credit card criteria

Credit CardCriteria

Structured Finance

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1Standard & Poor’s Structured Finance � Credit Card Criteria

ContentsCollateral Analysis And The Rating ProcessFor Credit Card Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Review Of The Originator’s Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Legal, Collateral, And Structural Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Rating Committees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Rating Surveillance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Collateral Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Modeling Assumptions For Interchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

‘BBB’ Ratings Criteria For Credit Card CIAs . . . . . . . . . . . 19

Collateral Invested Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Market Evolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Structural Credit Enhancement And Excess Spread . . . . . . . . . . . . . . . . . . . . 20

‘BBB’ Ratings Reflect Seller-Specific Considerations. . . . . . . . . . . . . . . . . . . . 23

Three ‘BBB’ Stress Test Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Charge-offs/Loss-Spike Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Portfolio Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Certificate Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Interest Rate Assumptions And Spikes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Payment Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Purchase Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

CIA Owner Trust Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Legal Issues Related To Rating CIAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Trust Analysis And Pooling And ServicingAgreement For Credit Card Receivables . . . . . . . . . . . . . . . . 35

Structural Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

The Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Types Of Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

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Cash Flow and Structural Analysis ForCredit Card Receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Cash Flow Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Subordination Of Interest Paid To The Collateral Interest Holder . . . . . . . . . 57

Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

Series Termination And The Credit Rating . . . . . . . . . . . . . . . . . . . . . . . . . . 63

Legal Considerations For Credit Card Receivables. . . . . . 65

General Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Bankruptcy-Remote Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Transfers, Ownership, And Security Interest . . . . . . . . . . . . . . . . . . . . . . . . . 68

Credit Enhancement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Selected Specific Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Pass-Through Certificates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Master Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Special Considerations For Private-Label AccountsFor Credit Card Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Collateral Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Special Considerations For UnsecuredConsumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Market Conditions Encourage Unsecured Lending . . . . . . . . . . . . . . . . . . . . 81

A Hybrid Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

Three Categories Of Unsecured Consumer Lending . . . . . . . . . . . . . . . . . . . . 83

Unsecured Consumer Lending Versus Credit Card Lending . . . . . . . . . . . . . . 84

Characteristics Of Unsecured Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . 84

Analyzing Unsecured Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86


Collateral Analysis AndThe Rating Process ForCredit Card Receivables

This section describes the stages of the Standard & Poor’s rating process and

focuses on the analysis of the credit card collateral being securitized. The

collateral analysis includes examination of the originator’s operations and

strategy and the analysis of the historical performance of the credit card portfolio.

The section then discusses the stresses applied to each performance variable and

the effect of each variable on the required credit enhancement for the transaction.

Review Of The Originator’s OperationsOne of the most important aspects of any credit risk assessment is the review of the

originator’s operations. In this review, emphasis is placed on the originator’s marketing,

underwriting, and servicing operations. A rating is based on the representations of

the parties to the transaction, but the scope of the review does not include an audit.

A traditional Standard & Poor’s rating addresses the likelihood of full and timely

payment of interest and principal to certificateholders. Therefore, it addresses the

likelihood of the first dollar of default.

Legal, Collateral, And Structural AnalysisStandard & Poor’s analysis focuses primarily on the legal, collateral, and structural

characteristics of the transaction. The legal criteria for structured finance ratings,

which were developed for MBS, have evolved to cover other asset types in the ABS

market. The fundamental tenet of the criteria is to isolate the assets from the credit

risk of the seller.

The collateral analysis involves an in-depth review of historical asset performance.

Standard & Poor’s collects and analyzes years of data on the performance variables

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that affect transaction credit risk and examines a broad array of issues related to the

originator’s operations.

The structural review involves an examination of the disclosure and contractually

binding documents for the transaction. These criteria cover many aspects of the

structure, from the method of conveyance of receivables to the trust to the method

of series termination.

Rating CommitteesA team of analysts is assigned to each transaction. After the team of analysts has

performed its review of the issuer’s operations and analyzed the collateral, a committee

of analysts is assembled to determine whether the transaction has sufficient enhance-

ment for the desired rating. The team leader is responsible for ensuring that all perti-

nent information is presented to the rating committee. The committee presentation

includes information gathered in the review process and information on the legal

and structural characteristics of the transaction.

The prospectus for publicly rated transactions is prepared by the issuer’s counsel

before a transaction is priced. However, Standard & Poor’s relies on the binding

agreements to determine whether the structure will provide timely payments. The

most important of these agreements is the pooling and servicing agreement and its

supplement. The supplement is usually drafted by the time a transaction is priced.

Analysts ordinarily present the structure of a transaction to a rating committee after

a transaction is priced, but in any event, as soon as practicable after the team receives

a draft of the supplement. Once the rating committee process is completed, a rating

letter is issued.

Rating SurveillanceAfter a rating is disseminated, it will be maintained by the asset-backed surveillance

group, which works in conjunction with the Structured Finance Ratings Asset-Backed

Group. The purpose of surveillance is to ensure that the rating continues to reflect

the performance and structure of the transaction. The surveillance team is responsible

for monitoring issue performance and identifying those issues that should be considered

for either an upgrade or a downgrade. The goal of the surveillance group is to identify

emerging risks in rated transactions. To that end, the asset-backed services surveillance

group monitors and evaluates monthly changes in performance. Data is collected

and analyzed from the individual master trusts and their component series on a

monthly basis.

To be able to analyze trust performance effectively, the asset-backed surveillance

area requires that servicers send pertinent information no later than the monthly

Collateral Analysis And The Rating Process For Credit Card Receivables


distribution date. The information required includes absolute numbers on the total

trust portfolio. This data enables the surveillance group to measure any collateral

erosion and determine trust income and expenses, as well as calculate relevant trust


Eligible principal outstandings: Principal eligiblecredit card receivables in trust pool net of financecharges, and other fees ineligibles, and so on, asof the end of reporting period, which is used asthe analytical basis to determine minimumcollateral required.

Total gross principal outstandings: Net eligibleprincipal outstandings plus other receivables suchas finance charges, and fee interchange, andother fees.

Prefunding account balance: Amount of cash ondeposit in prefunding account available to purchasenew receivables.

Gross losses: Losses on principal receivables.Erosion of collateral recognized during the report-ing period resulting from delinquency criteria,bankruptcies, and so on, as specified in thetrust documents.

Recoveries: Income on receivables that werecharged off during any period, if applicable tothe trust structure.

Net losses: Gross losses minus recoveries.

Delinquencies: Past due amounts not yet chargedoff and segmented by month correlated with thevarious aging criteria prior to charge off.

Total income and its components: Incomeflowing into the trust (excluding recoveries),specifically including cardholder interest paymentsand fees, interchange, discounted receivablesdiscounts, and other miscellaneous income.

Principal collections: Cardholder aggregatedprincipal payments collected from cardholdersduring reporting period to repay debt due.

Purchases: New receivables generated duringthe reporting period resulting from cardholderpurchases and cash advances.

Credit support balance and changes: Periodend balance of each credit support class oraccount used to meet trust covenants and anyuses or repayments during the period.

Outstanding invested amount: Balance of eachrated and unrated investor certificate (includingcollateral interest amount).

Surveillance Variables

Seller’s interest: Principal eligible receivablesminus total invested amount divided by principalreceivables.

Yield: Total trust income divided by total out-standing receivables; annualized.

Gross and net loss rate: Losses on principalreceivables divided by principal outstandings;annualized. Net loss rate includes recoveries.

Certificate rate: Certificate interest paid toinvestors divided by outstanding invested amount;annualized.

Servicing fee rate: Servicing fees paid fromtrust divided by outstanding invested amount.

Base rate: The addition of the certificate andservicing fee rates.

