account purchases; and second, it absorbs reductions in the receivable balance attributable to receivable dilution or as a result of reassignment of noncomplying receivables. Noncomplying receivables are receivables that breach any representations 38
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables made by the seller when sold to the trust and are, therefore, removed from the trust and bought back by the seller. Dilution. Receivables are generated in accounts when merchandise is bought, services rendered, cash advanced, or balances transferred. Dilution is any reduction to the receivables balance due to any reasons other than losses or an obligor’s cash payments. Examples of dilution include credit given to the cardholder by the merchant for merchandise returns; reductions in receivable balances offered by the issuing entity for items such as rebates, refunds, and adjustments for servicer errors; reductions due to fraudulent or counterfeit activities; and removals of noncomplying receivables. Returned or refused merchandise is the primary reason for dilution in a portfolio. Most services rendered (such as meals at a restaurant), balance transfers, and cash from cash advances are generally not returnable and, therefore, are not subject to dilution risk. Balance transfer has become a popular strategy to generate growth for almost all bank issuers. Many issuers have grown their portfolios by offering low introductory APRs and enticing consumers to transfer existing credit card balances. Since balance transfers are similar to cash advances and are not returnable, portfolios with a high percent of balance transfers typically have lower dilution rates compared with port- folios with a lower percentage of balance transfer accounts. Rebate Programs. Some credit card issuers offer rebate programs designed to attract new business as well as retain creditworthy and profitable accountholders. Chart 1 The Components And Mechanics Of Trust Principal Total Trust Principal Required Seller's Interest ($) Seller's Interest Invested Amount 140 130 120 Purchases > Principal Payments Payments + Charge-offs 110 Purchases > Principal 107 + Charge-offs 100 90 80 0 1 3 5 7 9 1113151719 23252729313335373941434547 515355 57 59616365676971 21 49 Seller's Interest < Required Amortization Period Begins Seller's Interest Standard & Poor’s Structured Finance I Credit Card Criteria 39
    • Specifically, some rebate programs allow a cardholder to earn points every time the card is used for purchases or to earn points for keeping the account balance current. Accumulated rebate points can be redeemed for items ranging from cash to free phone service or airline travel to a discount on merchandise such as a car purchase. However, there are credit concerns associated with rebate programs. If the issuing bank becomes insolvent and subsequently defaults on its obligation to provide cardholders with rebates already earned, the cardholders may deduct, or “set off,” the dollar amount of the promised rebate from their current credit card balances. This deduction will reduce the amount collectible on the account. For example, assume a bank offers each cardholder a $100 cash rebate for maintaining an average outstanding balance exceeding $5,000 for 12 consecutive months. Ms. Smith, who has a $6,000 balance, qualifies for the $100 rebate. Before making payment to Ms. Smith, the bank goes insolvent. Even though the bank has not credited Ms. Smith’s account for the rebate she earned, Ms. Smith may decide to set off the $100 from her current outstanding balance and, in turn, mail a $5,900 payment in full to the bank to reduce her balance to zero. The $100 set-off in the example above is a receivable dilution. Because rebate programs are subject to set-off risk, Standard & Poor’s will review and examine each rebate program to determine the likelihood of set-off risks and to quantify any potential set-off amounts. Quantifying Exposure To Dilution. Standard & Poor’s generally requires issuers to provide three to five years of monthly return and fraud data for dilution analysis. In determining the level of protection needed for certificateholders against dilutions during the life of the transaction and the required seller/transferor interest, analysts focus on both the level and the timing of current and historical dilution patterns. Since the majority of dilutions typically occur within one to three months from the date of sale, analysts focus on returns that occur during 30-, 60-, and 90-day cycles. In analyzing historical return data, analysts must first determine a steady-state dilution Table 1 Dilution Analysis Month Receivables ($) Returns ($) % 100% ($) 20% ($) 10% ($) Total ($) % January 5,593,504,000 22,174,327 0.40 22,174,327 — — — — February 5,489,499,000 18,267,896 0.33 18,267,896 4,434,865 — — — March 5,406,525,000 13,255,427 0.25 13,255,427 3,653,579 2,217,433 19,126,439 0.35 April 5,365,474,000 19,777,845 0.37 19,777,845 2,651,085 1,826,790 24,255,720 0.45 May 5,444,411,000 21,689,546 0.40 21,689,546 3,955,569 1,325,543 26,970,658 0.50 June 5,516,669,000 14,005,223 0.25 14,005,223 4,337,909 1,977,785 20,320,917 0.37 Average — — — — — — — 0.42 40
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables rate (see table 1). The March data from table 1 shows that $13 million of merchandise was returned. Out of the $13 million, it is assumed that a majority of returns are from March sales, but a portion of returns are also from previous months’ sales. In this example, analysts assume that 20% of March returns are from February sales and 10% of March returns are from January sales. This artificial staggering of returns over 30, 60, and 90 days from the date of purchase allows analysts to arrive at a steady-state return rate that is more conservative than historical experience in the portfolio. The return rates for each month are then generally averaged to arrive at a steady-state dilution number (0.42% in table 1). For an ‘AAA’ rating, this steady state is typically stressed by a 3x to 5x multiple. If an issuer provides historical timing data that shows that a majority of returns occurs very soon after the date of sale, Standard & Poor’s will consider relaxing the 20% and 10% lag assumptions and may choose instead to use primarily the current month’s dilution numbers. The magnitude and timing of dilution vary among issuers. These variations depend on the specific obligor profile and on a specific merchant’s policy regarding merchandise returns and rebates, as well as the merchant’s liability for stolen cards, fraud, and warranties. If historical data shows that a majority of returns occurs in later months, Standard & Poor’s may chose to increase the lag assumptions. Bank credit card transactions are typically structured requiring the seller or issuer to reimburse the trust for dilution adjustments. If the seller is unable to do so, the seller’s interest will be reduced to absorb any dilution adjustments. If the seller is unable to reimburse the trust for dilution, or if the seller’s interest is zero and cannot further absorb dilutions, a dilution adjustment to the trust receivable balance is made, causing the trust portfolio to shrink. As the trust portfolio shrinks, principal finance charge collections generated by the remaining collateral will also decline, reducing potential collections needed to pay down outstanding certificates. Because of this risk and because credit support is typically sized only to cover losses, credit card securitizations also must include mechanics to cover dilution risks. One way to cover dilution risk is to structure a deal that ensures that a minimum seller’s interest is always available to absorb any dilution adjustments should the seller default on its obligation to reimburse the trust for noncash or noncharge-off receivables reductions. Minimum Seller’s Interest. Most bank-sponsored credit card-backed issues require a minimum seller’s interest of 7%. Standard & Poor’s analyzes an issuer’s rebate programs, portfolio composition, and timing of returns and determines if the 7% dilution requirement is sufficient. Following analysis of an issuer’s data, some bank master trusts have been allowed to reduce their dilution coverage below the standard 7% level. However, deviation from the 7% minimum seller’s interest requirement is allowed only after careful and detailed analysis of an issuer’s historical dilution performance and only if the deal’s structure provides that principal collections are Standard & Poor’s Structured Finance I Credit Card Criteria 41
    • immediately retained in the trust for the benefit of investors any time the seller’s interest drops below its required minimum amount. Timing Of Seller’s Interest Test. In most structures, the seller’s minimum interest test is performed monthly (see chart 2). For example, on Jan. 12, the determination date, the servicer will look back to the end of December to determine whether the seller’s interest was below the required level. If the seller’s interest was below the requirement as of Dec. 30, the seller must add accounts by Jan. 22, the required des- ignation date (10 days after the determination date), in order to satisfy the required minimum seller’s interest test. If the deal is not in compliance on the required desig- nation date, the deal will enter rapid amortization and all principal payments col- lected will be passed through to investors beginning Feb. 15, the amortization date, to pay down outstanding certificates. Some master trusts require daily testing of the seller’s interest. Before the seller is allocated or paid any amounts from daily collections, the seller’s interest must be at or higher than its required minimum amount. If the seller’s interest falls below the required seller’s interest on any day, principal collections that would have otherwise gone to the seller are instead deposited in a trust excess funding account (EFA) until the seller’s interest, together with cash on deposit in the EFA, brings the trust back into compliance with the minimum requirements. Tax Considerations. Credit card-backed deals are typically structured and charac- terized for federal tax purposes as either debt of the transferor, where the trust is a “mere security device,” or as interest in the partnership formed by the trust. Chart 2 Timeline Dec Jan Feb 12/1 12/31 1/1 1/12 1/15 1/22 1/31 2/1 2/15 monthly period distribution amortization date date determination required date designation date 42
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables Generally, the intent of the seller is to treat the certificates as debt for tax purposes. It is, therefore, common for the issuer’s counsel to provide a tax opinion stating that the certificates would be treated as debt. A credit card trust may choose to be classified as either a corporation or a part- nership by filing a form with the IRS. Failure to pick an option results in the default classification as a partnership. Payout Events The inclusion of payout events in credit card transactions protects investors against adverse situations and provides a way for investors to receive accelerated return of principal when unfavorable scenarios unfold. A trustwide payout event triggers the start of the rapid amortization period for all the series issued by the trust, while a series payout event triggers rapid amortization for the specific series. During early amortization, all principal collected (and not just the certificate’s floating share of principal) is passed through to the investors in order of seniority as quickly as possible. Payout events include asset performance tests, seller insolvency events, and occurrence of servicer defaults. All payout events indicate potential problems in the deal that could threaten the likelihood of ultimate payment to investors. By accelerating payments and paying all principal collections received to certificate holders, investors are less exposed to losses in a deteriorating environment. Standard & Poor’s views asset performance payout events, such as the base rate trigger, the required minimum seller’s interest test, and the required minimum principal receivables trigger, as important and necessary payout events that provide protection to investors. The value of the inclusion of these events in structures compared to deals that exclude them is evident and quantified upon reviewing the results of various cash flow runs. The Base Rate Trigger. A violation of a base rate trigger as defined in the series supplement causes the series to enter a rapid amortization period. The base rate trigger is an automatic payout event and does not require investors’ approval. The base rate trigger usually consists of two components: I The net portfolio yield, defined as finance charge collections minus losses, expressed as a percentage of the investor interest; and I The base rate, defined as the amount of monthly interest owed to certificates and portfolio servicing fees, expressed as a percentage of the investor interest. If the base rate exceeds the net portfolio yield for a three-month rolling average, the base rate trigger is violated and principal will be returned to investors as quickly as possible, beginning on the next distribution date. The violation of a base rate trigger indicates that the trust assets are not yielding enough to pay trust and certificate expenses. When a base rate trigger occurs, the deal is no longer solvent and it enters early amortization, ensuring that investors’ interests are paid down as soon as possible before performance worsens. Standard & Poor’s Structured Finance I Credit Card Criteria 43
