12/19/2008

Card Lenders Falling Into Cashflow 'Trap'

Banks may soon lose access to leftover cashflows that they typically pocket from their credit-card securitizations.

The cause: an ongoing deterioration in the performance of credit-card pools. As defaults continue to mount amid weakening economic conditions, many trusts are nearing the point at which they must "trap" incoming payments - that is, create special reserve accounts with capital that remains after bondholders receive routine installments.

Under normal circumstances, that money, or excess spread, would flow to the issuer throughout the deal's life as profits. But these are hardly normal times.

Cash-trapping mechanisms are designed to protect investors in credit-card securitizations from losses in the event that poor asset performance causes their holdings to unwind ahead of schedule. They usually kick in, on a graduated scale, when a pool's excess spread dips below a pre-determined level of 4-4.5% for three consecutive months.

As of the end of October, the average trust was barely above that point, at 4.51% according to S&P. That followed a dramatic drop brought on largely by rising defaults in the preceding months, from levels that usually ran above 7%.

It isn't clear which banks might be forced to trap cashflows, but most large-scale issuers of credit-card bonds are in the danger zone. Bank of America operates trusts whose excess spreads are below 4.5%, according to Fitch. J.P. Morgan oversees some pools with spreads below 5%.

What's more, widespread expectations are that excess spreads will keep dwindling, which fits in with warnings that a convergence of economic factors are causing credit-card performance to fade along with other types of consumer debt.

Rating agencies don't predict excess spreads, citing uncertainty over interest rates and the fact that lenders can manage their asset pools by changing cardholder rates and imposing fees. However, "we are expecting to see some excess-spread-trapping trigger rates hit within the next 12 months," S&P analyst Ildiko Szilank said.

The timing is unfortunate for issuers, as the global credit crunch has already left many of them starved for capital. Nonetheless, few industry players expect excess spreads to deteriorate to the 0% levels that would trigger early amortizations of securitization pools, and possibly lead to bondholder losses.

Even under a scenario in which unemployment rises above 9% in the second quarter of 2010, S&P believes that prime-quality bankcard securities will remain well protected. The rating agency expects the unemployment rate to hit 8.3% by the fourth quarter of 2009, up from 6.7% last month. Based on that projection, the agency says defaults on credit-card accounts could climb as high as 9% in late 2009 or early 2010, from 6.5% at the end of October.

Fitch shares S&P's view that investors are unlikely to face losses. The agency said in a Dec. 15 report that it ran several worst-case "stress" scenarios against a hypothetical asset pool and determined that bondholders remain safe. "While downgrades would certainly result from certain levels of stress, the rated classes would not come close to approaching principal or interest shortfalls," analysts wrote.

Industry participants also note that some credit-card lenders are raising interest rates for all borrowers in response to Federal Reserve regulations that would make it harder for them to punish delinquent customers, which could help boost their incoming cashflows. The Fed was set to approve the matter on Dec. 18, with a July 2010 implementation date.

Pricing of credit-card bonds is another matter. Such instruments are changing hands on the secondary market at their widest-ever spreads - 550 bp over Libor for 2-year senior paper - as investors express fears over whether borrowers will be able to pay their bills. Deutsche Bank analysts said in a Dec. 4 report that consumer bankruptcy filings have jumped 31% this year, to about 955,000.

Wachovia analysts expect the number of bankruptcies to rise to about 1.1 million this year, in part because of swelling unemployment figures.

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