Total payment rate: Total monthly collections(obligor principal and finance charge payments)divided by the previous month’s total outstandings.

Principal payment rate: Principal monthly col-lections divided by the previous month’s eligibleprincipal outstandings.

Delinquency rates: Past due amounts dividedby principal outstandings, segmented by month;annualized.

Purchase rate: Monthly purchases divided bythe previous month’s eligible principal outstandings.

Surveillance Ratios

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and series ratios (see boxes for surveillance variables and ratios requirements).

Monthly statistics are published by Standard & Poor’s in its Credit Card Quality

Indexes so that industry participants can use the information as a way to track credit

card performance trends.

Performance information is disclosed in a report that is prepared monthly by the

servicer of the transaction. Before a transaction’s closing date, the data that will be

itemized in the servicing report is reviewed to ensure that all necessary information

is included.

The surveillance team also tracks the credit quality of all entities that support a

rated security, such as credit or liquidity enhancers. Analysts review performance

data monthly and contact the issuer if performance deviates beyond a reasonable

band. If a committee vote results in a rating change, the issuer and trustee will be

notified. For public ratings, a press release is normally disseminated.

Collateral Analysis

Review Of The Originator’s Operations

An on-site review of an originator’s operations and management is one aspect of the

rating process. The purpose of the review is to develop an issuer-specific profile in the

areas of marketing, underwriting, servicing, and collections, and to assess other risk

factors such as geographic concentrations and economic conditions. The review pro-

vides analysts an opportunity to discuss with senior management competitive pres-

sures, franchise value, strategic objectives, underwriting, account management poli-

cies, and servicing and collections procedures. The diversity of marketing and under-

writing practices among issuers may result in significant differences in performance.

The review also enables analysts to evaluate the corporation’s organizational and

technological infrastructure, and the quality of its resources, which are critical to

effective servicing and collection of trust receivables.

Marketing

In the securitization process, the issuer retains the risk of maintaining its cardholder

borrowing base. The scope and quality of an issuer’s marketing strategy are important

determinants in an issuer’s ability to generate enough new receivables to support a

securitization program and to effectively manage the performance of the receivables.

Issuers market their credit card products through various distribution channels,

including branch networks, “take-ones” at public locations, advertisements in maga-

zines, toll-free telephone numbers, and direct mail solicitations. Traditionally, most

direct mail offers were “preapproved,” offering lines of credit “up to” specified

amounts. However, due to changes in the Fair Credit Reporting Act (FCRA), issuers



now extend “prequalified” solicitations or “invitations to apply.” The net result is

a benefit to issuers, which now have greater leverage to decline responders who no

longer qualify.

Issuers employ a broad range of marketing strategies. For example, many issuers

focus on offering accounts to cardholders who are likely to revolve their balances

because, if credit risk is kept in check, a portfolio of revolving cards is highly profitable

compared with a portfolio of convenience users. There are many ways to attract

revolvers. Many lenders use segmentation techniques that help identify cardholders

who will be attracted to a specific offer and run small sample offers to test response

rates, profitability, and performance. If successful, they roll out a full-scale direct

mail program that targets cardholders with profiles that are similar to those of the

test sample. Others may focus on price leadership and offer low “teaser” rates to

entice cardholders to transfer balances. Responders with pristine credit profiles may

receive permanently low rates. Each of these marketing strategies affects performance

differently. In their review, analysts assess an issuer’s ability to identify, compete for,

price, and maintain high-quality accounts.

Underwriting

Standard & Poor’s assesses the quality with which a particular underwriting methodol-

ogy is developed, implemented, and practiced. Once a potential cardholder or group

of cardholders has been identified, the issuer must determine which type of credit

offer to extend. Issuers that extend similar credit offers (for example, APR and credit

line amounts) to populations with vastly different credit and behavior profiles are

called “mass marketers.” Until recently, mass-marketed offers were the predominant

credit offer in the marketplace. Mass-market issuers maintain the spread between

revenues and losses by subsidizing bad credits with good credits in their portfolio.

In response to increased competition, some issuers turned to a more “targeted”

approach, which involves segmenting their cardholder base and offering a range of

products tailored to the risks and needs of particular groups of customers. For example,

low-rate balance transfer offers are targeted to low-risk customers who revolve balances.

A targeted approach involves additional analysis of credit bureau or third-party sta-

tistical service data, or an issuer’s proprietary data warehouse. Statistical techniques

are used to develop sophisticated credit scoring models to predict and assess the

credit risk of potential cardholders, and to match an offer’s pricing to the risk profile

of the potential cardholder.

Credit scoring is a statistically based tool used to rank applicants by risk level

given the information found on applications or credit bureau reports. Points for a

variety of characteristics are added, producing a score that positions the applicant

along a scale and quantifies the odds that the account will be paid as agreed.


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Issuers use credit scores in assessing a borrower’s risk of default. Cutoff points

for acceptance can change depending on the degree of risk an issuer wants to accept.

Despite their ability to provide relative rankings, credit scores do not correlate per-

formance with specific scores. The probability of a negative performance at a certain

score level will change with adverse selection in a pool of applications as well as

over time.

A targeted approach using scoring is expensive to develop and requires frequent

testing to maintain. However, for those issuers that rely primarily on credit card

accounts for corporate growth and earnings, the investment is essential to maintaining

market share and profitability. Issuers that use proprietary statistical models to offer

customized products are better able to maintain a consistent spread between revenue

and losses for each cardholder or group of similar cardholders. Their primary marketing

channel is direct mail, with limited amounts of preapproved underwriting.

Servicing And Collections

Once a new account is booked, the issuer’s ability to manage that account will

determine its tenure and profitability. Timely and accurate monthly statements and

friendly and efficient customer service generate goodwill and may increase card

usage. With the increase in competition in the industry and the availability of other

credit offers, cardholders demand better service. If an issuer cannot demonstrate an

ability to address and meet valid customer needs, it will eventually lose market share

and be left with a portfolio of cardholders with few other credit options available.

At the same time, it is important to assess an issuer’s ability to keep operating costs

in check. Over time, innovative technological techniques, such as image processing

and artificial intelligence, enable an issuer to reduce expenses, providing additional

flexibility in pricing and marketing strategies.

Adverse selection from attrition will increase the risk profile of the issuer’s portfolio

and may generate losses for certificateholders in securitized pools. Standard & Poor’s

analyzes attrition rates and the issuer’s ability and strategy to retain cardholders.

For example, some issuers have developed statistical models that help predict which

cardholders are likely to be attracted to other offers and pay down in the coming

months. Issuers can then offer these cardholders additional features such as upgrades

to gold cards, lower finance charge rates, elimination of annual fees, and cash back

features that do not impair the profitability of the account.

Effective collection efforts maximize profits to the issuer. The interests of certificate-

holders may be compromised if the issuer cannot demonstrate a prompt and effective

means to collect delinquent balances. Analysts evaluate the quality of collections

staff, collections strategy, and the timeliness of implementation when assessing loss

levels on a portfolio. For example, many servicers leverage senior collection employees

by having them focus on more seriously delinquent accounts. Many also use predictive



dialing systems that queue delinquent accounts based on a statistical behavioral

score that identifies the riskiest cardholders. The systems also use other ranking criteria,

such as size of outstanding balances, and they incorporate legal criteria regarding

when collections staff are allowed to call delinquent cardholders. The dialer systems

calculate the optimal time of day to reach a cardholder. These systems have a positive

impact on the efficiency of collections.