    • When analyzing the impact of a base rate trigger on credit enhancement levels, analysts examine structural features that can affect the strength of the base rate trigger. First, if the net portfolio yield definition includes excess finance charge collections from other series issued from the trust, a payout event may be delayed even though the trust portfolio is deteriorating. The inclusion of excess finance charge collections from other trust series may artificially boost portfolio yield performance. For example, if charge-offs are rising and excess finance charges are included, a payout event would not occur until after charge-offs increased above the level of finance charges allocated to the series plus excess finance charge collections from all other series issued from the trust. To account for the inclusion of excess finance charge collections in the base rate definition, Standard & Poor’s may assume higher initial steady-state loss rates in all cash flow modeling. A second consideration concerning the base rate is servicing fees. Servicing fees should be based on a fee sufficient to attract a successor servicer. The standard servicing fee for the credit card industry is 2%. An exception to the standard fee arises when credit is given to servicer interchange. In deals that include interchange credit, the original servicer accepts a smaller servicing fee from finance charge collections, but receives an additional fee generated from interchange revenue. To gain credit for servicer interchange, the servicer and trustee that is obligated to act as successor servicer must have the requisite rating, among other qualifications. In addition, the trustee must be able to service the trust portfolio as a successor servicer. Only in these circumstances will Standard & Poor’s allow the base rate to include a servicing fee that is less than the allocable servicing fee of 2%. Some deals are structured such that a base rate trigger can cause a payout event to occur before excess spread declines to zero. For example, in certain deals, a payout event will occur if the net portfolio yield declines below the base rate plus 1%. This type of trigger allows a deal some cushion before losses and expenses exhaust excess spread completely. A base rate plus 1% trigger will cause a transaction to go into rapid amortization sooner than it would if a normal base rate trigger were employed. Standard & Poor’s recognizes the structural advantage of a tighter base rate trigger and, as a result, may require less credit enhancement when a stricter base rate trigger is incorporated. In nonsocialized master trusts, the base rate trigger is specific to individual series within the master trust. While the net portfolio yield definition is the same for all series in nonsocialized master trusts, the base rate definition will vary for each individual series in the master trust depending on the interest coupons carried by the certificates in each series. Assuming the same net portfolio yield and servicing fee exist for all outstanding series, a series with higher coupons will trigger a payout event before a series with lower coupons. 44
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables Socialized trust structures pay the trust’s expenses, including monthly interest, based on the needs of individual series. The expense need of each individual series varies depending on the coupon rate of outstanding certificates. Since collections received are allocated based on series’ needs, portfolio yield is reallocated to series with higher expenses from series with lower expenses. Consequently, if net portfolio yield is insufficient for one series in a socialized trust to cover expenses, it is insufficient to cover expenses for all other series in a socialized trust. Violation of a base rate trigger in a socialized structure will, therefore, cause all series in a group to enter into rapid amortization and pay out at once. Required Minimum Seller Interest And Required Minimum Aggregate Principal Receivables. If the seller’s interest is less than the required minimum seller’s interest or the aggregate principal receivables are less than the required minimum aggregate principal receivables, an early amortization event will occur unless requisite additional receivables are added to the trust typically within 10 business days. The required seller’s interest is generally measured as a fixed percentage of current principal receiv- ables or current investor interest. Therefore, as a series begins to amortize, the invested amount and required minimum seller’s interest will decline on an absolute basis. However, the minimum aggregate principal receivables test is calculated in most deals based on the invested amount of the series as of the end of its revolving period. As a result, the minimum aggregate principal receivables test requires that the princi- pal receivables be maintained at a higher level than that required by the minimum seller’s interest test when the invested amount of the series is amortizing (see chart 3). If either minimum requirement test fails, an automatic payout event occurs. Chart 3 Minimum Aggregate Principal Vs. Required Seller's Interest ($) Invested Amount Required Seller's Interest Seller's Interest 140 120 100 Minimum Aggregate 80 Principal Amount 60 ($100) 40 20 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 Month Standard & Poor’s Structured Finance I Credit Card Criteria 45
    • Failure Of The Seller To Make Payments Or Deposits. A payout event also occurs if the seller fails to either make a payment or deposit within five business days of the required date under the pooling and servicing agreement, or if the seller fails to per- form in any material respect a covenant that is left unremedied for 60 days. This payout event is not automatic and, as a result, requires investors representing at least 50% of the invested amount of a series to vote before such an event results in a series payout event. Representations And Warranties. A payout event occurs if there is a material breach of a representation or warranty by the seller that is unremedied for 60 days. An unremedied material breach is a payout event that requires investors representing at least 50% of the invested amount of a series to vote before it affects the series. The Role Of The Servicer In The Transaction. The servicer agrees to service and administer the receivables in accordance with its customary practices and guidelines, and it has full power and authority to make payments to and withdrawals from deposit accounts that are governed by the documents. Fidelity bond coverage is typically required to cover any potential wrongdoing by its employees and officers. Servicers are generally paid 2% of the invested amount for their obligation to service receivables. Because some servicers of bank receivables are highly rated, some are allowed to commingle funds with the company’s general funds until one business day before the distribution date. Those without a short-term unsecured rating of ‘A-1’ or higher are not allowed to commingle and must deposit collections in an eligible deposit account immediately but no later than within two business days of receipt. Independent accounting reports stating whether the servicer is in compliance with the terms outlined in the documents and whether the servicer’s policies and procedures are adequate are required at least annually. Any exceptions are listed with an expla- nation within the accounting report. A servicer is not allowed to resign unless law prohibits it from performing its duties. Even if a servicer resigns, the resignation is not effective until a successor servicer or the trustee, as successor, has assumed all the servicer’s responsibilities for the same fee. Servicer Default. Any servicer default that would have a material adverse effect on investors is considered a payout event. A servicer default occurs, for example, if a conservator or receiver is appointed or if the servicer fails to make any required payments. This payout event also requires investors representing at least 50% of the invested amount of a series to vote before it takes effect for that series. Investors Are Not Paid In Full By The Expected Payment Date. If any class of securities rated by Standard & Poor’s is not paid in full by the expected payment date of that class, a rapid amortization will automatically begin and, from that point on, all principal collected will be paid to certificateholders until the class is paid in full. A delay in principal payment to investors results if scheduled controlled deposits 46
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables or payments during a controlled amortization or an accumulation period are insufficient to retire certificates by the expected maturity date. Trust Payout Events. Trust payout events will result in rapid amortization for all series in a master trust. The following trust payout events are automatic payout events and do not require an investor vote: I An insolvency event of the seller, which occurs when the seller is no longer able to pay its obligations and must appoint a conservator, receiver, or liquidator, or file for bankruptcy. Under an insolvency event, the ability of the seller to generate new receivables is clearly impaired, and a payout event would be necessary. In addition, after the insolvency of the seller, the trust may not have an ownership or first priority perfected security interest in new receivables generated, which further jeopardizes the likelihood of receipt of collections from the collateral seller. I The trust is deemed an “investment company” under the Investment Company Act. I The seller is unable to transfer receivables to the trust. Types Of Trusts Credit card securitizations are structured as either discrete trusts, nonsocialized master trusts, or socialized master trusts. Discrete Trusts The first credit card transactions were issued from discrete trusts. As the market evolved, many of the structural features of discrete trusts were transferred to the master trust structures. For example, eligibility criteria for accounts and receivables, representations and warranties of the seller, servicing and servicer requirements, cash flow allocations between the seller and investor interest, trust payout events, and series termination methods are all used in similar ways in both discrete trusts and in master trusts. However, the advent of the master trust brought increased flexibility for issuers. Master Trusts The master trust permits the issuer to sell multiple series from the same trust. Master trusts also allow each series to share the credit risks as well as the cash flow from one large pool of credit card receivables. Intercreditor agreements exist among the investors in each of the series that provide the “fire walls” that preclude investors in one series from taking credit support from another series. Deal documents further state that, unless specifically designated as a subordinated series at issuance, no series is subordinated in terms of cash flow allocation to another series within the trust. There are two types of master trusts: socialized and nonsocialized. The two types of trusts differ in the way finance charge collections are allocated to the series. Standard & Poor’s Structured Finance I Credit Card Criteria 47
    • Nonsocialized Master Trusts In nonsocialized master trusts, finance charge receivables are allocated to the total investor’s interest and seller’s interest pro rata based on the principal amount of he series. Principal in a nonsocialized trust is allocated to the investor’s and seller’s interest of each series based on principal requirements. No reallocation or sharing of excess cash flow occurs until each series is paid its full amount of allocable cash flow to cover its current expenses. Although rare among the newer trusts, some nonsocialized trusts do not share excess finance charges at all. Nonsocialized master trusts that do not share excess finance charges were common at one point, and in these instances, excess finance charge collections are not used to cover the monthly shortfall of other series but, rather, are allocated and paid to the seller. The majority of nonsocialized master trusts do permit the sharing of excess finance charge collections. Socialized Master Trusts In socialized master trusts, finance charge receivables initially are allocated to a group of series based on the amount of that group’s outstanding principal. Finance charges are then split among the series sellers’ interests and investors’ interests based on size within the group. The investors’ share of finance charges is then reallocated to the investor interest of each series within the group based on the pro rata costs of such series. Ultimate allocation, then, is based on costs, which include certificate interest, servicing fees, and investor default amounts, rather than on the size of the series aggregate investor amounts. Principal is allocated among each group and series based on principal size. This is similar to the principal allocation method used in nonsocialized master trusts. As is the case with some nonsocialized master trusts, socialized master trusts may also provide for shared principal among groups, if necessary. Grouping In A Master Trust A typical feature of all master trusts is the grouping of series within a trust. This feature is used most effectively in socialized master trusts. For example, an issuer may separate floating-rate series from fixed-rate series and issue floating series out of group one and fixed from group two. As previously mentioned, Standard & Poor’s assumes that for floating-rate transactions, the deal’s costs will become greater during the rapid amortization period. Cash flows are run assuming the certificate rate increases to an ultimate capped level over time. This stress for floating-rate liabilities can have a large impact on enhancement levels when compared to enhancement levels needed on similar fixed-rate transactions. By separating fixed- and floating-rate transactions into groups within a trust, the enhancement levels for a series within a group will more accurately reflect the risk of each series. It should be noted, however, that issuers 48
    • Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables use socialization, in part, to smooth out interest rate volatility and avoid a potential base rate trigger by combining high-liability transactions with deals with lower costs. Therefore, some issuers chose to keep fixed- and floating-rate series together and issue both types from one group. When fixed- and floating-rate transactions are grouped together in socialized trusts under Standard & Poor’s interest rate-stress scenarios, the fixed-rate transactions tend to subsidize the floating-rate transactions, which have potentially higher costs. In a socialized structure, cash flow is reallocated from the fixed-rate series to cover the higher-cost floating-rate series. Therefore, since all cash flow within a group is shared, all series within a socialized group require the same enhancement level. As a group, the required enhancement level for the fixed-rate series in a socialized trust may seem higher than it is in nonsocialized trusts, while the level for floating-rate transactions may seem lower. However, the individual enhancement levels between a fixed- and floating-rate deal, if analyzed separately, will be the same for either a socialized or a nonsocialized trust. Although grouping will affect the enhancement level of each series within a socialized group, it should be noted that the total amount of enhancement for all series in a socialized master trust is not affected by grouping. Enhancement levels depend on the performance of the collateral and the series certificate rates. Whether a group is constructed as a socialized or nonsocialized trust has little consequence on the total risk affecting certificates issued by the trust. All other variables being equal, overall enhancement levels for socialized and nonsocialized trusts are identical. The greatest advantage to socializing finance charge collections is the ability to avoid a series specific base rate amortization by reallocating the group’s resources to the series in need. However, if the group’s costs are not covered by net yield, the largest risk is that all series in a socialized group will amortize simultaneously. In contrast, in nonsocialized trusts, interest costs are separated from each other, helping to isolate amortization events to series with higher interest rates. A Typical Transaction From A Master Trust: Nonsocialized Trusts That Share Excess Finance Charges. Issuers commonly create nonsocialized master trusts that allow sharing of excess finance charge collections and principal collections among series in a group. However, excess finance charges among outstanding series arise only after each series pays its expenses in full. After series expenses are covered in full, available excess finance charges from such series are then shared among other series that experience finance charge shortfalls according to need. Some nonsocialized trusts also share principal collections. In these cases, principal collections are allocated to series only during accumulation or amortization. During either period, principal cash flow is collected to either accumulate up to the scheduled controlled deposit amount (during accumulation), or to pay the controlled amortization amount (during amortization), or to make a principal bullet payment on the scheduled Standard & Poor’s Structured Finance I Credit Card Criteria 49
