What are Credit Card Asset-backed Securities?
Credit card asset-backed securities (ABS) are fixed income bonds that are backed by the cash flow from credit cards. As companies collect on credit card payments, interest, and fees, cash flows that fund the principal and coupon payments of bonds are collected. The popularity of these securities began in 1987 as credit card use becomes more widespread.
- The securitization of credit card receivables is the process of pooling together cash flow and selling it as securities.
- Credit card asset-backed securities are split into the revolving period and amortization period.
- Cash flow from credit cards is first put into a trust structure and then distributed to the investor and seller interest.
The Securitizing of Credit Card Receivables
Securitization is the action of pooling together cash flows from debt and selling it to third parties as securities. The securitization of credit cards began in the late 1980s as banks looked for new funding sources for credit cards.
Basic master trust structure
The basic structure was used for credit card securitization before 1991. The credit card issuer pledges the accounts and receivables to a master trust. The master trust then sells the securities to investors. The credit card issuer keeps an interest in the master trust and the interest, principal collections, and defaults return to the bank.
Master note trust structure
Also known as issuance trusts (IT), the master note structure backs bonds with a pool of revolving credit card accounts and receivables. The structure differs from the earlier one as it provides more flexibility in terms of maturities on the bonds.
As credit card ABS issuers grow, they often end up with multiple master trusts. When it occurs, the issuers issue a collateral certificate. The collateral certificate enables the owner to make a claim on all the previous master trusts.
Investor interest and seller interest
Investor interest is the principal amount owed to ABS investors. The seller interest is the residual interest in the trust that the credit card issuers are required to maintain. Seller interest is important, as it aligns the credit card bank with other investors as the banks themselves have a claim on the asset-based securities.
What is the Asset-backed Security Life Cycle?
Credit card asset-backed securities have two main periods after the issue. The two periods are the revolving period and the amortization period.
1. Revolving period
During the revolving period, investors do not receive principal payments. Instead, investors only receive interest. This enables issuers to use the principal collections to purchase new receivables. This period also lets the issuer finance short term credit card loans by using the principal amounts collected.
2. Amortization period
When the amortization period begins, principal collections are used to repay the ABS investors. Unlike corporate bonds, where principal payment is only made once, at maturity, the principal for credit card ABS are paid gradually over a period of time.
In a controlled amortization, principal payments are paid in equal amounts during the amortization period. On the other hand, in a controlled accumulation, principal payments are deposited into a trust account each month and held till the maturity date.
Cash Flow Allocations
Cash flow allocation is the process of passing principal and interest payments on credit card accounts through the ABS trust. It also includes allocating cash flows to investors and sponsors, which can be more complex.
Making groups is one of the methods of allocating cash flow. First, cash-flow is allocated between investor and seller interests. The investor interest is further split into smaller groups depending on the characteristics of the security.
Allocation of principal collections to series depends on the life cycle of ABS. As mentioned before, the principal is only given to investors during amortization periods. For ABS that are in the revolving period, the principal is reallocated and shared with other series.
Finance charge collections and allocations
The main fees collected by a credit card fund are the interest on the outstanding balance and late fees. When expressed as a percentage of total receivables, it is called portfolio yield.
Principal discounting, interchange, recoveries
Principal discounting is a process that temporarily boosts portfolio yield and spread and is used during times where the excess spread is significantly lower, to avoid early amortization. Recoveries are reported as part of finance charge collections and are included in the calculation of the portfolio yield. It is used when calculating excess spread.
An interchange is a fee paid to the bank that issued a credit card to compensate them for taking on credit risk. Credit risk is present as the bank grants the credit card user a grace free period in which they do not need to pay the amount they spent.
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