Finally, an issuer’s ability to manage fraud losses is examined in a review. Most

issuers combat fraud with neural network systems that detect such activity in the

authorization process. For example, systems are typically programmed to detect

authorizations at gasoline stations for as little as one dollar. Criminals frequently use

gas pumps to test their ability to use a stolen card. Other fraud prevention measures

include mailing deactivated cards that can only be activated by the cardholder with

certain security information or mixing mass mailings of credit cards with mail that

does not contain cards. Also, issuers often stay in contact with the law enforcement

community to discuss the latest card-theft techniques used by organized crime.

Geographic Concentrations And Other Risks

Portfolios can contain additional risk factors that Standard & Poor’s evaluates during

a review. For example, the portfolio could be geographically concentrated, subjecting

it to regional economic or industrial downturns that would be diluted in a more

diversified pool. The portfolio could be heavily biased toward a particular type of

cardholder whose performance may skew the portfolio. Cardholders with similar

interests or affiliations, known as affinity groups, behave differently than consumers

who carry cards that offer rewards, such as airline miles or cash rebates.

Economic and industry trends may also affect the performance of an issuer’s port-

folio. For example, the local employment pool may be stressed due to new corporate

entrants in the region, which may reduce servicing quality or increase wage costs.

Stronger competition in an increasingly saturated market may cause an issuer to be

more lax in its underwriting standards to increase revenue. Changes in consumer

behavior, such as a greater willingness to build up excess credit or declare bankruptcy,

may cause credit quality to deteriorate.

Analysis Of Historical Collateral Performance

Before analyzing stressed cash flow scenarios, analysts examine the historical perfor-

mance of the issuer’s portfolio. Typically, the issuer’s entire portfolio is reviewed, as

master trust structures allow for account additions after a rated series closes, which

may affect the trust’s performance.

In most cases, Standard & Poor’s looks for three to five years of data from first-time

securitizers, since a track record is extremely important. Standard & Poor’s asks for

a range of portfolio data and data is usually provided in a variety of ways. However,


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vintage data is considered an important segmentation and is most often requested

since it allows analysts to examine how originations from different years or campaigns

have performed. Analysts can then examine the trends in performance and match

them to changes in underwriting or servicing strategies. Vintage data can also be

used to gauge the issuer’s loss curve, and determine the ultimate level of charge-offs

by removing the effects of growth. Analysts can then infer how the issuer’s current

strategy may unfold in terms of performance.

Cash Flow Stress Tests And Their Relationship With Payout Triggers

After assessing the seller and servicer’s operations and analyzing the performance of

the issuer’s receivables, the analytical team runs cash flow scenarios that stress five

key performance variables: payment rate, purchase rate, losses, portfolio yield, and

certificate rate. Implicit in the cash flow runs is the assumption that a base rate payout

event will cause the transaction to amortize. A base rate amortization will occur

when the three-month average portfolio yield, net of losses, is insufficient to cover

the certificate interest and servicing fees averaged for the same period. At that point,

all principal payments collected from cardholders are passed through to investors.

The guidelines that follow encompass many of the parameters used to model a

typical transaction, but these are not all-inclusive. A variety of cash flow runs are

presented to a rating committee for deliberation. Also, as the market for credit card-

backed certificates is dominated by ‘AAA’ and ‘A’ rated paper, the discussion focuses

on the stress levels for those rating categories. A separate discussion of Standard &

Poor’s ‘BBB’ cash flow modeling will be discussed in a later section.

Payment Rate

The payment rate is one of the most important variables in the model because a higher

payment rate ensures that investors are paid out quickly in adverse scenarios. In a

base rate amortization, reductions in enhancement can accumulate rapidly, exposing

investors to potential default losses. Enhancement reductions, or write-downs of the

certificate, will occur when the portfolio yield is unable to cover charge-offs plus the

certificate rate and servicing fee. That is, draws on credit enhancement occur when

the excess spread is negative. Therefore, transactions that pay principal at faster

rates (i.e., those with higher payment rates) are exposed to losses over a shorter period

of time and, therefore, need less enhancement.

For a transaction with a standard base rate trigger and a typical mix of fixed- and

floating-rate assets, analysts usually assume that a transaction will enter rapid amor-

tization with a 5% annualized negative spread rate. In the first month of the rapid

amortization stress period, increases in charge-offs are the main reason excess spread

is negative. In subsequent months, charge-offs and floating-rate certificate rates, if

applicable, are assumed to rise to their ultimate levels, which raise the total negative



spread in the trust. The payment rate assumption in an ‘AAA’ stress scenario is usually

45%-55% of the issuer’s steady-state portfolio payment rate. The discount percentage

applied to the steady-state payment rate depends on the level of payment rates, pay-

ment rate trends, servicing practices, and payment-rate volatility. The ‘A’ scenario

typically is 10% faster than the ‘AAA’ assumption (that is, 50%-60% of the

steady-state assumption).

Purchase Rate

The pooling and servicing agreement governing credit card receivables-backed trans-

actions calls for the continued transfer to the trust of all receivables arising in the

designated accounts. Therefore, purchases keep the amount of principal receivables

in the trust from declining. Higher purchase rates increase the pace of the repayment

of principal to investors. For example, assume that the monthly principal payment

rate equals 10% of the outstanding principal amount in the trust. If the purchase

rate was less than 10%, the amount of principal receivables in the trust would decline

each month, leaving a lower amount of principal collections to retire old receivables.

A steady payment rate on a declining trust balance would result in fewer dollars of

principal payments in subsequent months. However, if the purchase rate equaled the

10% payment rate, the principal receivables in the trust would remain at their initial

level, and the portfolio would not decline. Thus, monthly principal collections would

also be maintained. If the purchase rate exceeded the 10% payment rate, principal

collections would be greater than payments received and the portfolio would continue

to grow.

The purchase rates used in the model vary based on the seller’s business and per-

formance characteristics, the seller’s credit rating, and the certificate rating that the

issuer is trying to achieve. But the chief risk associated with a purchase rate assumption

is the risk of seller bankruptcy or insolvency. Therefore, higher-rated lenders are usually

given more purchase-rate credit because they are more likely to survive adverse business

conditions and fund purchases in the future. Also, bank card issuers that are part of

the VISA or MasterCard associations have franchise value that would make it more

likely for other originators to bid for their accounts if they were to disengage from

the business.

Insolvency is the chief risk because if the originator becomes insolvent, the trust

may not have ownership of, or a first perfected security interest in, receivables origi-

nated after insolvency. In the event of an insolvency, the documents generally require

the servicer to allocate collections to the trust as if the trust owned all the receivables.

Further, if the servicer is legally prevented from doing so, the documents call for the

allocation of all collections from each account to be used first to pay off the oldest

balances (as in first in, first out accounting). Since the trust has an interest in the


12

oldest balances, this allocation method is more advantageous than a pro rata

distribution.

The purchase rates modeled for bank cards range from 2% to 5%. In contrast,

most retail lenders are given no purchase rate credit because retailers are typically

unrated and because of low franchise value, whereby retailer cards are assumed to

have little utility in a U.S. Bankruptcy Code Chapter 7 liquidation.

Charge-offs

The risk of volatility in the charge-off rate, portfolio yield, and certificate rate is par-

tially captured by the base rate trigger. Therefore, there is only slight variation from

transaction to transaction in the stress scenario’s negative spread at the start of the

modeled rapid amortization period. As previously mentioned, rapid amortization

cash flow modeling for a ‘AAA’ case begins with excess cash flow starting at a negative

5% annualized rate. That negative rate usually results in a charge-off level that is

1.5 to two times the steady-state assumption at the start of a rapid amortization

before reaching an ultimate ‘AAA’ stress loss case within 12 months. However,

cumulative negative spread will be affected by the ultimate charge-off level and the

rate of deterioration of each performance variable, which is determined through

portfolio-specific analysis.