    • payment date. Principal sharing occurs when principal collections allocated to other series in their revolving period are not needed by those series and, consequently, are reallocated to other amortizing or accumulating series in the trust that do need principal collections. 50
    • Cash Flow And Structural Analysis For Credit Card Receivables C redit card structures utilize both socialized and nonsocialized master trusts. This section further highlights the differences between the trusts by examining how each trust allocates finance charge collections, defaults, and principal to investors and sellers within a trust and how allocation of these three components differs during revolving and nonrevolving periods. The section concludes with a dis- cussion of some structural features associated with credit card analysis, including the subordination of interest, the reallocation of subordinated cash flows, and the impact of issuing a paired series. Cash Flow Allocations Finance Charges And Default In Nonsocialized Trusts All nonsocialized trusts allocate defaults and finance charges based on size, whether or not they share excess finance charges. Allocations are made in two steps: I Finance charges are allocated to each group and seller’s interest, pro rata, based on size. I Each group’s allocations are divided among all series and classes based on series and class size. An example of how nonsocialized trusts allocate finance charges and defaults is best illustrated using the structure depicted in chart 1. In this structure, the sum of the investor interests in group one totals $900 million, and the seller owns $100 million. Assuming a static amount of principal receivables, as finance charges are collected and charge-offs are realized, the series in group one would be allocated 90% of finance charge collections and charge-offs. The seller in this example would be allocated 10% of those amounts (see chart 2). The amounts allocated to group one would then be allocated pro rata to each series within group one. Since the invested amount Standard & Poor’s Structured Finance I Credit Card Criteria 51
    • of the third series in chart 2 totals 50% of group one’s trust principal amount, it will receive 50% of the finance charges, and it will be allocated 50% of defaults. Similarly, series 1 and series 2 will receive 20% of finance charge collections, and each series will be allocated 20% of defaults, since each represents 20% of the trust’s principal balance. Each series must pay its own expenses, including monthly interest, servicing fees, and the allocated charge-offs, from finance charges allocated to that series. Only after each series covers its own costs will it distribute excess finance charge collections, if any, to other series in the group. Any excess finance charge collections paid to other series are distributed among those series based on need. Following allocation of finance charge collections and defaults at the group level, allocations are made among classes within a series. Specifically, chart 3 diagrams a multi-step allocation among classes in a standard nonsocialized master trust series. Class A Available Funds are defined as class A’s percentage of investor finance charge collections, and will be used to pay: I Class A interest, I Class A servicing fees, and I Class A investor defaults. The remainder, if any, is characterized as excess spread, which is used later in the payment waterfall. Chart 1 A Typical Trust Structure A Nonsocialized Master Trust That Shares Excess Finance Charge Collections Group 1 Seller's Series 1 Series 2 Series 3 Interest $200 mil. $200 mil. $500 mil. $100 mil. Investor Interest Investor Interest Investor Interest Class A Class A Class A $180 mil. 'AAA' $160 mil. 'AAA' $400 mil. 'AAA' (with 20% support) (with 20% support) (with 20% support) Class B Class B Class B $20 mil. 'A' $20 mil. 'A' $50 mil. 'A' (with 10% support) (with 10% support) (with 10% support) Collateral Interest Collateral Interest $20 mil. $50 mil. Cash Collateral Account 'N.R.' 'N.R.' $20 mil. 'N.R.' 52
    • Cash Flow And Structural Analysis For Credit Card Receivables Class B’s percentage of investor finance charge collections, called Class B Available Funds, pays: I Class B interest, and I Class B servicing fees. The remainder is also characterized as excess spread. Collateral Available Funds, or the collateral interest’s percentage of investor finance charge collections, are used to pay: I The collateral interest’s servicing fee. The remainder is characterized as excess spread. Although collateral available funds may be used to pay interest to the collateral interest amount (CIA), some transactions subordinate that interest. The CIA interest is then paid in the secondary excess spread waterfall following the payment of class Chart 2 Allocations Of Finance Charges And Defaults In Nonsocialized Trusts Finance Charge Collections $100 Seller's Interest: Group One $100 mil. $900 mil. $90 Seller's 1: Seller's 2: Seller's 3: $200 mil. $200 mil. $500 mil. $20 $20 $50 Defaults $10 Seller's Interest: Group One $100 mil. $900 mil. $1 $9 Series 1: Series 2: Series 3: $200 mil. $200 mil. $500 mil. $2 $2 $5 Standard & Poor’s Structured Finance I Credit Card Criteria 53
    • Chart 3 Waterfall For Step Two in Nonsocialized Master Trusts Class A Available Funds Class B Available Funds Collateral Available Funds Class A Monthly Interest Class B Monthly Interest Class A Servicing Fee Class B Servicing Fee Collateral Servicing Fee Class A Investor Defaults Excess Spread in the following priority Excess Finance Excess Finance Charge Charge Collections from Collections from Other Series Other Series Class A Required Amount (in priority) I Interest I Servicing Fee I Investor Defaults Increase Class A Investor Interest for any prior charge-offs Class B Required Amount (in priority) I Interest I Servicing Fee I Investor Defaults Increase Class B Investor Interest for any prior reductions and charge-offs Pay the collateral interest holder in the following priority: I Interest I Servicing Fee I Increase invested amount for prior reductions Fund CCA up to the required amount and pay other fees to the collateral interest holder Excess Finance Charge Collections for Other Series 54
    • Cash Flow And Structural Analysis For Credit Card Receivables A and class B required amounts and following payment to class A and class B for any unreimbursed costs (see chart 3). When the collateral interest’s interest payments are subordinated and made available to cover more senior classes’ costs, both class A and class B benefit. Finance charge income that would have been used to pay the CIA interest is used instead to cover class A and B interest and defaulted amounts to the extent not covered by class A and class B available funds, respectively. If available funds are insufficient to pay the costs of interest, servicing fees, and investor defaults as outlined above, a shortfall exists. This shortfall is defined as a class A required amount or a class B required amount, and subsequently will be paid in the secondary waterfall. Class A required amounts are paid from the following sources in priority: I Excess spread (and excess finance charges from other series, if such excess is shared); I Withdrawals from a cash collateral account (CCA) or draws on an LOC, if applicable; and I Reallocated principal from the subordinated classes. All reallocated principal collections will first result in a reduction of the collateral interest until its principal balance is zero, before reducing the class B principal balance to zero. In addition, if the monthly investor share of principal and interest collections received is not sufficient to pay the class A required amount, classes will be written down in an amount equal to the class A investor default amount in the following priority: I Collateral interest amount, I Class B, and I Class A. Similarly, to the extent any class B required amounts exist, they are paid from: I Excess spread (and excess finance charges from other series, if such excess is shared) if it is not needed for class A; I Withdrawals from a cash collateral account or draws on an LOC, if any, if it is not needed for class A; and I Reallocated principal from the collateral interest if it is not needed for class A. If monthly cash flow amounts are not sufficient to pay the class B required amount, classes will be written down in an amount equal to the class B investor default amount in the following priority: I Collateral interest amount, and I Class B. After payments of the class A and class B required amounts, collateral interest holders are paid their interest, their share of the servicing fee, and reimbursed for any prior write-downs. Remaining excess spread is then used to fund the cash collateral account, if applicable, to its required amount before amounts are paid to collateral interest Standard & Poor’s Structured Finance I Credit Card Criteria 55
    • holders as required. If not paid to CIA holders, remaining amounts are released as excess finance charges for the benefit of other series. Finance Charges And Defaults In Socialized Trusts Finance charge allocations in a socialized master trust differ from the allocations of a nonsocialized trust. In socialized trusts, defaults are also allocated to each group and series based on size, but investor finance charges are allocated based Chart 4 Finance Charge Allocations In A Socialized Master Trust Master Trust Finance Charge Collections Allocated to Group One Series 1 Series 2 Series 3 Step 1 Finance Charges Allocated Finance Charges Allocated Finance Charges Allocated Based on Size Based on Size Based on Size Seller’s Investor’s Seller’s Investor’s Seller’s Investor’s Finance Finance Finance Finance Finance Finance Charges Charges Charges Charges Charges Charges (based (based (based (based (based (based on size) on size) on size) on size) on size) on size) Reallocated Group One Investor Finance Charge Collections (Finance Charge Collections are Reallocated and Distributed to Each Series in the Following Priority Based on Each Series’ Costs) Series 1, Series 2, and Series 3 Monthly Interest Step 2 Series 1, Series 2, and Series 3 Investor Default Amount Series 1, Series 2, and Series 3 Monthly Fees Series 1, Series 2, and Series 3 Additional Amounts Excess Spread Shared Based on Cost 56
    • Cash Flow And Structural Analysis For Credit Card Receivables on the series size and then reallocated and distributed to series based on need. Chart 4 demonstrates how allocations typically occur among group one series in a socialized trust. Finance charge collections are allocated in three steps. Group Allocation. Finance charges are allocated to each group, pro rata, based on the size of the group. Within the group, such amounts are divided between the investor’s interest and seller’s interest of each series. Series Reallocation. The group’s investor interest finance charges are then reallo- cated among series within a group based on need; therefore, the term “socialized.” It is at this stage that socialized trusts differ from nonsocialized trusts. In socialized structures, if the total finance charge income allocated to a group is insufficient to cover the costs of all series within that group, all series will experience negative excess spread. If this occurs for three months on average, all series in the group will enter rapid amortization at the same time. A socialized trust is an all-or-nothing proposition- either all series in a group perform as expected or all enter rapid amortization simultaneously. In contrast, since series cost are separate in a nonsocialized structure, one series may enter rapid amortization while the others remain in their scheduled revolving or accumulation periods. Class Allocation. Once finance charge income has been reallocated among series within a group, within each series, the series share of finance charge collections will be divided among all its classes based on class size similar to the way allocations are made in a nonsocialized structure at the class allocation level. Need-based allocation deals will distribute funds according to the pro rata costs of the series, which include interest, servicing fees, and cardholder default amounts. Because the trust is socialized, if the cash flow allocated to the group is insufficient to cover the costs associated with all series within the group, the shortfall will be allocated equally to all series. The cash flow allocated to each series will be applied in the following order of priority: I Monthly interest, I Investor default amounts, I Investor monthly fees (including servicing fees), and I Investor additional amounts. If reallocated amounts will result in any excess, all series will receive a pro rata share of that excess. Subordination Of Interest Paid To The Collateral Interest Holder In nonsocialized master trusts, the collateral invested amount’s participation in trust receivables entitles it to receive a pro rata allocation—along with the class A, class B, and seller’s interest—of finance charges generated by the receivables. Standard & Poor’s Structured Finance I Credit Card Criteria 57
