Structured finance: The credit card trick

AS THE YEAR draws to a close to bite so the nightmare caused by the sub-prime crisis gets ever more scary. The post-summer rally following the Federal Reserve’s rate cuts is now a distant memory as the credit/liquidity crisis takes on yet more twists and turns. Banks have revealed more losses – largely a consequence of the rating agencies announcing fresh downgrades of asset-backed bonds and ABS CDOs, and from further deterioration in the market value of those securities. The level of dislocation means that sub-prime is more than just a bad dream; fears for the health of the biggest financial institutions are growing and the odds of a US recession are rising fast. Yet an amazing disconnect has emerged between mortgages and the other structured finance stalwart asset class of US consumer credit – credit cards.

On the one side sits sub-prime – the most tainted term and asset class in financial markets. Securities that contain any sub-prime collateral are shunned, even by vulture funds. The financing of an entire class of borrowers is under threat, forcing policymakers to rush to find new ways of funding mortgages. On the other side is credit card securitization, where volumes are booming. Furthermore pricing – although dramatically wider than a year ago – is reasonable and improving. Incredibly, considering the background in the housing market, the underlying collateral appears sound.

The increase in credit card volumes in 2007 is impressive. According to Barclays Capital, credit card ABS issuance totalled $15.2 billion in October, the highest monthly total ever. Year-to-date, issuance is a record $83.4 billion, a 41% increase on the same period a year ago. Compare this with the $65.5 billion for the whole of 2006 and $57.9 billion for 2005. For the casual observer this rapid increase might set alarm bells ringing. Why would any US consumer credit asset class be booming when mortgage-backed debt is in so much distress?

When they think about a downturn in consumer credit risk, most people equate that to a situation where rising unemployment causes a recession. An example is the collapse of the auto industry and the devastation that caused to Detroit. Following job losses, people’s incomes fall, they default on their credit card and car loans – and ultimately their mortgages.

"A number of borrowers have over-extended themselves financially by taking high LTV loans often taken with interest rate bets – adjustable rate and interest only structures," says Michael Zeltkevic, director in the finance and risk practice at Oliver Wyman. "You don’t see the traditional pattern where people default on credit cards, car loans and then their mortgages – you see the opposite. There are a high number of mortgages being defaulted on first. They (borrowers) are being somewhat rational, having taken a leveraged bet on home prices. As that is not working out, they understand that they are going to lose that home and are willing to walk away. The same borrowers are not defaulting on credit cards and car loans because they still have jobs. They need to pay for groceries and they need their cars to go to work. It’s not an unemployment-driven crisis, so far; it’s a collateral value-driven issue where people have used leverage to invest in real estate. As that is unwinding, that is putting a lot of mortgage performance issues to the forefront."

The belief that credit cards will be the next asset class to fall is widely held; anecdotal evidence suggests house owners are using their cards to pay their rising mortgage repayments because, traditionally, borrowers pay mortgages before other loans. But ABS specialists do not seem to share this view.

"While investors are concerned about US consumer credit overall, few people are worried about the health of the large credit-card ABS platforms," says Martin Attea, vice-president, Lehman Brothers. "There have been a lot of ABS credit card deals done over the past couple of months and volumes are up over 2006. There were a lot of maturing deals and so supply was always going to be substantial. Issuers have been able to get good sizes done... and despite a fair amount of volume in September and October the market tightened."

Tightening new-issue spreads in the face of record volume is usually a positive sign of market sentiment. For instance, Citi did a five-year deal in September at a spread of 35 basis points, and Amex came along a month later and printed at 25bp. In the middle of November, pricing had eased but the point is clear. Investors are happy to buy credit card ABS, despite the febrile state of market participants’ minds.

Investors are sanguine

So why are ABS investors ignoring concerns about borrowers using their credit cards to make mortgage payments. This would be a worrying, if not perverse, reversal of recent history. During the latter period of US house price appreciation it was widely stated by economists that "Americans have been using their houses like ATMs". Comments like these were often made in reference to fears that static or falling house prices would hurt US consumer spending and therefore global growth. The jury is still out on those predictions but there appears to be a direct link between consumers’ rates of home equity extraction and the credit card sector. Strong activity in the former has supported the strong performance, and suppressed volumes, of credit card ABS – in addition to boosting US GDP.

US home owners turn to credit cards

Revolving consumer credit debt rises as home equity extraction falls

Source: Federal Reserve Board

According to Fitch, excess spread, which measures the profitability of credit card securitizations, trended upward in the third quarter of 2007. The three-month excess spread increased 35bp, from 7.16% in July to 7.51% in August, and an additional 14 bp, to 7.65%, in September. Excess spread is a slight 8bp below last year’s level but remains robust when compared with historical levels.