In a ‘AAA’ scenario, the ultimate charge-off level is typically increased by three to

five times the issuer’s steady-state charge-off level. The steady-state level is determined

by examining historical portfolio statistics and by incorporating an assessment of

underwriting and servicing quality. For ‘A’, ultimate charge-offs are assumed to

reach two to three times the steady-state level.

Portfolio Yield

Portfolio yield generally consists of three types of payments: finance charges, fees,

and interchange. Periodic finance charges are the interest cost associated with an

unpaid balance at the end of a grace period. Fees include annual membership fees,

late payment fees, and overlimit fees. Interchange is the fee paid to originators by

VISA or MasterCard for absorbing risk and funding receivables during grace periods.

Although some issuers do not include all of these sources in portfolio yield, others

include these and more. For example, recoveries from previously charged-off

accounts can be included, as can the proceeds from “receivable discounting.” A dis-

counted receivable arises when a portion (usually 1%-5%) of principal receivables is

designated as finance charge receivables. Collections of discounted principal receivables

are then treated as finance charges. Several bank card master trusts incorporated

discounting before a bulletin from the Office of the Comptroller of the Currency stated

that discounting could not be considered recourse.



Competition naturally exerts downward pressure on portfolio yield, but external

pressures, such as macroeconomic influences and the legislated interest rate cap,

also exist.

In the past, legislation has been introduced in the U.S. Congress to place a cap on

the amount of interest that an issuer can charge a credit card holder. Resolution S.

1922 would have limited credit card interest rate payments to four percentage points

above the rate used by the IRS to assess penalties on late tax payments. Resolution S.

1603 would have capped credit card interest rates at five percentage points above the

average six-month Treasury bill rate, adjusted annually. Finally, resolution H.R.

3860 would have capped rates at the six-month Treasury bill rate plus 10 percentage

points, adjusted semiannually (see chart 1). Although none of these proposals became

law, similar resolutions could become law in the future. For this reason and the others

stated above, in most cases, Standard & Poor’s compresses yield to 11% or 12%

in ‘AAA’ scenarios and about 12% in ‘A’ scenarios for most bank card portfolios.

However, for high yield portfolios, the standard stress yield case as described above

may not be applied. Rather, for high yield portfolios, the stress yield will likely not

be as compressed because portfolio yield may be composed largely of fee income rather

than finance charge income, and the impact of a legislative case would be less severe.

In addition, such issuers are targeting higher-risk customers who are less likely to have

the ability to switch to a lower-priced card. Higher-yielding portfolios will be analyzed

on a case-by-case basis. Following an examination of historical yield data and any

yield volatility, an appropriate yield stress will be determined for each rating category.


Jun-

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25S.1603 Rate S.1922 Rate H.R.3860 Rate(%)

Chart 1

Proposed Legislative Caps(Not Enacted)

14

Certificate Rate

The modeled certificate rate for ‘AAA’ ratings equals the actual rate for fixed-rate

transactions, but rises in floating-rate transactions to the capped rate when interest

rate caps are provided, or to a level that exceeds the yield on the portfolio in uncapped

deals. That ultimate uncapped level usually peaks at a rate of 15% under the ‘AAA’

stress case and 14% under the ‘A’ stress case. The rate of increase to these ultimate

levels can vary, however. In determining the ultimate level of increase on floating-rate

transactions, analysts will take into consideration other factors, including the issuer’s

ability to manage and reprice its portfolio and the rating on the certificates. Additionally,

analysts recognize that the relationship between portfolio yield and the variable cost

of funds is an important factor in determining the level of excess spread for floating-

rate certificates.

Principal Allocation Assumptions

The method used to allocate principal between the seller and the investor certificates

during amortization is yet another cash flow aspect to consider. The transactions are

usually structured to pay investor certificates based on a fixed/floating ratio allocation.

The fixed/floating allocation freezes the numerator for the series payment ratio at an

amount equal to the series investor interest at the end of the revolving period, but

the denominator floats to equal the current principal receivables in the trust. The

principal allocation percentage (PAP) for investor certificates in amortization will

equal the lesser of 100% and the following percentage: Investor interest at the end

of the revolving period divided by the greater of: (1) principal in the trust plus cash

in the excess funding account, and (2) the sum of the numerators for all series’ PAP.

Standard & Poor’s assumes that the seller’s interest would quickly reach zero in

amortization due to dilution and fixes both the numerator and denominator in the

cash flow assumption so that the ratio is equivalent to 100%. This results in a slower

payout of rated classes than if the seller’s interest were assumed to be positive under

a fixed/floating allocation. As mentioned above, series with slower principal payments

require more enhancement to cover losses.

Also, during amortization, the cash flow allocation sections of the documents provide

that certificateholders receive the benefit of principal collections from other principal-

sharing series in their revolving period. However, analysts assume that such amounts

will not be available, as many factors could cause a disruption in such cash flow. One

example of such a disruption is a seller insolvency that would cause a trustwide rapid

amortization event in which all series would amortize at the same time.



Assessing The Value Of Servicer Interchange

Interchange income paid to an issuing bank is part of its overall compensation for

assuming credit risk and offering a grace period on finance charge accrual. Interchange

income is generated when merchant banks discount the amount they pay to merchants

for credit card charges. This discount amount is ultimately shared among the merchant

bank, the issuing bank, and VISA or MasterCard as compensation for their clearing-

house function. The issuing bank’s share of interchange income is actually generated

during the settlement process between VISA or MasterCard and the issuing bank

(see chart 2).

In the context of credit card receivable securitization, the issuing bank’s share of

interchange income can affect the performance of the trust portfolio because the issuer


Chart 2Interchange Cash Flow

MerchantBank

Payment

Charge

®

®

Card-IssuingBank

Step 3Merchant bankreimburses themerchant for thepurchase minus afixed "discount fee";e.g., 1.9% of thetotal $100 purchaseprice (the merchantreceives $98.10).

Step 7VISA or MasterCard forwardpayment of $98.70 to themerchant bank. They alsocollect fixed processing feesfrom the merchant bank andthe issuing bank. MerchantBank nets $0.60 ($98.70- $98.10)prior to paying VISA orMasterCard fees.

Step 1Cardholder usesa VISA or MasterCardcredit card to makea $100 purchasemerchant establishment.

Step 2At the end of thebusiness day, themerchant submitsthe charge to themerchant bank.

Step 4Merchant banksubmits thecharge to VISAor MasterCard.

Step 6Card-issuing banksubmits paymentto VISA orMasterCardminus a fixed"interchange fee";e.g., 1.3% ofthe total $100purchase price. The total paymentmade is $98.70

Step 5 VISA or MasterCardforwards the $100 chargeto the bankthat issuedthe creditcard to the customer.

Step 8Card-issuing bank bills the cardholderfor the $100 purchase.

Step 9Cardholder pays the issuing bank the $100 or at least theminimum amount with the remaining balance paid overtime. Card-issuing bank nets $1.30 in interchange ($100cardholder payment - $98.70 payment to VISA orMasterCard). The trust's pro rata share of this $1.30 isusually included as finance charge collections.

Cardholder Merchant

16

typically promises to remit a pro rata share of interchange directly to the trust. At

the trust level, such supplemental cash flow is then recharacterized and applied as

additional finance charge collections to pay for transaction expenses such as certificate

interest, servicing fees and trustee fees, and defaulted amounts. If structured this

way, interchange income can provide extra loss coverage by creating a greater level

of excess spread. However, because of legal considerations, Standard & Poor’s will

not assign any credit to interchange unless certain conditions are met.