    • Although the collateral invested amount is always allocated its pro rata share of finance charges, many structures subordinate the payment of CIA monthly interest until class A and class B receive their full monthly payment. In these structures, finance charges allocated to CIA are only used to pay the collateral servicing fee in the primary waterfall. Interest payments to the collateral invested amount are paid later from excess spread. If the collateral invested amount receives its monthly interest payment solely from excess spread, the class A and class B certificates benefit. The basis for this benefit lies with the priority of payments at the excess spread level; that is, excess spread is used first to reimburse class A and B certificates for any unreimbursed costs before paying CIA monthly interest. In nonsocialized trusts, the benefit derived by subordinating collateral invested amount monthly interest is a function of the size of the collateral invested amount and the share of finance charges allocated to it. The larger the share of finance charge collections that would have been used to pay CIA interest, the more that can be redirected and used to pay any existing class A or class B required amounts. Therefore, the larger the collateral invested amount, the bigger the benefit to the class A and B certificates. In socialized trusts, the collateral invested amount’s share is determined by its expenses. The lesser of either the CIA monthly interest due to investors or finance charges allocated to CIA determines the actual dollars available for redirection as excess spread and, ultimately, paid to the class A and B certificates. Excess spread is used to pay the class A, class B, and CIA expenses that remain unpaid after the application of class A, class B, and CIA available funds. Excess spread is used first to pay unpaid class A expenses—monthly interest, servicing fees, and defaults—followed by unpaid class B expenses, and then unpaid CIA expenses, including subordinated monthly interest. However, if finance charges were sufficient to meet class A and class B expenses in the first payment waterfall, there would be no need to use any additional source of funds to help meet those expenses. In simulating a stress case, Standard & Poor’s models a scenario in which class expenses always exceed finance charges allocated to that class, so that no excess spread exists. Therefore, any structural feature that generates additional excess spread will create a measurable benefit to the senior certificates. The following example should help illustrate the economic benefit of redirecting subordinated class finance charges to excess spread and, ultimately, senior certificates. Assuming that yield on the portfolio would generate $1,000 per month in finance charges and class A represents $90,000 and the collateral invested amount is $10,000, the collateral invested amount would be allocated 10/100 or 10% of the $1,000 finance charge collected, or $100. If the certificate rate payable to the collateral invested amount were 6%, monthly interest allocable to the collateral invested 58
    • Cash Flow And Structural Analysis For Credit Card Receivables amount would represent $50 ($10,000 multiplied by 6%/12). In a revolving period scenario, diverting this $50 of CIA finance charges to excess spread would produce 0.7% of additional benefit annually to the senior certificates ($50/$90,000 multiplied by 12). These additional amounts are then available to cover any unpaid class A’s interest, servicing fees, and defaults. Standard & Poor’s, however, generally evaluates transactions under performance stresses associated with a rapid amortization period. Under this more conservative scenario, excess spread has evaporated to zero while losses increase. This causes two things to happen simultaneously: the senior certificates will amortize and be paid down by monthly principal payments, and the collateral invested amount will be written down for unreimbursed series losses. The more quickly the CIA is written down, the less benefit it can convey to the class A and B certificates. Summing each of the monthly benefits to the senior certificates based on the current size of the collateral invested amount will more accurately capture the total economic benefit available to the senior certificates from subordination of collateral invested amount monthly interest. Principal Revolving Period In the revolving period, principal collections from cardholders are allocated between the seller and the investor interest, pro rata. The investor portion of principal collections is then reinvested in new receivables that arise in the accounts already conveyed to the trust. Principal cannot be used to pay down the investor interest during the revolving period, including the collateral interest, unless the actual credit enhancement exceeds the required enhancement. In that case, the collateral interest is allowed to be paid down to a required level that will never be below an absolute floor amount. Amortization Period At the end of the revolving period, the numerator of the ratio used to allocate principal to the investor interest freezes; that is, it is not allowed to decrease. The numerator will equal the size of the investor interest at the end of the revolving period. However, the denominator may float each month to equal the greater of the following: I The principal amount in the trust, and I The sum of the numerators for all series in the trust. Although the certificates are amortizing, the allocation percentage will remain fixed. This will amortize the certificates more quickly than a pro rata allocation of principal, shortening the period of time that the certificates are exposed to losses on the underlying assets (see Fixed Principal Allocation Upon Seller Insolvency). The fixed principal allocation feature provides benefit to all certificateholders. Standard & Poor’s Structured Finance I Credit Card Criteria 59
    • Credit card structures are typically sequential pay structures: the class A certificates are paid in full before the class B certificates are paid, and then payments are made to class C. One exception to this sequential structure occurs during a controlled accumulation or a controlled amortization period. During either of these periods, principal allocated to the collateral interest may be used to amortize it, subject to a floor of 3% of the initial investor interest. If the transaction includes a cash collateral account and the transaction is in one of these two periods, the cash collateral account may be reduced to 1% of the initial investor interest. If both a collateral invested amount and cash collateral account are used as enhancement, a weighted average of 3% and 1% will be used as a floor. Fixed Principal Allocation Upon Seller Insolvency. As mentioned above, at the end of the revolving period, the investors’ share of principal payments will be governed by a fixed allocation percentage. As principal is repaid to investors, their actual percentage participation in the trust is likely to decrease and, therefore, become smaller than the fixed percentage. The pooling and servicing agreement generally provides that if an insolvent seller is unable to transfer receivables that were created after the bank’s insolvency, then collections on all receivables (both pre-insolvency and post-insolvency) will be paid first to the master trust until all certificates are retired, and then to the seller. If such allocations are prohibited, the bank will apply collections on each account to that account’s oldest balances. The oldest balances are the pre-insolvency balances that have been transferred to the trust. This provision is commonly referred to as the FIFO allocation. There is insufficient legal precedent to conclude with certainty that the FDIC, acting as receiver in the event of a bank/seller’s insolvency, would comply with the FIFO allocation mechanism instead of simply allocating collections based on a pro rata split between the certificates and the seller’s interest. If allocations of principal were made on a pro rata basis between investors and the seller, certificateholders would be paid more slowly. This would subject them to risk for a longer period of time. There are many reasons why Standard & Poor’s believes that the FDIC would be unlikely to challenge the enforceability of the FIFO provision. First, if the receiver successfully challenged the FIFO allocation, the payout to investors would be slower and, as a result, the assets would be encumbered by a lien for a longer period of time. In addition, a successful challenge would not necessarily increase the creditworthiness of the receiver’s participation in the pool, because achieving an earlier payout for the receiver will not reduce the credit risk of the assets. Finally, since credit card receivables are high-yielding assets, the FDIC would not incrementally benefit under a scenario of accelerated receipt of collections. It would be a great administrative burden for FDIC to change the FIFO allocation provisions. FIFO is very easy to apply because it allocates cash flow on an aggregate 60
    • Cash Flow And Structural Analysis For Credit Card Receivables basis, and not on an account-by-account basis. If the receiver decided to apply col- lections based on something other than the FIFO formula, each account balance would be flagged as of the insolvency date and all principal collections on each account would be applied to pre-insolvency balances (which are held by the trust) before being returned to the seller. Although this method may more accurately reflect the actual percentage participations in the pool, the costs associated with the accounting would seem unjustified in an expected scenario when weighed against the marginal benefit gained by the receiver. Also, the investors would most likely be paid in full by the time necessary accounting and system changes were completed, since for most trusts, it takes no longer than eight months for investors to be paid in full once a deal enters its rapid amortization period and collections are allocated based on a fixed percentage. Required Enhancement Freezes. If a deal enters amortization as a result of a payout event, or due to a draw on a cash collateral account, or because of a reduction to the collateral interest, the credit enhancement will be “frozen” and will not be allowed to be reduced until the rated certificates are paid in full. Shared Principal Collections. Most master trusts have the ability to share principal collections among series. Series that are in their revolving periods do not need principal collections to amortize their investor amounts. Series that are not in need of principal collections will share their allocation of principal collections with other series that are either amortizing or accumulating principal before a bullet maturity. The ability to divert cash flow from many revolving series to a few nonrevolving ones helps make principal payments more predictable and readily available for series that need principal. The sharing is usually accomplished by paying each series with insufficient principal collections proportionately, based on the size of the shortfall. Controlled Accumulation Or Amortization. To make principal payments to investors more predictable, issuers have structured transactions with controlled amortization or controlled accumulation periods. The latter helps the issuer pay investors a lump- sum payment, or bullet, on an expected payment date. Ordinarily, the controlled accumulation or controlled amortization period starts one year before the expected payment date and equal and fixed principal amounts (“controlled amounts”) are either deposited into a trust account or paid directly to investors. Any principal payments in excess of the controlled amount are either shared by other series with principal payment shortfalls or paid to the seller. If the issue is structured with a controlled accumulation period, a principal funding account (PFA) is established. The servicer deposits the controlled amount in the account each month until the earlier of the bullet maturity date or the occurrence of a pay- out event. In either case, all cash on deposit in the principal funding account is used to pay down the class A certificates. Standard & Poor’s Structured Finance I Credit Card Criteria 61
    • Transactions with a PFA feature include reserve accounts to cover negative carrying costs while the certificates are outstanding. Since the finance charge allocation formula allocates no finance charge collections on the portion of the invested amount that is backed by cash in the principal funding account, shortfalls due to negative carry may occur. Negative carrying costs may arise because cash in the principal funding account can only be invested in high-quality, short-term investments, which may yield less than the interest rate on the certificates. The size of the required reserve fund deposit depends on the difference between the rate needed to pay certificate- holders and the reinvestment rate assumption of 2.5% used for cash on deposits. To cover negative carry risk, a typical deal needs a reserve fund sized to 50 basis points of the initial aggregate invested amount. This sizing of the required reserve account amount assumes an extremely conservative scenario when the PFA is close to being fully funded and the negative carry risk is the greatest. Standard & Poor’s may allow other ways for a deal to cover its negative carry risks. Negative carry shortfalls may be covered by a letter of credit or by allocating the seller’s share of collections provided the seller is rated at least ‘A-1’. Variable Accumulation Periods. Although an accumulation period is typically scheduled to start one year before a bullet maturity date, the servicer may elect to delay its commencement if, according to a formula based on payment rate assumptions as outlined in the pooling and servicing agreement, the principal-sharing trust will generate enough principal in future months to fully pay certificateholders by the expected maturity date. The parameters used by the servicer to estimate future principal collections include more recent payment rate behavior and the number of series that are expected to share principal receivables with the maturing one. Postponement of the start of a variable accumulation period can not be delayed beyond one month prior to the class A’s expected maturity date. Paired Series. Some transactions allow the issuer to use the principal of an amortizing series to fund a new series, called a paired series. Issuing a paired series gives issuers an alternative way to finance what would otherwise be an increasing seller’s interest. To accomplish the simultaneous winding down of one series paired with the funding up of a new series, an issuer can elect to adjust the numerator in the principal allocation percentage and, therefore, alter allocation between outstanding series in the trust. Adjusting the numerator primarily affects the tail of the transaction, which normally begins with the end of the revolving period and ends with the series termination date. Adjusting the numerator changes the fixed percentage allocation and potentially lowers the percentage of principal that is distributed to the amortizing certificates. Under this scenario, Standard & Poor’s will measure the series termination date from the last date that the principal allocation percentage can be adjusted, which is typically the expected final payment date. Series that allow for the adjustment of the principal 62
