Credit Card Sector Faces Challenging Period Ahead: Moody's

Credit card performance deteriorated across all five metrics in August, as tracked by Moody’s Credit Card Credit Indices, which tracks over $435 billion of U.S. Bank credit card loans backing securities rated by Moody’s. The charge-off rate index continued to climb in August 2008 and is all but certain to surpass the peak rates following the previous recessions. Moody’s continues to have a negative outlook on the sector and believes that deterioration will continue into and throughout 2009.

Amid a stubborn, worldwide economic crisis and worsening collateral performance, the U.S. credit card industry is bracing for an exceptionally challenging period. Although the balance sheet strength and liquidity of the sector’s largest credit card issuers remains quite strong, the uncertainty and tempo of the turmoil will test even the stalwarts’ ability to adapt.

Credit Cards and the Macro Environment
The economy and credit markets continue to deliver bad news for the consumer sector. Key macroeconomic indicators of consumer performance, like consumer confidence and retail sales, are worsening. The unemployment rate, one of the biggest macroeconomic drivers of credit card delinquencies and charge-offs, is now 6.1% — the highest it has been in nearly five years. According to baseline economic forecasts by Moody’s Economy.com (MEDC), the unemployment rate is expected to continue to rise, peaking in the fourth quarter of 2009 at about 7.3%. Credit card charge-off rates will likely rise with the unemployment rate. Extrapolating from the MEDC forecasts, the Moody’s charge-off rate index would rise to approximately 8.5% – - well above the 7.1% post-recessionary peak in May 2003.

Revolving consumer debt fell in August for the first time in ten years. The Federal Reserve reported that revolving debt fell at a seasonally adjusted annual rate of -0.8%. The drop is probably attributable to a combination of consumers’ pull back in spending as well as some of the credit tightening measures card companies have made over the last several months.

The sustained credit crunch has constrained some issuers’ access to funding. Issuers that rely on continued access to the capital markets are subject to significantly higher spreads, tighter terms and lower investor demand — if they are able to access the market at all. With an expectation of worsening collateral performance in the months to come, Moody’s expects balance sheet strength and liquidity to become an increasingly important dimension to its credit analysis, especially for those issuers with limited alternative funding resources. Moreover, in this economic environment, the risks associated with a relatively weak funding profile may be compounded for those seller/servicers that also have relatively weak backup servicing arrangements.

Enter: Basis Risk
In recent weeks, basis risk (in this case, the difference between the Prime rate and LIBOR) has emerged as yet another significant challenge for card issuers. Since most issuers’ card portfolios are priced off of Prime while most of their securitized notes are priced off of LIBOR, the narrowing of these two indices has a direct and adverse impact on the margins between their assets and liabilities. The degree of narrowing is material — approximately 2.50% over the last few weeks. Ironically, the Fed’s recent move to ease interest rates by 50 basis points (and indirectly lower the Prime rate by the same) may only exacerbate this problem so long as LIBOR remains unusually high. In any case, if this narrowing persists, all else being equal, excess spread margins for the related credit card trusts will be significantly and suddenly reduced in the coming months.

A significant and sudden drop in excess spread comes at an exceptionally challenging time for credit card trusts. For virtually all issuers, excess spread has been steadily falling since January 2008 due mainly to rising charge-offs and falling yield. The excess spread index, which at 6.12% in August, is still above the long-term mean of 5.8%. Nevertheless, with the expectation of rising charge-off rates throughout the coming year, excess spread will erode further.

Excess spread, which is the yield less the expenses of the related securitized transaction (e.g., coupon, servicing fee, charge-offs), is an important gauge of collateral performance to investors of bonds backed by credit card receivables. It is essentially bondholders’ first line of credit protection, and for virtually all credit card ABS, if the three-month average excess spread falls below zero, then the related bonds begin to amortize ahead of schedule.

Game Changing Restrictions?
Complicating matters further are the proposals by the Federal Reserve and federal law makers which may restrict card companies’ ability to (among other things) re-price for risk. This change could further challenge issuers’ ability to manage yield. Also included in the proposals are changes that would force issuers to alter cardholder payment allocations in a way that would likely disrupt issuers’ origination models that are reliant upon introductory "teaser" rate offers. The execution, implementation and timing of these proposals are difficult to predict, but many in the industry expect the Federal Reserve’s proposals will be finalized before the end of the year.

Card Companies’ Response
Card companies are responding to the current economic environment by tightening credit standards, selectively reducing credit lines, limiting credit authorizations, increasing fees and rates, and more diligently pursuing collection strategies. These actions will likely ease, but not eliminate, the trend of rising charge-offs in the coming months.

Rating Implications
The securitization market is demonstrating signs of stress. Many short-term financing arrangements (typically privately placed and often in commercial paper conduit programs), which were routinely renewed each year, are now negotiated with tighter terms and much higher spreads — if they are renewed at all. With an expectation of worsening collateral performance in the months to come, Moody’s expects liquidity and funding to become an increasingly important dimension to its credit analysis, especially for those issuers with limited alternative funding resources.

To date, Moody’s has taken a number of rating actions on securities backed by credit card receivables; however, for some issuers a further weakening of the collateral performance or a worsening of their liquidity profile may put downward pressure on the related outstanding credit card ABS ratings.

These findings are detailed in Moody’s Credit Card Credit Indexes for August 2008.

August 2008 Charge-Off Rate Rose to 6.82%
The August charge-off rate rose to 6.82%, up 48% from the rate a year ago, 4.61%. The rise in August marks the twentieth consecutive month of year-over-year increase. The charge-off rate also increased significantly from its month-prior figure of 6.36% in July. The charge-off rate measures those credit card account balances written off as uncollectible as an annualized percent of total loans outstanding.

August 2008 Delinquency Rate Rose to 4.60%
The August 2008 delinquency rate, which measures the proportion of account balances for which a monthly payment is more than 30 days late as a percent of total balances, rose to 4.60% from 3.83% a year ago.

August 2008 Payment Rate Fell to 17.40%
In August 2008, cardholders paid back, on average, 17.40% of their credit card debts — about 13% lower than last year’s August rate of 20.07%. The drop in August marks the thirteenth consecutive month of year-over-year decrease and is the steepest decrease since the inception of the index.

August 2008 Yield Fell to 17.63%
Yield (the annualized percentage of income, primarily finance charges and fees, collected during the month as a percent of total loans) fell to 17.63% from 19.81% a year ago. The drop in August marks the sixth consecutive month of year-over-year decrease. Prior to this most recent data point, the yield experienced eleven consecutive months of year-over-year increases.

August 2008 Excess Spread Fell to 6.12%
The one-month excess spread, which is the yield less the expenses of the related credit card asset-backed transactions (e.g. coupon, servicing fee and charge-offs), dropped to 6.12% in August from its year-prior level of 8.17%.

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