Legal Analysis Of Interchange Income

Standard & Poor’s historically has felt that the benefit of receiving interchange income 10

could evaporate upon a seller insolvency. This view was predicated on legal analysis

that suggested that perfecting interchange fees would be problematic because of the

following issues:� The property rights of the issuing bank in interchange fees are not clearly defined

in the membership agreements with VISA and MasterCard, and� Interchange fees are subject to setoff by VISA and MasterCard.

As VISA and MasterCard are not parties to the transaction, they provide no

representations, warranties, or covenants related to interchange fees. Additionally,

interchange rates are revised annually by VISA and MasterCard.

Servicing Fee Requirements And Interchange Dependency

As a means of reducing required credit enhancement levels, some servicers have offered

to have a portion of their servicing fee paid from interchange, if it is available. This

arrangement can reduce the required level of credit enhancement by contractually

limiting a portion of the required servicing fee to the actual level of monthly interchange

income allocated to the trust. For example, the servicer may require a 2% annual

servicing fee but contractually agree to accept 1% of the servicing fee from interchange

income to the extent it is available. If interchange did not exist, the servicer would

only be paid a 1% servicing fee from trust cash flows. The implication of this structural

provision is a 1% reduction in the servicing fee expense assumption for cash flow

modeling purposes, but this is only possible if the conditions below are met.

Modeling Assumptions For InterchangeStandard & Poor’s normally assumes no benefit is derived from interchange due to

perfection issues associated with these fees. Because of the legal analysis discussed

previously and the fact that interchange income is generated during the settlement

process between VISA and MasterCard and the issuing bank, analysts assume that

interchange income will not exist in a worst-case early amortization scenario. This is



one of the assumptions used to support the reduction in portfolio yield for cash flow

modeling purposes.

However, if certain conditions are met, credit will be applied in the analysis for

servicer interchange. Analysts will run stressed cash flow scenarios with full credit

to servicer interchange only if the transaction meets the following criteria:� For investment-grade certificate ratings, the trust must have a servicer and a

trustee (as successor servicer) willing to be paid a portion of its servicing fee

from servicer interchange. Both must have high long-term senior unsecured debt

ratings, and both must accept a reduced servicing fee if interchange is not avail-

able in the future.

The rationale is that one of the highly rated entities should be available to service

the portfolio at the lower servicing fee.� The trustee must have credit card-servicing capabilities.

The trustee is obligated to service or find a replacement servicer if the current servicer

is no longer able to service the trust. Standard & Poor’s assumes that the trustee will

not be able to find a replacement servicer that will service the trust at the contracted

fee and will be required to assume that role itself. For this reason, the trustee must

have experience with servicing a credit card portfolio.

If these provisions are incorporated into the structure of the transaction, analysts

assign value to interchange income. Otherwise, interchange is viewed as an unperfected

source of income that would disappear upon the seller’s insolvency. However, if

interchange credit is given, the certificate ratings will be dependent on the servicer

and trustee’s ratings and may be affected by a downgrade of either party’s ratings.



‘BBB’ Ratings Criteria ForCredit Card CollateralInvested Amounts

This section describes the criteria underlying Standard & Poor’s ‘BBB’ ratings.

It begins with a brief description of the collateral invested amount (CIA)

and the evolution of the CIA market. Then the section summarizes the

stresses applied to key performance variables under three separate cash flow scenarios:

the combined-stress case, the loss-spike test, and the interest rate-spike test before

concluding with a discussion of the legal aspects unique to rating CIA pieces.

Collateral Invested AmountA popular form of credit enhancement to the more senior classes, class A and class

B, is a subordinated interest known as the collateral invested amount (CIA). The

most subordinated interest is referred to by a number of different names, including

the enhancement invested amount, the C class, and the collateral interest. For purposes

of this section, it will be called the collateral invested amount or CIA. All references

are to securities issued by a master trust and backed by bank credit card receivables.

As the market has matured, issuers have placed a greater interest in expanding the

universe of buyers for the CIA to diversify funding sources. This is especially important

because many traditional CIA buyers reached their lending limits for selected names.

In addition, many investors that traditionally purchase more senior classes of credit

card-backed securities have taken an interest in purchasing the most subordinated

class to increase yield in exchange for incremental risk. These factors, along with

heightened investor concerns over consumer credit quality, have helped drive the

demand for Standard & Poor’s ratings on CIA interests.

20

Market EvolutionThe earlier credit card deals incorporated letters of credit (LOCs) from highly rated

institutions to protect investors against the risk of default. To avoid a rating depen-

dency on the credit quality of the LOC provider, the market moved to cash collateral

accounts funded by the same institutions that formerly provided the LOCs. Since

CIAs were introduced in the early 1990s they have become the most common form

of credit enhancement.

When CIA structures were first introduced, issuers had their CIAs rated mainly for

tax purposes, rather than to allay investors’ credit concerns. Issuers understood that

an investment-grade debt rating was viewed favorably by tax lawyers opining whether

the IRS would deem the CIA as debt for tax purposes. The former LOC and cash

collateral account providers were, and have continued to be, the primary investors

in the CIA market, having built their expertise for evaluating the credit risks well

before the enhancement was a ratable subordinated debt interest.

As the traditional investor market for CIAs has become saturated, issuers have

become more interested in having their CIAs rated by Standard & Poor’s to gain

greater acceptance from potential new investors and to reduce their reliance on existing

sources of finance. Additionally, traditional buyers began to express interest in having

CIAs rated to increase their ability to syndicate their positions, which would free up

capacity to invest in future transactions and create a more liquid market. Across the

board, investors have become more sensitive to credit risks and price volatility due

to credit spreads.

Structural Credit Enhancement And Excess SpreadAll credit card structures incorporate a series of amortization events that, if triggered,

cause principal collections allocated to investors to be passed through immediately

and before the scheduled payment date. Among other things, amortization events

include insolvency of the originator of the receivables, breaches of representations

or warranties, a servicer default, failure to add receivables as required, and asset

performance-related events. Additionally, a transaction will generally amortize early

if the three-month average excess spread falls below zero annualized. Excess spread

is generally defined as finance charge collections minus certificate interest, servicing

fees, and charge-offs allocated to the series. Early amortization is a powerful form

of structural credit enhancement for all certificateholders, including the CIA holders,

who are generally in the first loss position.

In a typical credit card structure, credit enhancement for the A and B classes is

fully funded at closing. For example, the class A certificate relies on the credit

enhancement provided by the subordination of class B and the CIA and/or a cash

‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts


collateral account, if any. In contrast, the enhancement for the CIA is dynamic and

typically in the form of a reserve account. The reserve account is funded from excess

spread plus an initial deposit, if necessary. The amount of excess spread deposited

into a reserve account is dictated by the terms of the CIA loan agreement. Generally,

if excess spread falls below specified levels, excess finance charge collections are

trapped in a reserve account for the CIA’s benefit. A typical loan agreement will

require a targeted reserve fund balance based on the current level of excess spread.

Table 1 shows one example of a reserve account structure and the required trigger

levels. In this example, if the three-month average excess spread is above 4.5%, no

deposit is required. Should excess spread fall between 4% and 4.5%, excess spread

will be trapped in the reserve account until the reserve account balance is equal to

1.5% of the initial series invested amount. As excess spread falls, the targeted reserve

fund balance increases. At less than 3% excess spread, the targeted reserve account

will be 4%. In an adverse scenario, this structural credit enhancement is designed

to build the reserve account before the excess spread falls below zero. Similarly,

amounts held in the reserve account can be released if excess spread increases

above a specified level.

Reserve account structures vary and affect the amount of excess spread that can

be trapped under an adverse scenario.