    • Cash Flow And Structural Analysis For Credit Card Receivables allocation percentage will usually have later series termination dates than series that do not allow for this adjustment. Series Termination And The Credit Rating Although each deal incorporates an expected payment date, Standard & Poor’s rating addresses the return of principal not by the expected payment date, but by the series termination date, which typically is two to five years after the expected payment date. As Standard & Poor’s rating addresses the return of principal by the series termination date, analysts must assume the length of the amortization period is extended to the latest possible date allowed under the documents and assess whether or not the lengthening of the amortization period jeopardizes payment to investors by the series termination date, its final legal maturity. The amortization or accumulation period is assumed to start after the last possible day of the revolving period. In the case of a variable accumulation period that is scheduled to start 12 months before the expected payment date, but may be delayed until one month before that date, analysts will assume that the end of the revolving period will occur at the latest possible date; that is, one month before the expected payment date. Standard & Poor’s runs cash flows that stress the length of the amortization period to determine a legal final payment date on which investors must be paid the full out- standing principal balance. Unlike stress credit runs, under a stress termination case, yield is assumed to rise such that the fixed payment rate will represent a much larger payment of interest, and less payment collected will be applied as a reduction of principal. At the same time, payment rates are run at slower rates, similar to the rates used in the enhancement stress scenarios. Charge-offs are assumed to be low, so that draws on credit enhancement are not used to return principal to investors, causing the investors’ principal balance to be reduced more quickly. All of these factors have the effect of lengthening the amortization period. The series termination dates of most bank card transactions are between 24 and 48 months after the end of the revolving period. Standard & Poor’s Structured Finance I Credit Card Criteria 63
    • Legal Considerations For Credit Card Receivables S tructured finance ratings are based primarily on the creditworthiness of isolated assets or asset pools, whether sold or pledged to secure debt and without regard to the creditworthiness of the seller or borrower. This section discusses the critical legal issues surrounding credit card securitization including insolvency of the issuer, special-purpose entity requirements, first priority interest or true sale transfers of receivables into the trust, and perfection of the trustee’s interest in the receivables once transferred. While this discussion focuses on the major legal concerns found in most structured financings, it also describes legal criteria unique to credit card transactions, especially those issues related to securities issued from a master trust. General Overview Structured financing seeks to insulate transactions from entities, such as credit card account originators, unrated or rated lower than the rating they wish to obtain for their ABS. Standard & Poor’s worst-case scenario assumes the bankruptcy or insolvency of each transaction participant that is deemed not to be a bankruptcy-remote entity or that is rated lower than the transaction. Standard & Poor’s resolves most legal concerns by analyzing the legal documents and, where appropriate, receiving opinions of counsel that address insolvency and other issues. Understanding the implications of Standard & Poor’s assumptions and its criteria enables an issuer to anticipate and resolve most legal concerns early in the rating process. Credit card receivables are originated by banks or nonbank corporations, such as bank holding companies or retailers. Some of the legal issues raised by credit card transactions differ depending on whether the originator/seller of the credit card receivables is a corporation or a bank (and, therefore, not subject to the U.S. Bankruptcy Code). When the originator/seller is a nonbank corporation, as a general matter, a pledge of collateral by the originator/seller would not ensure that the creditor would have timely access to the collateral if the pledgor were to be the subject of a proceeding Standard & Poor’s Structured Finance I Credit Card Criteria 65
    • under the U.S. Bankruptcy Code, 11 U.S.C. Although a creditor ultimately should be able to realize the benefits of pledged collateral as a matter of law, several provisions of the Bankruptcy Code may cause the creditor to experience delays in payment and, in some cases, receive less than the full value of its collateral. Under Section 362 (a) of the Bankruptcy Code, the filing of a bankruptcy petition automatically “stays” all creditors from exercising their rights with respect to pledged collateral. The stay would affect creditors holding security interests in any collateral pledged by a borrower that has become a debtor under the Bankruptcy Code. Although a bankruptcy court could provide relief from the stay under certain circumstances, it is difficult to estimate the likelihood of such relief from the stay. Moreover, in most cases, it would be difficult to estimate the duration of the stay. Similarly, under certain circumstances, a bankruptcy court can permit a debtor to use pledged collateral to aid in the debtor’s reorganization (Section 363) or to incur debt that has a lien on assets that is prior to the lien of existing creditors (Section 364). Under Section 542, a secured creditor in possession of its collateral may be required to return possession of such collateral to a bankrupt borrower. As a result, when a seller/originator of credit card receivables or any intermediary entity that is not bankruptcy remote is subject to the Bankruptcy Code, the existence of a strong asset pool to secure debt alone cannot determine the rating on such debt. The transaction structure must provide the means by which assets would be available to pay debt service in a timely manner notwithstanding the insolvency, receivership, or bankruptcy of the seller/originator or other nonbankruptcy-remote entity involved at any level of the transaction as transferor of the receivables. If the seller/originator is a bank, the provisions of the Bankruptcy Code do not apply to its insolvency proceedings, and under the Federal Deposit Insurance Act—which does not contain an automatic stay provision similar to that in the Bankruptcy Code—the FDIC would act as receiver or conservator of the financial institution. Although the automatic stay is not applicable, the FDIC has extensive powers, including the power to ask for a judicial stay of all payments and/or to repudiate any contract. To provide for greater flexibility in securitized transactions, however, the FDIC has stated that it would not seek to avoid an otherwise legally enforceable and perfected security interest so long as: I The agreement was undertaken in the ordinary course of business, not in contem- plation of insolvency, and with no intent to hinder, delay, or defraud the bank or its creditors; I The secured obligation represents a bona fide and arm’s-length transaction; I The secured party or parties are not insiders or affiliates of the bank; I The grant of the security interest was made for adequate consideration; and 66
    • Legal Considerations For Credit Card Receivables I The security agreement evidencing the security interest is in writing, was duly approved by the board of directors of the bank or its loan committee, and remains an official record of the bank. Based on such advice, if the issuance complies with the above conditions, the security interest granted by a bank should not be avoidable in the event of the bank’s insolvency. In addition, the FDIC has advised that a secured creditor of an insolvent bank under the supervision of the FDIC would not be stayed by the receiver from pursuing its remedies, and, upon a bank default, a creditor could foreclose on its collateral using commercially reasonable “self-help” methods, if certain conditions are met. In rating ABS higher than the rating of the issuer, seller, or borrower, Standard & Poor’s seeks to insulate the transaction from the consequences of the bankruptcy or insolvency of the issuer, seller, or borrower. This determination is made either: I On the basis that if the pool of assets supporting payments on the securities is owned by an entity, that entity is bankruptcy remote (thus, unlikely to be the subject of a bankruptcy or insolvency proceeding); or I In the case of banks, on the basis that a secured creditor that has a first priority security interest in the credit card receivables would not be prevented by the FDIC acting as receiver from using self-help remedies to realize on its collateral in a timely manner. In addition, for each entity involved in the transaction, all transfers of property and funds of the entity are evaluated to ensure that these transfers would not be deemed preferential transfers under the Bankruptcy Code and, in some instances, that they would not be deemed fraudulent conveyances under applicable state and federal laws. Bankruptcy-Remote Entities In transactions involving assets originated by nonbank corporations, Standard & Poor’s analysis relies on the fact that the entity to which the originator sells the receivables is deemed bankruptcy remote. Standard & Poor’s criteria seek to ensure that the entity is unlikely to become insolvent or be subject to the claims of creditors (who may file an involuntary petition against the entity). The following criteria would need to be met to ensure that such entity is a special-purpose entity (SPE) and thus bankruptcy remote: I The entity should not engage in any other business activities that might cause it to incur liability, other than those arising from the transaction itself. I The entity should be prohibited from engaging in any dissolution, liquidation, merger, consolidation, or asset transfer so long as the rated obligations are outstanding. Standard & Poor’s Structured Finance I Credit Card Criteria 67
    • I The entity should be restricted in the transaction documents or its organizational documents from incurring additional debt, other than debt rated by Standard & Poor’s as high as the rating on the issue in question, or debt that is fully subordinated to the rated debt and is nonrecourse to the issuer or any assets of the issuer other than cash flow in excess of amounts necessary to pay holders of the rated debt. I The entity should have at least one independent director on the board of directors. The consent of the independent director should be required in order to institute insolvency proceedings. I The parties to the transaction documents should covenant that so long as the rated securities are outstanding, they will not file any involuntary bankruptcy proceeding against the entity. The entity should also agree to abide by certain “separateness covenants” whereby the entity undertakes, among other things: I To maintain its books and records separate from any other person’s or entity’s; I Not to commingle its assets with those of any other entity; I To conduct its business in its own name; I To maintain separate financial statements; I To pay its own liabilities out of its own funds; I To observe all corporate formalities; I To maintain an arm’s-length relationship with its affiliates; I To pay the salaries of its own employees; I Not to guarantee or become obligated for the debts of any other entity or hold out its credit as being available to satisfy the obligations of others; I To allocate fairly and reasonably any overhead for shared office space; I To use separate stationery, invoices, and checks; I Not to pledge its assets for the benefit of any other entity; and I To hold itself out as a separate entity. If the SPE is wholly owned by a parent that is not bankruptcy remote, Standard & Poor’s will request an opinion of counsel to the effect that, in an insolvency of the parent, the SPE would not be substantively consolidated with the parent under applicable insolvency laws (for example, bankruptcy laws for Bankruptcy Code entities, applicable insurance laws for insurance companies, and applicable banking law for banks). Standard & Poor’s continues to monitor developments in banking and insurance law and evaluates the need for nonconsolidation opinions on a case-by-case basis. Transfers, Ownership, And Security Interest The second level of Standard & Poor’s bankruptcy analysis involves the evaluation of the nature of each party’s property rights and whether third parties (which may be unrated or are not bankruptcy remote) have retained rights that may impair the 68
    • Legal Considerations For Credit Card Receivables timely payment of debt service on the securities. Standard & Poor’s will look at each asset transfer and analyze whether the transfer is a sale or a pledge of collateral. In general, Standard & Poor’s criteria require that transfers from entities that are not bankruptcy remote (other than banks) be “true sales.” Standard & Poor’s will require opinions of counsel to the effect that, in an insolvency of the seller the transfer would be viewed as a true sale of the property by the seller, and, therefore, the property would not be viewed as property of the estate of the seller under Section 541 of the Bankruptcy Code or be subject to the automatic stay under Section 362 (a). For transfers of receivables by bankruptcy-remote entities or banks, Standard & Poor’s examines the documents to ensure that the transferee of the receivables, generally the trustee, has a first priority perfected security interest (FPPSI) in the pledged property and the proceeds thereof. Standard & Poor’s requires that proper steps be taken to perfect the security interest under applicable law. In general, filing Uniform Commercial Code documents (UCC-1) will be sufficient to perfect the sale or the grant of a security interest in credit card receivables. Standard & Poor’s will also require an opinion of counsel to the effect that the trustee has a first priority perfected security interest in the credit card receivables and other property (but not interchange) pledged to secure the rated issue. Credit Enhancement For any reserve funds or other credit support established under the documents, Standard & Poor’s will examine the transfers of funds deposited in such accounts. To the extent that monies other than proceeds of the rated securities are used for such funds, Standard & Poor’s may require one or more of the opinions listed above. Standard & Poor’s also may require an opinion that the funds transferred and the related debt service payments to the securityholders would not be recoverable as a preference under Section 547 (b) of the Bankruptcy Code or be deemed a fraudulent conveyance under state and federal laws. To the extent that a transaction relies on funds invested under an investment agree- ment with a rated entity or a guarantee, LOC, or insurance from a rated institution, Standard & Poor’s may require an opinion that the investment agreement, guarantee, LOC, or insurance policy is the legal, valid, and binding obligation of such institution, enforceable in accordance with its terms. To the extent the institution is a U.S. branch or division of a foreign institution, a foreign enforceability opinion also would be required, addressing the enforceability of the obligation against the foreign institution, among other matters. Standard & Poor’s also will review the investment agreement, guarantee, LOC, or insurance policy to ensure that there are no circumstances that would relieve the institution from its obligation to pay. Standard & Poor’s Structured Finance I Credit Card Criteria 69
