Credit Card Asset-Backed Securities (ABS)
Refers to a type of security that is collateralized by credit card debt and is a type of fixed-income bond
What are Credit Card Asset-backed Securities (ABSs)?
This type of security is collateralized by credit card debt and is a type of fixed-income bond. They have an estimated, not a finalized, maturity date and are therefore considered to be unamortized.
They differ from mortgage-backed securities by characteristics, valuation, and cash flow, as do other types.
The COVID-19 pandemic hit the market disproportionately, as some securities that suffered the most were credit cards, travel, and entertainment related.
It is a fixed income bond backed up by the cash flow from credit cards. Fixed income securities are debt instruments that provide holders with regular interest payments and the principal at maturity.
Asset-backed securities are securities that are collateralized by a pool of assets (usually generated from debt instruments such as loans and leases). These assets are typically liquid but cannot be sold on their own.
Therefore, through a process of "securitization," the issuer makes the assets marketable to investors. Likewise, the issuer can improve their credit risk by getting shakier assets off their books.
As for investors, it is beneficial to buy these securities because they can provide a fixed revenue stream, allowing them to tap into more unconventional income-generating assets that are not available in other investments.
Some unconventional assets include cash flows from movie revenues, royalty payments, and aircraft landing slots. However, ABSs, backed up by credit card debt, are very popular.
Types of Asset-Backed Securities
There are various kinds of securities that are backed by assets. Below is a list of common types that investors interact with daily:
1. some consider Collateralized Debt Obligations (CDOs) to be separate investment vehicles from ABS. CDOs on a wider and more diverse range of assets, including other ABS and CDOs.
2. Home Equity is one of the largest categories of ABS. These types of loans are given to borrowers with subprime credit scores who did not qualify for a mortgage loan.
Mortgage Backed Securities are considered separate from ABS, and they predate them. They consist of principal payments, interest payments, and prepayments.
3. Auto Loan is another large category of ABS. They consist of monthly interest payments, principal payments, and prepayments (the payments are considered to be much lower than home equity abs).
4. Student Loans are collateralized by government student loans (which have a better repayment record and lower risk of default) or private student loans.
These types of securities are structured to mimic the cash flow of a typical bond. However, its maturity date is only estimated, not defined, because the underlying cash flow is highly variable.
Asset-Backed Securities are divided into three tranches: class A, B, and C. Class A (senior tranch) is structured to have an investment grade rating to make it attractive to investors and is typically the largest of the three.
Class B has a lower credit quality and, in turn, a higher yield than class A. Lastly, class C has a very poor credit rating; at times, it can be too low to sell to investors. Therefore, investors use these tranches to absorb their losses.
What is the Asset-backed Security Life Cycle?
Its life cycle is divided into two distinct periods after the issue: the revolving period and the amortization period. Additionally, its life cycle is characterized by its maturity date being estimated and not defined.
The revolving period is a phase in which the investors do not receive principal payments, only interest payments.
This enables the issuers to use the principal collections to buy new receivables, and it also allows the issuers to finance more short-term credit card loans.
Although the principal and interest payments are very variable over the security's life, the seller can increase or decrease interest to maintain the stability of the payments.
The amortization period is the final phase in which the investors get paid with principal collections. The length of this period is dependent on the monthly payment rate.
If the monthly rate is high, the excess principal collections are used to buy more receivables. On the other hand, if the monthly payment is low, the period could be extended.
Controlled amortization involves equal principal payments to investors over a specific period (usually one year). The amount of interest earned during this period declines with the principal.
Although the receivables vary over time, the interest absorbs different amounts to maintain a steady cash flow for the investors.
Controlled accumulation, on the other hand, involves the entirety of the principal payments being deposited into a trust account and held until maturity, when they will be distributed to investors. Until maturity, investors receive equal interest payments and final interest payments.
Lastly, early amortization occurs when the credit profile of security deteriorates due to the collateral value falling below the amount specified to maintain the security's current credit rating.
This results in "early amortization triggers" that divert the principal payments from the sellers to the investors to minimize risk by repaying them faster.
Cash Flow Allocations
Cash flow allocation transfers the interest and principal payments on credit card accounts throughout the ABS trust. Likewise, the process includes allocating cash flows to investors and sponsors, which is typically more complex than the former.
There are multiple methods for doing so, which include:
1. Groups
This method involves allocating cash flow between investor and seller interests. Additionally, the investor's interest is further divided into smaller sections that depend on the security characteristics.
2. Principal collections
The second method involves allocating the principal cash flows to series. As aforementioned, the principal is only given to investors during the amortization period. However, some have revolving periods whose principal is reallocated and shared with other series.