Average bank card excess spread remained positive from 1992 through 1997

(see chart 1). Although performance varies significantly by issuer and a number of

issuers have supported their transactions, since credit card securitization began, the

situations in which a deterioration in portfolio credit quality has caused excess spread

to fall below zero are infrequent. In fact, many of the incidents of negative excess

spread were a result of policy changes or a particularly high fixed-rate coupon on

the certificates. Others have occurred from changes in charge-off policies causing

temporary and short-lived blips in charge-off rates. Incidents of negative excess

spread are more likely in discrete trust structures. In contrast, the more common

master trusts are generally larger, more diversified, and less prone to any loss spikes


Table 1

Sample Reserve Account Trapping Mechanism

Reserve Fund Target % of Initial Three Month Average Excess Spread Series Invested Amount

4.5% 0.0%

4.0% - 4.5% 1.5%

3.5% - 4.0% 2.0%

3.0% - 3.5% 3.0%

3.0% 4.0%

22

associated with account seasoning. Additionally, several issuers have increased

excess spread by managing the composition of the securitized portfolio to reduce

loss rates or discounted receivables to boost yield.

Cash flow models are used to measure the effect of a deterioration in excess spread

on a transaction and how this deterioration affects the amount of cash that can be

trapped in a spread account to cover defaults. The cash flow model formulas reflect

the payment allocation provisions in the pooling and servicing agreements, as well

as the CIA loan agreement. For cash flow modeling purposes, excess spread is assumed

to be the lower of either the current level or the first trigger level (4.5% in the example

above) when simulating a stress test. Excess spread is not a cash flow model input;

rather, it is a model output.

Once an excess spread trigger level is breached, the reserve account builds from

monthly excess spread, if any, up to the targeted balance. If finance charge collections

are insufficient to cover certificate interest, servicing fees, and receivable charge-offs,

excess spread is negative and amounts in the reserve account will be reduced. To

achieve an investment-grade rating on a CIA, a sufficient amount of excess spread

must be available to fund a reserve account to avoid a default under various ‘BBB’

stress tests.

0

5

10

15

20

Jan-98Jan-97Jan-96Jan-95Jan-94Jan-93Jan-92

Chart 1Bank Card Trusts Excess Spread

(%)

Bank Card Loss Rate

Bank Card Wtd Base Rate

Bank Card Spread



‘BBB’ Ratings Reflect Seller-Specific ConsiderationsWhen moving down the ratings spectrum, greater reliance can be placed on the card

issuer’s ability to originate and effectively manage its credit card business. In addition,

compared with the ‘AAA’ and ‘A’ stress cases discussed in the section Collateral

Analysis And The Rating Process, when evaluating CIA pieces, less-conservative

portfolio-stress scenarios are assumed for cash flow modeling purposes.

The ratings on the more senior classes are typically above the unsecured debt rating

of the bank that originates and services the credit card receivables that have been

transferred to the issuer. The senior class can be rated above the unsecured rating of

the bank because the senior class ratings are based primarily on the creditworthiness

of isolated pools of assets, without regard to the creditworthiness of the bank. The

probability and potential impact of the bank’s insolvency are factored into the rating

assigned to the senior certificates. Therefore, in assigning a rating to the more senior

classes, the transaction’s structure must provide the means by which the assets’ cash

flow would be available to pay debt service in a timely manner notwithstanding the

insolvency, receivership, or bankruptcy of the issuer.

In contrast, the CIA ratings are often at or below the rating of the originator/servicer.

Therefore, greater reliance can be placed on the bank’s ability to effectively service

the portfolio during the life of the transaction and to originate and transfer receivables

to the issuer. When the bank’s rating is at least as high as that of the credit card-backed

security, the bank’s credit card business can be viewed as an ongoing concern for

purposes of the CIA analysis, and performance is modeled accordingly.

In rating the CIA, the analysis incorporates many of the same factors Standard &

Poor’s considers when assigning an unsecured rating to the bank. These include

quantitative factors such as loss rates, bankruptcy data, payment rates, the mix of

variable- and fixed-rate accounts, and repricing information. More qualitative factors

are also included, such as marketing, pricing and account-retention strategies,

underwriting and account-management policies, the use of technology, the strategic

importance of the securitization program as a source of funding, and management

expertise. Additionally, Standard & Poor’s assesses macroeconomic conditions, con-

sumer behavior, geographic concentrations, competitive pressures, and franchise

value. All of these factors are critical in determining the appropriate ‘BBB’ enhancement

level for CIA classes. The links between secured and unsecured ratings at the invest-

ment-grade rating level imply the possibility that a ‘BBB’ structured rating may be

downgraded in conjunction with the downgrade of an issuer’s unsecured rating to

below investment grade.


24

Table 2

General Guidelines for BBB Cash Flow Stress Test Scenarios

Key ModelingVariable

Yield

Charge-offs

Payment Rate

Purchase Rate

Certificate Rate

Excess Spread

CombinedStress Scenario

Decrease to 75% ofexpected case over an18 month period.

Increase to 1.5 to 2times Portfolio theexpected case over an18 month period.Absolute increase formost portfolios shouldbe 2.5% to 5%.

75% of expected case.

Assumes a flat portfoliofor investment gradeoriginator/servicers anda declining portfolio fornon-investment gradeoriginators/servicers.

Actual rate for fixedrate securities in series.Increase to 75% ofworst case portfolioyield over 18 months for floating rate securities in a series.

Starts at lower of current level and high-est excess spread trig-ger (if current is abovetrigger level, portfolioyield and/ or loss rate is adjusted). ExcessSpread is a model out-put for future periods.

Loss Spike Scenario

Expected steady state.

Increase to 2 to 3 timesthe expected case overan 18 month period.Absolute increase formost portfolios shouldbe 5% to 10%.

Same as combinedstress scenario.


Actual rate for fixedrate securities in series.Start and remain at thehigher of current levelor certificate rate whichwould first first excessspread to be trapped forfloating rate securitiesin a series.


Interest RateSpike Scenario





Assumptions based onthe stochastic modelingof interest rates, usingMarkov chain MonteCarlo techniques.




Three ‘BBB’ Stress Test ScenariosWhen analyzing a CIA, Standard & Poor’s will evaluate the impact of a deterioration

in pool performance or an increase in the deal’s certificate rate, or both, using three

separate cash flow scenarios. The three ‘BBB’ scenarios include a combined-stress, a

loss-spike, and an interest rate-spike scenario. Under the combined-stress scenario,

all key variables are stressed simultaneously. This combined worse case approach is

similar to the ‘AAA’ and ‘A’ stress cases, in which various performance variables are

stressed at the same time. For the loss-spike stress test, the certificate rate and portfolio

yield are held constant at the steady state and the loss rate is stressed more severely.

The interest rate-spike scenario incorporates a sharp increase in the coupon for

floating-rate securities in a series and holds loss rates and portfolio yield constant

at their expected steady states. The portfolio purchase rate and payment rate

assumptions are the same for all three scenarios. There is no strict formula for

specific stress levels applied to each modeling variable. Instead, the level of stress

is portfolio specific and is based on an analysis of the pool characteristics and an

evaluation of the originator/servicer.

Charge-offs/Loss-Spike AnalysisIn a ‘AAA’ scenario, the peak annualized loss percentage is typically three to five

times the expected steady state for the portfolio. This peak is reached in 12 months.

In contrast, in a ‘BBB’ combined-stress scenario, loss rates are increased to 1.5 to

two times the expected steady state. The peak is reached in 18 months and the absolute

level of increase typically does not exceed 500 basis points for the combined-stress

scenario. For a ‘BBB’ rating, a transaction should also be able to survive an increase

in losses of two to three times the expected steady state under a loss-spike scenario.

Standard & Poor’s uses ‘BBB’ loss guidelines that examine the historic performance

of securitized portfolios. Table 3 shows in basis points the absolute level of increase

for nine frequent issuers. This compares monthly loss data for each master trust for

18 months beginning in 1992 or since the trust’s inception if it was created after 1992.