    • Selected Specific Criteria In credit card receivables-backed transactions, criteria that have legal implications generally relate to the structure of the transaction (that is, bankruptcy-remote entities, credit support, and deal-specific structure). Criteria relating to the nature of the collateral will stem from Standard & Poor’s review, for each credit card issuer, of the underwriting policy, credit and collection policies, and form of credit card agree- ment and related documents governing the creation of credit card accounts and the receivables arising under such accounts. Based on the characteristics of the credit card receivables, Standard & Poor’s determines whether a transaction’s credit enhance- ment and seller’s interest is sized to appropriate levels given the portfolio’s risk of dilutions and losses. Criteria Related To Transaction Structures In general, credit card receivables-backed transactions are structured as revolving asset transactions. The legal analysis set forth below does not address legal issues related to commercial paper programs or commercial paper conduits that are backed by credit card receivables. Rather, it focuses on the typical credit card receivable term transactions. Standard & Poor’s concerns regarding the originator’s bankruptcy risk have been addressed in credit card receivables-backed transactions by adopting one of two types of structures, depending on whether the seller/originator of the receivables is a bank or a corporation (such as a retailer). If the seller/originator is a bank, it is not eligible to become a debtor under the Bankruptcy Code, and a direct pledge of the receivables to the trust issuing the rated certificates is sufficient to make Standard & Poor’s comfortable with the timely availability of the receivables to pay the holders of the rated securities, based on the advice of the FDIC that, in an insolvency of a bank, the receiver would respect a first priority perfected security interest in assets of the bank pledged to securityholders. The bank originating the receivables also could choose (for accounting, bank regulatory, or other reasons) to structure the transaction with the two-tier structure described below, and interpose an SPE between the bank and the trust, so as to remove the assets from the bank’s balance sheet. If the bank chooses the one-tier structure, the bank designates a pool of credit card accounts, the receivables in which will be transferred to a trust in consideration for the rated certificates and a retained interest in the trust assets. The bank then offers and sells the certificates. For this type of structure, Standard & Poor’s requires, at closing and for each addition of accounts, an opinion that: 70
    • Legal Considerations For Credit Card Receivables I The transfer of the receivables from the bank to the trust either constitutes a true sale or creates a first priority perfected security interest in the assets and proceeds thereof in favor of the trustee; I The receivables constitute accounts or general intangibles as defined in the UCC; and I The security interest of the trustee in the assets would not be subject to avoidance if the FDIC is appointed as a receiver of the bank. If the seller/originator of the credit card receivables is not a bank, the two-tier structure is used to isolate the receivables from the bankruptcy risk of the seller. This structure provides for an outright sale of the receivables to a bankruptcy-remote SPE and for the sale of the receivables by the SPE, or the grant of a first priority security interest in the receivables to the trust issuing the certificates. Under the two-tier structure, an originator of credit card receivables or its affiliate typically establishes an SPE subsidiary to which it contributes or sells all receivables existing in a pool of designated accounts as of a specified cutoff date and all future receivables created in such accounts (some transactions provide for an ongoing auto- matic sale of all the receivables in all the accounts existing and to be created by the originator). The SPE sets up a trust that issues the rated obligations and transfers the receivables to the trust in consideration for the rated trust certificates, a certificate to be retained by the SPE (or within its consolidated group) representing the transferor’s interest, a pari passu interest in the receivables held by the trust, and, in some cases, subordinated certificates that may or may not be rated. The SPE offers and sells the rated certificates (and, in certain circumstances, the subordinated certificates) to investors and uses the proceeds of the sale to pay the originator/seller the purchase price for the receivables transferred. Standard & Poor’s legal analysis examines the effects of the insolvency of the originator/seller on the transaction structure. In transactions in which the originator sells the receivables to an SPE that establishes a trust, Standard & Poor’s will request the following: I A true sale opinion for the transfer of the receivables from the originator/ seller to the SPE. The true sale opinion should state that the credit card receivables will not be property of the originator/seller’s estate under Section 541 of the Bankruptcy Code or be subject to the automatic stay under Section 362 (a) in the event of any bankruptcy of the originator/seller. I An opinion that the transfer of the receivables from the SPE to the trust either constitutes a true sale or creates a first priority perfected security interest in the assets and proceeds thereof in favor of the trustee. Standard & Poor’s also will request the opinions described in 1 and 2 to be delivered in connection with any subsequent transfer to the SPE and the trust of receivables in additional accounts. I If applicable, a “nonconsolidation” opinion stating that the SPE would not be consolidated with its parent in the event of bankruptcy of the parent. Standard & Poor’s Structured Finance I Credit Card Criteria 71
    • In some transactions, there may be several entities interposed between the trust and the originator of the receivables. In these transactions, Standard & Poor’s will examine each transfer of receivables and generally will request the following: I A nonconsolidation opinion concluding that the SPE would not be consolidated with its parent or the seller of the receivables. I A true sale opinion for each transfer of receivables in which the transferor is a nonbankruptcy-remote entity. I A true sale or first priority perfected security interest opinion for the transfer between the SPE and the trust. In some instances, because the value of the receivables purchased-which, to support the true sale argument, should be fairly reflected in their purchase price-is in excess of the amount of rated securities issued, the originator/seller, if it is the parent of the SPE, will contribute an amount of receivables equal to such excess to the capital of the SPE and/or the SPE may use a subordinated promissory note to cover that amount. In the cases where the originator/seller is not the parent of the SPE, the SPE will use the subordinated promissory note method. The subordinated note permits the deferral of the payment of a portion of the purchase price until the SPE has funds available for the payment (generally from distributions on the interest retained by the SPE in the trust assets). However, to the extent the amount of the subordinated note is greater than an amount representing expected losses on the assets sold to the SPE, the subordinated note may undermine the validity of the true sale analysis, as the originator/seller could arguably be said not to have fully divested itself of all rights in the receivables (one of the legal tests of ownership), and a court could view the holding of the subordinated note as a “financing” by the originator (secured by a pledge of, or lien on, the assets) incompatible with a true sale of the assets. Standard & Poor’s is concerned that the use of a subordinated note may suggest that the originator/seller has not transferred all of the risks and benefits of owning the assets because the originator/seller is entirely dependent on performance of the receivables or the assets in order to be repaid. Accordingly, Standard & Poor’s will evaluate the likelihood of repayment of the subordinated note. Standard & Poor’s requires that the subordinated note be shadow rated at an investment-grade level (taking into account defaults, but not dilutions, of the credit card receivables). Its analysis focuses on, among other things, the amount of equity that is contributed to the SPE and is available for payment of the subordinated note. This requirement offers Standard & Poor’s additional comfort that the risks and benefits analysis—because of the likely repayment of the subordinated note— would result in the transaction being deemed a sale. 72
    • Legal Considerations For Credit Card Receivables Criteria Relating To Collections On Collateral Most structured finance transactions do not explicitly look at the rating (or implied rating) of the servicer, so long as the servicer does not commingle funds, maintains them in eligible accounts, and remits such funds with reasonable promptness (generally within 48 hours) to the trustee. Standard & Poor’s evaluates, however, whether in the event of the insolvency of the servicer, there would be sufficient funds to pay the rated obligations in a timely manner. The filing of a bankruptcy petition against the servicer would place a stay on all amounts held on the date of the filing in a servicer account. Since these amounts would no longer be available, the transaction needs to cover the commingling risk through credit support. (Given the high number of obligors under credit card accounts that would have to be notified to make their payments to a lockbox, the option of establishing lockbox accounts is generally not used in credit card transactions.) Pass-Through Certificates For reasons generally related to the preference of credit card issuers for off-balance- sheet treatment of credit card transactions, the structure of these transactions involves in most cases a trust that will acquire the receivables and issue trust certificates. In addition, issuance of trust certificates permits greater flexibility when several series are contemplated. Master Trusts In some structures, Standard & Poor’s is asked to issue different ratings on several series of securities issued by a master trust. In a master trust, each certificate of each series represents an undivided interest in all of the receivables in the trust. If a lower- rated transaction defaults, it is possible that the SPE or the master trust and all higher- rated transactions will be forced into default. A court may view all transactions as assets of the issuer and seek to satisfy the holders of defaulted securities with excess cash flows allocated to the other transactions. Standard & Poor’s views the allocation provisions in the master trust as akin to an intercreditor agreement and, therefore, believes that a court would respect the allocation of cash flows to the separate series notwithstanding an insolvency of the SPE or the originator. Standard & Poor’s also will look for nonrecourse language in the pooling and ser- vicing agreement, as well as the rated securities to the effect that the rated securities are issued on a nonrecourse basis and payable only from the allocable portion of the proceeds of the trust estate pledged to the trustee and that the holders will not look to any other assets of the SPE to satisfy the debt. The rated securities should also Standard & Poor’s Structured Finance I Credit Card Criteria 73
    • state that they “do not constitute a claim” of the holder against the SPE transferor or the master trust in the event the pledged assets are insufficient to pay the holders. In addition to the opinions addressing multiple issuance problems, each transaction will require opinions, if any, that reflect the appropriate credit structure and transfer of receivables as set forth above. 74
    • Special Considerations For Private-Label Accounts For Credit Card Receivables I n addition to evaluating VISA and MasterCard portfolios, Standard & Poor’s also analyzes portfolios backed by private-label credit card receivables, assigning its first ‘AAA’ rating backed by private-label credit card receivables in 1988: Sears Credit Account Trust series 1988-A, class A certificates. This section provides a comparative analysis of Standard & Poor’s rating approach to private-label credit card portfolios and bank card portfolios. In particular, the focus here is on the different performance-variable stresses used and their impact on the credit analysis. The section concludes with a discussion of dilution coverage. Collateral Analysis Although private-label and bank credit card receivables share many similar charac- teristics, Standard & Poor’s private-label analysis reflects differences in, among other things, credit card utility, issuer motivation, and dilution experience. Standard & Poor’s rating approach is, generally speaking, similar for both products. For both types of collateral, cash flow scenarios are run that simulate the effects of a severe deterioration in portfolio performance. As in the case of bank cards, in the ‘AAA’ and ‘A’ scenarios, the model assumes a significant increase in portfolio charge-offs, as well as declines in portfolio yield and cardholder purchase and payment rates. When sizing credit enhancement levels, analysts consider the portfolio’s historical performance, the quality of the servicer, cardholder demographics, and the transaction structure. However, private-label cards exhibit some unique traits. The following are some important private-label considerations and their impact on credit analysis. Credit Card Utility And Purchase Rates When analyzing purchase rate assumptions for private-label and bank card portfolios, analysts rely primarily on the long-term senior unsecured debt rating of the entity Standard & Poor’s Structured Finance I Credit Card Criteria 75