3. Finance charge collections and allocations
This method involves the allocation of interest on the outstanding balance and late fees, as those are the main collected cash flows of a credit card fund. It is regarded as the portfolio yield, expressed as a percentage of total receivables.
4. Principal discounting, interchange recoveries
This method uses a princess called "principal discounting." It temporarily boosts the portfolio yield and spread. More specifically, this method is used to avoid early amortization when the excess spread is significantly lower.
The Securitizing of Credit Card Receivables
Securitizing is the process of pooling together cash flows from debt and selling them to third parties in the form of securities. There are two structures for this process: the Basic Master Trust Structure and the Master Note Trust Structure.
1. Basic Master Trust Structure was established in the 1990s, which entails using trust as the vehicle for securitization.
It involves a credit card issuer pledging his or her accounts and receivables to a master trust. After that, the master trust sells it as a security to investors.
Its flexibility, which enables a rotating pool of assets to be integrated into one portfolio, is its key advantage. For example, credit card receivables and residential mortgage-backed securities are usually securitized using this structure.
The credit card issuer keeps an interest in the master trust, but the interest, principal collections, and defaults return to the bank.
2. Master Note Trust Structure involves backing bonds with a pool of revolving credit card accounts and receivables. This structure provides more flexibility for the bonds' maturities than the previous one.
As its issuers grow, they often end up with multiple master trusts, which require the issuers to issue a collateral certificate. The collateral certificate enables the owner to claim all the previous master trusts.
Credit Card Asset-backed Securities History
One of the earliest kinds was mortgage-backed securities (MBS), first issued in 1981 by Fannie Mae.
In the lead-up to that event, the government passed the Real Estate Investment Trust Act in 1960 to promote real estate investment. Additionally, Bank of America released the first private label pass-through in 1977.
In 1983, Freddie Mac issued the first collateralized mortgage obligation, a CDO type. MBS predates Credit Card ABS.
80% of the ABS industry, disregarding mortgage ABS, is a credit card, student loan, and home equity ABS.
This kind of security was first issued in 1987 and gained popularity as credit card use became more widespread. Since then, these securities have become the primary source of funding for the credit industry for unsecured customer loans.
In 2008, many investors experienced significant losses from CDOs and MBS, which led to a significant change in the regulations and practices in the credit market.
Recently, the COVID-19 pandemic has affected the credit market negatively. The issuance of ABS was down 25% in 2020 from the previous year as credit tightened during the crisis.
Its effect was disproportionate as the ABS related to credit cards, travel, entertainment, and retail suffered the most. This downturn can be attributed to various factors, including changes in consumer spending patterns, economic uncertainties, and the average debt by age. The latter, especially among younger age groups, significantly influenced the credit card market dynamics during this period.
Credit Card Asset-Backed Securities (ABS) FAQs
A credit card is regarded as a liability, not an asset because it does not increase an individual’s net worth.
This fact stands regardless of whether an individual is indebted or pays off their dues on time. The card still has a limit and can drain borrowers’ funds if they exceed the limit or do not pay back their debt in time.
They are considered a category of asset-backed securities because they are assets to lenders and can therefore be securitized to make more money.
Additionally, credit card asset-backed securities are considered assets because they are money-making securities that have the potential to increase an investor’s net worth.
Mortgage-backed securities are a separate category from ABS because they consist of pooling mortgages. On the other hand, ABS deals with pooling other kinds of assets like credit card debt, home equity loans, etc.
The latter can have different characteristics, valuations, and cash flows depending on the asset collateralizing it. Both have a repayment risk.
However, the repayment risk on MBS is higher. Likewise, ABS is involved in a type of risk called credit risk. However, these securities are structured so that the lower-tier tranches absorb most of the risk (which in turn gives them higher yields).
Most of these types of securities pay a floating rate coupon that is a specified number of basis points above a specified interest rate index.
The number of basis points tends to be inversely proportional to the security's credit rating, as with most fixed-income securities.
- They protect potentially risky loans. Risky loans get removed from the lender’s balance sheet by being securitized and sold to other investors, which minimizes the lender's risk.
- They provide extra funding that can be used to issue more loans or for other business purposes.
- They provide an alternative and more stable investment and portfolio diversification.
- They minimize default risk and other types of credit risks due to the security being collateralized by a pool of assets.
- There is a lack of due diligence since investors cannot research each underlying asset. Therefore, it can expose them to unforeseeable risks.
- The potential repayment risk can result in lower yields. The repayment risk occurs when borrowers repay their debt earlier than necessary, resulting in lower interest cash flows.
- There could be widespread potential for defaults during an economic turndown. If the underlying assets are of low quality, the risk of widespread default is higher, which can cause the security to suffer.
On the WSO website, there are courses available that teach you the methods investors use daily to evaluate the profitability of securities, such as the Valuation Modeling Course and the DCF Modeling Course.
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