The table shows the maximum increase in the three-month average charge-off rate

over the 18-month period.

In examining issuer-specific portfolio loss volatility, Standard & Poor’s evaluates

pool performance in a variety of ways. For example, one-month and three-month

average loss rate changes over rolling 12-, 18-, and 24-month periods were analyzed

for all bank card issuers. Table 3 shows each trust’s monthly loss rate percentages

compared on an 18-month rolling basis. Assume a master trust had an annualized

loss rate of 5% in January 1994 and an annualized loss rate of 7.5% in June 1995;

the absolute level of increase would be 250 basis points for that 18-month period

‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts‘BBB’ Ratings Criteria For Credit Card Collateral Invested Amounts

26

Table 3

3 Month Rolling Average Loss Returns per 18 Month Rolling Period

Absolute Change RankTrust Name 1 2 3 4 5

Fleet abs. chg* 508 503 502 484 450min - max 2.58%-7.66% 2.72%-7.75% 2.47%-7.49% 2.85%-7.69% 3.10%-7.61%multiple 2.97 2.85 3.03 2.70 2.45

Capital One abs. chg 490 478 463 462 448min-max 3.02%-7.91% 3.37%-8.15% 2.96%-7.60% 2.79%-7.41% 3.79%-8.28%multiple 2.62 2.42 2.57 2.66 2.18

Citibank Standard abs. chg 302 284 276 249 247min-max 3.70%-6.72% 3.72%-6.57% 3.65%-6.41% 3.65%-6.14% 3.97%-6.44%multiple 1.82 1.77 1.76 1.68 1.62

Discover abs. chg 330 314 305 303 283min-max 4.13%-7.43% 4.35%-7.49% 4.63%-7.68% 4.31%-7.34% 4.21%-7.04%multiple 1.80 1.72 1.66 1.70 1.67

First Chicago abs. chg 310 307 300 278 264min-max 6.52%-9.62% 6.26%-9.33% 6.72%-9.72% 6.19%-8.97% 6.09%-8.73%multiple 1.48 1.49 1.45 1.45 1.43

First USA abs. chg 262 259 255 255 252min-max 2.38%-4.99% 2.82%-5.41% 2.95%-5.50% 2.37%-4.92% 3.97%-6.49%multiple 2.10 1.92 1.86 2.08 1.63

Household AFFNY abs. chg 304 297 297 266 259min-max 4.59%-7.12% 4.30%-7.27% 2.85%-5.82% 3.53%-6.19% 2.96%-5.55%multiple 1.55 1.69 2.04 1.75 1.88

MBNA II abs. chg 245 236 228 201 189min-max 1.61%-4.06% 1.72%-4.08% 1.94%-4.22% 2.16%-4.16% 2.32%-4.21%multiple 2.52 2.37 2.18 1.93 1.81

Providian abs. chg 293 274 267 255 253min-max 5.44%-8.37% 4.98%-7.72% 5.62%-8.29% 5.36%-7.91% 5.71%-8.24%multiple 1.54 1.55 1.48 1.48 1.44

Minimum Abs. Chg. abs. chg 245 236 228 201 189multiple 1.48 1.49 1.45 1.45 1.43

Maximum Abs. Chg. abs. chg 508 503 502 484 450multiple 2.97 2.85 3.03 2.70 2.45

Average Abs. Chg. abs. chg 338 328 321 306 294multiple 2.04 1.98 2.00 1.94 1.79

*Absolute Change is measured in basis points.



(a 50% increase or a 1.5x multiple). The issuer’s loss performance for other 18-month

periods, such as from February 1994 through July 1995, would be compared, and

so on. For each issuer in table 3, this 18-month rolling test was applied and the

top-five most volatile loss periods for each issuer are displayed.

In addition to the monthly loss rate history, Standard & Poor’s bases its expected

case steady-state loss rate on delinquency roll rate, vintage loss performance, and

lagged loss rate analysis. These analytical techniques help mitigate any distortions

due to recent account growth and provide insights into expected future performance.

In many cases, the expected steady-state loss rates are well above the historical average.

As a result, stressed loss rates are at considerably higher multiples compared with

historic averages.

Portfolio YieldPortfolio yield is affected by the terms of the cardholder agreement, the percentage

of convenience users in the portfolio, and the absolute level of charge-offs and delin-

quencies. Portfolio yield consists of cardholder finance charges and fees. It may also

include interchange income and recoveries from charged-off receivables. For modeling

purposes, the yield assumption is important, because yield dictates how much income

will be available to cover expenses (defaults, certificate rate interest, and servicing fees).

1996199419921990198819861984198219801978197619741972

Chart 2

Three-Month LIBOR & Federal ReserveCredit Card Interest Rates (sample period)

Year

0

2

4

6

8

10

12

14

16

18

20(%) Fed Reserve Rates 3-mo. LIBOR (avg.)

Note: The Federal Reserve Credit Card Interest Rates include data collected by the Federal Reserve on outstanding credit card receivables for 65% of the commercial banks, but do not include interchange.

28

In the past, legislative proposals have been introduced to cap the amount of interest

a card issuer could charge. However, movement toward competitive floating-rate

products has mitigated the risk of a legislative cap. Nonetheless, due to the remote

possibility of a regulatory cap, as well as market competition that naturally exerts

downward pressure on portfolio yield, the yield on a portfolio is assumed to decline

in a stress scenario. In a ‘AAA’ scenario, the decline in yield is simultaneous with an

increase in losses. Although not always the case, yield in a ‘AAA’ case is typically

lowered to 11% or 12% and little credit is given to an issuer’s ability to reprice its

portfolio in this environment. However, at the ‘BBB’ level, analysts assume that if

the portfolio is well managed and nationally diverse, there would be less pressure on

price in a rising loss environment. The entire credit card industry would likely suffer

and price competition would abate, allowing issuers to raise APRs to offset higher

losses. For this reason, in a ‘BBB’ combined-stress scenario, yield is reduced to 75%

of its expected steady state over an 18-month period.

Chart 2 illustrates the industry-average credit card interest rates for a sample period.

Although the gap between credit card interest rates and three-month LIBOR has

remained quite healthy, there is a wide variance among issuers in their pricing, product

mix, and account solicitation strategies. As a result, portfolio yield differences among

issuers are significant. Analysts factor issuer-specific portfolio management strategies

into the assumptions used for cash flow modeling purposes.

Certificate RateFor fixed-rate transactions, the modeled input for the certificate rate is the actual

rate payable to certificateholders. For floating-rate transactions, however, the certificate

rate is assumed to increase over time. In floating-rate deals in which interest rate

caps are provided, interest rates are increased to the level of the cap.

The relationship between portfolio yield and the variable cost of funds is an

important factor in determining the level of excess spread for series with floating-rate

certificates. Since banks can reprice credit card accounts and the vast majority of

cards issued in recent years have had floating rates, the differential between portfolio

yield and certificate rate is assumed to be positive in a ‘BBB’ combined-stress scenario.

Standard & Poor’s arrived at its positive 3% to 5% net margin relationship by

comparing the relationship between the three-month London Interbank (LIBOR)

rate and the Federal Reserve credit card interest rates for one extended period

(see chart 2). Over this 15-year period, the greatest positive differential between the

credit card rate and LIBOR was 14.36% in September 1992, and the average difference

was 10.82%. Over this period, the gap between credit card yield and LIBOR never

dropped below 5%, with 6.52% in July 1984 as the lowest point.



In examining the three-month LIBOR rate and the Federal Reserve credit card

interest rate between June 1973 and August 1982, there are instances when the net

interest margin dipped below 5%. For much of the period of September 1979

through July 1982, the net interest margin was less than 5%, averaging just under

2.25%. During that time, there were nine months in which the indexes inverted.