    • that has underwritten the credit cards and the utility of those cards should the entity become insolvent. An entity with a high long-term unsecured debt rating will usually receive more purchase rate credit than a lower-rated entity because a highly rated company is more likely to survive adverse economic conditions and fund purchases in the future. If a company can fund additional purchases while one of its securitizations is under- going a base-rate rapid amortization, it will be able to partially offset the constriction of the trust’s pool of principal receivables and prevent the pool’s outstanding receiv- ables balance from declining as rapidly in the absence of new purchases. When a constant monthly payment rate is applied to this relatively stable, but incrementally larger, receivables pool, a larger principal cash flow stream results. This larger cash flow stream will pay out certificateholders more quickly, shortening the window of risk certificateholders are exposed to and reducing the credit enhancement required for the transaction (see chart 1). As described in Collateral Analysis And The Rating Process, the monthly purchase rates used in bank card cash flows range from 2% to 5%. The range is dictated by both the rating of the financial institution and desired rating on the certificates. Unlike most bank lenders, most retail lenders have low long-term senior unsecured debt ratings and, upon an insolvency, their credit cards would have little utility. Consequently, retail cardholders will not use the card toward new purchases. As a result, most retailers are given no purchase rate credit. Chart 1 Principal Repayment Under Various Purchase Rate Assumptions ($) 100 90 80 70 60 50 40 30 20 10 0 0 10 20 30 40 50 60 70 Month PR—Purchase Rate 76
    • Special Considerations For Private-Label Accounts For Credit Card Receivables The Purchase Rate’s Impact On Cash Flows The purchase rate assumption significantly affects cash flow modeling results, maturity determination, and ultimately, the required enhancement levels needed to support a transaction at its desired rating level. The impact of the purchase rate assumption is best illustrated with the curves shown in chart 1. All three curves in chart 1 assume a total monthly payment rate of 8%, a fixed certificate rate of 7%, a yield of 11%, and peak losses at 20%. Monthly purchase rate assumptions, however, differ for each curve. The cash flow run, which assumes a 3% monthly purchase rate, is retired by month 21 and results in a credit enhancement requirement of 8.25% (see table 1). If a slower monthly purchase rate of 1% is assumed, the required credit enhancement increases to 10.5% and the transaction does not pay out until month 31. Finally, if no purchase rate credit is given, the required credit enhancement jumps to 13% and the transaction never pays out due to the asymptotic nature of the curve. If a cash flow run is asymptotic, Standard & Poor’s has devised a methodology for quantifying credit enhancement, even though model results show that certificateholders are never technically fully paid. Once a series termination date has been decided upon, the outstanding certificate balance as of that date is added to the required credit enhancement amount. This ensures that the rated certificates will be adequately enhanced for the life of the securitization and that they will be retired by the series termination date. Retailer Motivation And Charge-Offs All retailers want to increase sales, and a retail credit card is often viewed as a tool to increase sales volume. In fact, charge account purchases typically represent 40%- 50% of retailers’ total sales. When the economy experiences a downturn, however, the issuer may be tempted to sacrifice portfolio credit quality in order to achieve other business objectives, such as sales volume targets. Since many private-label issuers typically judge charge-off rates as a percentage of sales volume rather than aggregate receivables, they have less incentive to keep charge-offs as a percentage of receivables low. Consequently, charge-off rates in retailers’ portfolios are generally higher than those of bank cards. Table 1 The Effect Of Purchase Rates On Enhancement Levels Months Credit % difference Purchase rate outstanding enhancement (%) from 3% MPR 3% MPR 21 8.25 — 1% MPR 31 10.5 27 0% MPR * 13.0 58 MPR—Monthly purchase rate. *Asymptotic. Standard & Poor’s Structured Finance I Credit Card Criteria 77
    • However, if charge-offs do increase, retail card portfolios are usually better equipped to compensate for losses with higher portfolio yields. Although bank card finance- charge receivable collections generally include both annual fees and interchange, bank card APRs are still usually lower, resulting in lower portfolio yield relative to retail cards. Consumer Behavior And Payment Rates Although bank cards often are issued by out-of-state banks to customers with no existing relationship with the bank, individuals who apply for a particular retailer’s credit card often have a preexisting relationship with the retailer. Thus, customer loyalty may have a positive impact on the performance of private-label credit card receivables. Nonetheless, a customer’s loyalty to a store and his desire to maintain a good relationship with it can be taken only so far. If a customer encounters tough economic times and has to decide whether to pay a VISA credit card or a private-label credit card, loyalty may not be the critical factor. If a customer fails to pay his private- label credit card bill, he loses the ability to charge at one store or chain of stores. This may be perceived as less serious than having credit denied at all the locations that accept MasterCard or VISA. Even if an obligor has a financially sound credit profile, continued usage of a retail card is not guaranteed once the retailer becomes insolvent. A store bankruptcy could cause an obligor to pay down a private-label card more slowly than a bank card, because a bank card has greater utility due to the millions of merchants that are part of the VISA and MasterCard associations. Bankruptcy of the retailer would likely diminish the cardholder’s incentive to repay his loan. For that reason, analysts assume that payment rates for private-label portfolios will be slightly slower than payment rates for bank cards. Dilutions A receivable dilution is any reduction of the receivables balance for any reasons other than cash payments or charge-offs. Retail card receivables are typically subject to higher dilution levels than bank card receivables because all of the retail card charges result from merchandise purchases that are subject to potential return. On the other hand, cash advances, payments for many services, and balance transfers, which make up a sizable portion of bank card portfolios, but not retail card portfolios, are not subject to return. Standard & Poor’s considers the magnitude and timing of dilutions when quantifying the potential dilution exposure a securitization may encounter during its life. Other factors that are considered are the nature of the merchandise and the store’s return policy. For example, securitized receivables from private-label cards of retailers that primarily sell big-ticket items such as jewelry or consumer electronics may experience 78
    • Special Considerations For Private-Label Accounts For Credit Card Receivables Table 2 Dilution Coverage—Enhancement Vs. Seller’s Interest Required seller’s Class Class size Rating percentage Class sizes when seller’s interest covers dilution risk A 90 AAA 8.0 B 10 N.R. — Class sizes when credit enhancement covers dilution risk A 82 AAA 0.0% B 18 N.R. — N.R.—No rating. Assumptions: 10% required credit enhancement for ‘AAA’; 8% required dilution coverage for ‘AAA’. greater volatility in returns and, therefore, greater fluctuations in trust principal balance than receivable portfolios from stores that primarily sell clothes. As stated in the section Trust Analysis And Pooling And Servicing Agreement, one of the purposes of the seller’s interest is to serve as an overcollateralization buffer against receivable dilu- tion. The minimum seller’s interest test is the most common way that credit card- backed transactions address dilution risk. If the actual seller’s interest were to equal zero, any subsequent dilutions would cause the certificates to be undercollateralized. In that instance, the seller would be required to make an adjustment payment to the trust in the amount of the dilution. If the seller fails to make an adjustment payment and also fails to add receivables to the trust to fully collateralize the bonds after the addition, the deal will enter rapid amortization. A few private-label transactions address dilution risk in a different fashion. In these transactions, although the actual seller’s interest may be greater than zero, the required seller’s interest equals zero, and dilution coverage is included in the first loss credit enhancement piece. Dilution risk is covered adequately in either way by implementing a minimum seller’s test or by combining required credit enhancement to cover both credit losses and dilution risk. For example, if analysts examined dilutions and concluded that a transaction needed 9% dilution coverage to achieve a ‘AAA’ rating, that 9% could either be in the form of a required seller’s interest or it could be incorporated into the first loss protection for certificateholders (see table 2). Standard & Poor’s Structured Finance I Credit Card Criteria 79
    • Special Considerations For Unsecured Consumer Loans T his section focuses on personal loans and installment contracts and how these loans compare to credit card accounts. Also discussed is the analytical framework used in rating these types on loans. In addition to describing unsecured loans and how the behavior of unsecured obligors differs from that of credit cardholders, this section also examines how an unsecured loan transaction differs from a standard card deal and how these differences affect Standard & Poor’s credit and structural analysis. Market Conditions Encourage Unsecured Lending Most issuers continue to search for ways to maintain or attract the best obligors. As a result, lenders seeking to increase or maintain portfolio growth appear more willing to approve loans to a wide spectrum of creditworthy obligors, either by expanding existing product offerings or by introducing new ones such as the unsecured personal loan. As is the case in the credit card market, telemarketing and direct mail continue to be the major channels used to acquire these new accounts. In addition, accounts are generated when customers apply over the phone. The unsecured consumer product offers a natural extension of lending for credit card and finance companies. In some cases, it permits originators to reach obligors already leveraged. For others, the new product allows a company to diversify from its core business while leveraging off its vast consumer lending experience. Penetration of the market with consumer loans further allows the company to increase market share. Still other consumer lending institutions see the installment loan business as a means of diversifying and extending product lines, cross selling, and expanding market share without cannibalizing the existing customer base. Credit card lenders accustomed to unsecured lending most often use this option to diversify their revenue streams. Retailers, especially those in the furniture business, offer the installment contract to help increase sales of big-ticket items. Mortgage brokers leverage their existing databases by identifying customers who are accustomed to Standard & Poor’s Structured Finance I Credit Card Criteria 81
    • tying their debt to the equity of their homes. For homeowners, in particular, the unsecured product is more attractive than a home equity line of credit because the approval process is quicker and no appraisal is required. Instead, if the loan is tied to the value of the home, the loan-to-value (LTV) is computed using the homeowner’s assessment of the value of his home and credit is established relatively quickly. In general, issuers tend to target those obligors who have demonstrated good pay- ment performance, as well as those who show a propensity to carry debt, but not at excessive levels. For the customer, the main attractions are a fixed monthly payment schedule and a higher credit line compared with a credit card limit. An unsecured loan appeals to customers who need additional funding for a specific large purchase, but do not want to pay a transaction fee or maximize their credit card lines. Also, unlike a credit card that accrues finance charges based on an index such as prime, the interest charged on an unsecured personal loan is typically based on a fixed rate, so that an obligor will know exactly how much is due each month. A Hybrid Product The unsecured consumer loan product is a hybrid between traditional secured consumer lending and traditional credit card lending. Unsecured consumer lending includes closed-end personal loans, installment contracts, and the 125%-135% LTV product that allows obligors to borrow up to 25%-30% above the value of their home. Unlike a mortgage or an auto loan, the loan is unsecured as the originator does not have a claim on the collateral to support the loan extended. Unsecured loans offer an obligor an opportunity to obtain a line of credit faster than obtaining a home equity line approval. Once approved, the unsecured amount is generally higher than an approved credit card limit. Obligors use these loans primarily for debt/bill consolidation, home improvement, medical expenses, educational expenses, vacation purposes, refinancing of debt, or one-time large, discrete purchases. Although the method of disbursement of funds varies, obligors typically receive a lump-sum check to the approved level that expires 60 days from issuance. Some issuers send the checks to a third party so that the obligor’s debts are paid off directly. Other programs offer an open-ended line of credit accessed through checks. In these instances, obligors must make a monthly minimum payment based on their outstanding balance; these payments are similar those made on an obligor’s credit card account or balance. Most of the credit agreements stipulate level monthly payments over the life of the loan, which will then amortize like a mortgage or auto loan. The product is generally a closed-end, fixed-rate loan with a fixed maturity and limited revolving behavior. Some loans may involve full revolving ability similar to the revolving behavior allowed on credit cards. Other loan programs strictly prohibit additional purchases and are, therefore, purely amortizing. These types of unsecured consumer loans are most similar 82
    • Special Considerations For Unsecured Consumer Loans to a mortgage or auto loan. Still others offer options of both loan types, and may involve quasi-revolving periods during which obligors are allowed to reborrow and subsequently redraw once the original loan partially amortizes. Although there is typically no open-to-buy line, once the loan is partially paid down, the borrower may reapply and redraw on the loan to its original approved limit. However, unlike with a credit card, redraws up to an approved limit are not automatically granted. Rather, the customer’s creditworthiness is generally reassessed at the time of the new request, and the application goes through the underwriting process as if a new application had been submitted. Three Categories Of Unsecured Consumer Lending Although unsecured consumer lending may seem homogeneous among lender programs, subtle differences do exist among the products. To date, Standard & Poor’s has reviewed unsecured consumer loans that can be broadly classified into three categories: fully amortizing loans, revolving loans, and partially amortizing loans. Fully amortizing loans are one-time loans disbursed to the obligor in a lump-sum payment. The obligor does not have an open-to-buy line beyond the current outstanding principal balance of the loan. Rather, obligors agree to make monthly payments until the outstanding balance is paid off. This type of loan typically has a fixed payment schedule and a fixed term, although in some cases extensions are permitted. Prepayments on such amortizing loans are allowed. However, prepayment activity is usually minimal, and prepayments are similar to mortgage prepayments. In a low interest rate envi- ronment, prepayment activity may increase, but only if alternative financing at a lower rate is available. Revolving loans are most similar to credit card loans. In both cases, obligors are approved for a defined credit line and may draw on the line anytime the account is open. Unlike a straight amortizing or a partially amortizing loan, an obligor of a revolving loan may decide not to utilize 100% of his approved credit line immediately after the loan is approved. Rather, a revolving customer will draw upon his credit line based on his current needs. The obligor may also pay down his outstanding balance and then redraw amounts up to his original credit line anytime and without reapproval from the lender. Partially amortizing loans combine characteristics found in both amortizing and revolving loans. A partially amortizing loan is initially a fully amortizing loan. However, as the customer develops a positive payment history, the lender may approve redraws on the same account, but only up to the loan amount originally approved. This type of loan amortizes, but before amortizing to a zero balance, the customer may request additional advances similar to the way in which a customer would redraw on a line of credit in a purely revolving loan. However, because redraws are limited, this loan Standard & Poor’s Structured Finance I Credit Card Criteria 83
    • cannot be labeled a pure revolving loan. When a request for a redraw is granted, the lender is, in essence, refinancing the loan and reevaluating credit risks, but doing so under the same loan account. Unsecured Consumer Lending Versus Credit Card Lending Even in instances in which the unsecured consumer loan revolves, there is a difference between a revolving unsecured consumer loan and a revolving credit card. A credit card is purely a revolving loan for which an obligor is given a line of credit that can be drawn upon or paid down at any time. Conversely, unsecured consumer loans are more likely to amortize in some fashion. Typically, a credit card obligor does not utilize his card up to his limit immediately after approval; although in cases where the obligor has used the new card for a balance transfer, this may not always be true. On the other hand, most obligors of unsecured consumer loans receive cash advances on loans up to the approved credit line on the first day the loan is approved. A credit card obligor draws on his credit line when he makes direct purchases from merchants. In return, merchants will shift customers’ credit risk to the credit card company and compensate the credit card issuer for absorbing the risk in the form of an interchange fee. In exchange for the right to keep an outstanding loan balance monthly, obligors must pay finance charges and annual fees. Credit card users are also entitled to a grace period of approximately 25 days from the date of loan origination before the outstanding balance begins accruing finance charges. An obligor of a revolving unsecured consumer loan, however, typically draws on his credit line by using checks, which, when cashed, are drawn from lender’s funds. Therefore, when an obligor makes a purchase from a merchant, the merchant is not charged an interchange fee. In addition, there is no grace period for purchases made with disbursements from an unsecured loan. Therefore, revolving unsecured consumer loans are generally not used for small purchases or subject to convenience usage. As a result, although both of these loan types revolve, an obligor of a revolving unsecured consumer loan will exhibit much lower revolving activity than a credit card user. Characteristics Of Unsecured Consumer Loans Charge-Offs The average term of unsecured loans is typically four to seven years, with an average balance of between $10,000 and $20,000, although the terms can be shorter and the amounts lower, as they sometimes are, for example, in furniture retail contracts. Average yields typically are not significantly different from yields found in general- purpose card trusts, although in cases where the product is used for bill-consolidation 84
    • Special Considerations For Unsecured Consumer Loans purposes, yield on the unsecured product is lower compared with its credit card product counterparty. Since the product terms vary, charge-off numbers range widely among issuers and are affected by factors such as the targeted obligor, the issuing entity, and the specific characteristics of the loans. Also, the loss curves for unsecured consumer loans are longer than credit card loss curves, although the exact shape of the curve will vary depending on the remaining term of the loan. Still, credit card losses typically peak between month 18 and month 24 following origination. In contrast, a comparable revolving unsecured consumer loan with no defined maturity will experience a peak level of losses past month 24. Payment Rates Payment rates for the unsecured product are much lower than they are for typical credit card portfolios for which principal payment rates are generally constant, assuming card repurchases are equal to principal payments. This may be because utility usage is limited compared with a credit card. Since there is often no open-to-buy line, there is little benefit to an obligor for paying down an unsecured consumer loan quickly. Unless an obligor intends to refinance the loan, there is little incentive for an obligor to prepay. Additionally, most obligors become accustomed to making their monthly minimum payment. As a result, prepayments on this product are often negligible. However, unlike a revolving credit card where the obligor carries an outstanding balance that fluctuates monthly, since some of the unsecured loans are either truly amortizing or quasi-amortizing, it is natural that the payment rate increases as the loan seasons. Early payments represent mostly interest costs. However, as the loan amortizes, principal payment will represent a larger part of the payment. For a $10,000 loan with a maturity term of 38 months, assuming no prepayments, the payment rate is equal to 2.5% at month six, but grows to roughly 46% by month 34. However, payment-rate increases over time occur only if the original terms of the loan are not changed. If the loan is extended for any reason or if the obligor is permitted to reborrow, payment rates cannot be assumed to increase in the same manner as if the loan amortizes. Nonetheless, in general, payment rates for more seasoned portfolios will be greater than they are for portfolios dominated by new originations. Dilution A receivable dilution is any reduction of the receivable balance for reasons other than cash payment or charge-off. Dilutions are typically lower for the unsecured product than they are for either a retail or bank card because most of the proceeds from the unsecured loans are used as cash advances or for services rendered that are nonreturnable. Although dilution, in general, is relatively low in unsecured lending, dilutions due to fraud may be a concern in these transactions and are factored into the overall credit assessment. Standard & Poor’s Structured Finance I Credit Card Criteria 85
    • Analyzing Unsecured Consumer Loans The unsecured consumer product is not a true revolving product, although frequently borrowers are given the option to redraw. Because of that characteristic and because of the relatively short-term maturity inherent in the product, most issuers have elected to structure deals backed by the unsecured product utilizing a master trust structure that includes a revolving period. However, due to the nuances of the unsecured product, the traditional stresses used in Standard & Poor’s credit card analysis of yield, pay- ment rate, and purchase rate must be adjusted. Instead of running the stress yield at the regulatory cap, a less severe stress is often used. More credit is given to the yield on the portfolio at the time of closing, because once an installment loan is originated, the interest rate is fixed and will not change even upon the subsequent passage of a regulatory legislative cap. However, full credit is not given to cutoff date yield, because new accounts and receivables subject to a regulatory cap may be added after closing and those additions would depress yield. Also, in most cases, the yield is not as high as the yield on credit card portfolios because a portion of credit card customers will use unsecured consumer loans to realize savings by consolidating higher interest rate credit card debt. The payment rate assumptions are perhaps the most difficult to analyze for this type of asset. Vintage analysis of repayment trends in this product validates the positive correlation between the age of the accounts and the rate of payment. In the absence of any reborrowing by the obligor, principal repayments are expected to accelerate over time due to the amortization feature of unsecured installment loans. However, the ability to modify and extend, as well as the option to reborrow, makes the deter- mination of the payment rate more difficult. The payment rate, in some cases, may be negative if reborrowings exceed the payment rate: the higher the reborrowing percentage, the lower the net payment rate. Any subsequent advances granted are considered reborrowings. As the reborrowing percentage increases, more receivables are generated, but the net effect on the static pool will be a lower payment rate. Also, if an extension or a request for additional borrowings is granted, the customer’s monthly payments typically remain unchanged, but the final maturity of the loan is extended and the payment rate is lowered. Each additional advance posted will cause the maturity date of the aggregate balance to extend. As discussed in Collateral Analysis And The Rating Process, monthly purchase rates used in bank card cash flows range from 2% to 5%. The range is dictated by both the rating of the financial institution and the desired rating on the certificates. Like most retail lenders, unsecured consumer lenders have no or relatively low long-term senior unsecured debt ratings, and their loans will have little utility once the issuer becomes insolvent. In addition, even for revolving unsecured loans, repurchases are lower compared with credit card repurchases. Furthermore, there are no repurchases 86
    • Special Considerations For Unsecured Consumer Loans allowed for the straight amortizing unsecured loan. As a result, there is typically no purchase rate credit given in the unsecured product analysis. In fact, in most scenarios, a zero prepayment scenario with no new purchases or redraws is assumed. Structural Adjustments Because of the unique characteristics of the unsecured product, when securitizing this product, adjustments are made to the standard credit card structure. One adjustment is necessitated because of the inclusion of a quasi-amortizing asset in a revolving master trust structure. In deals with semirevolving features, some programs have included a semirevolving period that allows for the addition of new receivables during this period. However, during this time, amortization may still occur, even if the deal is in an interest- paying period, if the payment rate is lower than new purchases. If this occurs, the amortization of principal may be shared pro rata among outstanding certificates. If the issuer elects to isolate investors from receiving any principal payment during the revolving period, the issuer may issue a variable-funding certificate (VFC) to absorb any unwanted principal collections. Another variation on the standard credit card structure is the base rate trigger. The concept of a base rate trigger protects a deal from adverse conditions. In a typical credit card deal, if yield is no longer sufficient to cover losses and other trust expenses, and that insufficiency exists for three consecutive months (excess spread is less than zero), the base rate test is violated and the deal enters into early amortization. In most unsecured loan transactions, a variation of the typical base rate test is used. In place of a typical base rate trigger, an amortization payout event is linked to any credit draws either through a decline in the required overcollateralization amount or a write-down of the most subordinated class. For example, if overcollateralization is below 4% on average for three months, or if, on average over three months, the daily balance of class D (in a class A/B/C/D structure) is not equal to its required class D invested amount, the deal will enter rapid amortization. In either case, whether the base rate is tied to the overcollateralization amount or the sizing of the most subordinate class, the trust is protected when yield is no longer sufficient to cover losses and other trust expenses and credit support is no longer adequate to support the rated certificates. As is the case in a standard credit card master trust, during a rapid amortization period, all principal collections are used to pay the certificates sequentially. Standard & Poor’s Structured Finance I Credit Card Criteria 87