Standard & Poor’s assumes that the likelihood of an inversion during a period of

rapidly rising loss rates and a declining portfolio yield (the ‘BBB’ combined-stress

scenario) is remote. The early 1980s was an unusual period when interest rates sky-

rocketed in reaction to the oil crisis. It is unlikely that the low level of net interest

margin observed then will be repeated. In addition, the credit card market and the

way it funds itself have evolved. LIBOR was not a widely traded index in the early

1980s and, consequently, was less liquid and more volatile. Furthermore, during that

time period, most bank card issuers did not borrow at the LIBOR rate. Instead,

since most issuers were full-service consumer banks, they relied primarily on consumer

deposits to fund their credit card businesses.

The cost of borrowing based on the federal rate for deposits was arguably lower

than LIBOR during the early 1980s. Since lenders did not borrow based on LIBOR,

they did not need to adjust yield and reprice portfolios to compensate for a rising

LIBOR-rate environment. At that time, virtually all credit card issuers offered the

same price to consumers: 19.8%. If the events of the early 1980s were repeated, it

would be reasonable to assume that originators would reprice their portfolios and

avoid a negative relationship between yield and certificate rate.

Although Standard & Poor’s thinks that it is unlikely that LIBOR and credit card

rates will invert in the future, it does not ignore that possibility when analyzing

CIAs. For this reason, a ‘BBB’ rated CIA must pass an interest rate-spike stress,

which incorporates the interest rate environment experienced between 1979 and

1981. This interest rate-stress scenario does not incorporate a simultaneous rise in

loss rates and decline in portfolio yield.

Interest Rate Assumptions And SpikesStandard & Poor’s approach to interest rate modeling is based on the stochastic

modeling of interest rates, using Markov chain Monte Carlo techniques. This technique

involves the use of a probability transition matrix that allows the volatility to vary

from period to period. The rates are generated via an autoregressive time series model,

and the volatility represents the random error at each point in the simulation. Besides

using a transition matrix to govern the jumps among volatility states, the modeling

uses a probability transition matrix for the levels of rates, thereby eliminating very

unlikely jumps in rates from period to period. The results are interest rate scenarios

30

that show minimal error when compared to actual rate paths. The assumptions used

in CIA credit card modeling are a subset of the simulation results.

Interest rate data from 1973 through the present are modeled via autoregressive

time series models. An autoregressive model gives the estimate of the next period’s

rate as a linear combination of one or more past values plus some random error.

The random error is the volatility of the interest rate data, which includes the periods

of high volatility, such as the 1973-1974 oil crisis and the early 1980s. Simulating

rates via this approach with a constant volatility yields excessively volatile results.

Therefore, three volatility assumptions are used in the simulations: low, moderate,

and high, corresponding to different periods in history. Using a transition matrix

based on the historical data, the volatility may vary from period to period based on

the likelihood of moving among the states. For example, if the current period is one

of low volatility, it is most likely that the next period will be one of low volatility.

However, there is some probability that the next period will be one of moderate

volatility, and some smaller probability that the next period will be one of high

volatility. The transition probabilities weight the historical periods so that the

experiences of the early 1970s and early 1980s are not overrepresented. Similarly,

a transition matrix for the level of rates governs the period-to-period jumps, pre-

venting jumps from 5% to 12% in one period, for example, if such a jump is

very unlikely.

When applying the model to credit card C class ratings, Standard & Poor’s is

concerned with the interest rate risk over an 18-month period or a 25-month period.

A total of 1,000 10-year interest rate paths are simulated. For each of these paths,

the rates during each 18-month rolling period are averaged. That is, the periods 1-18,

2-19, 3-20, ..., 103-120, each represent an 18-month period. Each 10-year path gives

103 18-month periods, so for the entire simulation, there are 103,000 18-month

periods. The results are rank ordered and the results for the 18-month period

corresponding to the 95th percentile are selected. In addition, the 18-month period

with the steepest slope is also selected.

Similarly, for the 25-month scenario, the same 1,000 10-year periods are grouped

into rolling windows of months 1-25, 2-26, and so on, yielding 96 25-month periods

for each 10-year path. In either case, the 95th percentile and the steepest slope scenarios

are then used in the interest rate-stress modeling for the C class rating. The results

determine the sufficiency of the spread in the deal to protect CIA investors.

Payment RateThe principal payment rate is one of the most important cash flow variables because

it determines how long certificateholders are subjected to the credit risk of a deterio-

rating pool of assets. Portfolios with fast principal payment rates will allocate losses



to a series over a shorter period of time and, all else being equal, require less enhance-

ment than portfolios with slow principal payment rates. The payment rate assump-

tion in a ‘AAA’ stress scenario is usually 45%-55% of the issuer’s steady-state portfolio

principal payment rate. The payment rate assumption for ‘BBB’ stress scenarios is

between 70%-75% of the issuer’s steady-state portfolio principal payment rate. The

actual percentage used depends on the historical average payment rate for the portfolio,

the minimum payment rate and whether it has changed over time, the existence of

any cobranded products, the quality of servicing, and the historical volatility of

payment rates.

Purchase RateTrust agreements call for any purchases arising on designated accounts to be contin-

ually transferred to the trust. The bank’s ability to continue to generate and transfer

receivables to the trust is an important consideration when rating the CIAs. Purchases

affect the level of principal receivables in the trust. Higher purchase rates accelerate

the repayment of principal to investors and lower the enhancement levels required.

Purchase rate assumptions vary based on pool characteristics, past performance,

and account management strategies used by the servicer. There are also legal consid-

erations when determining purchase rate assumptions for cash flow modeling purposes.

If the originator of the receivables becomes insolvent, the master trust may not have

an ownership or a first perfected security interest in receivables originated after the

insolvency. In the event of an insolvency, the documents generally stipulate that the

servicer allocate collections to the trust as if the trust owned all the receivables origi-

nated from the designated accounts. Further, if the servicer is legally prevented from

doing so, the documents normally call for the allocation of all collections from each

of the designated accounts to be used first to pay down the oldest balances. Since

the trust has an interest in the oldest balance, this allocation is more advantageous

than a pro rata distribution.

Since an insolvency of the originator could adversely affect its ability to originate

and transfer receivables to the trust and, consequently, cause a slowdown in the rate

of principal repayment to investors, Standard & Poor’s varies purchase rate assumptions

based on the unsecured credit rating of the originator for purposes of the CIA rating

analysis. For cash flow modeling purposes, an investment-grade bank is assumed to

be able to originate and transfer sufficient receivables to maintain the principal balance

of the portfolio. For noninvestment-grade originators, the master trust portfolio is

assumed to be declining and, as a result, the rate of principal return to investors will

be slower.

32

CIA Owner Trust StructureEach CIA structure is slightly different. Some CIA ratings require initial deposits in

a reserve account at closing, others are protected by a fully funded cash collateral

account. Still other CIA pieces rely solely on dynamic credit enhancement based on

current excess spread levels. The earlier credit card deals utilize a three class tranche

structure: class A, class B, and the CIA, with all three classes issued out of a master

trust. Subsequently, however, several of the major issuers began using a new owner

trust structure.

In this second type of structure, issuers take the interest and principal entitlement

to the CIA class together with the rights to all remaining excess cash flow after covering

all of the class A and class B costs available at the master trust level, and transfer

the cash into an owner trust. The ‘BBB’ notes are then issued out of this second-tier

owner trust and these notes are collateralized and payable only from the cash flows

allocated to them at the owner trust level. All cash received at the owner trust level

is pooled together and used to pay ‘BBB’ noteholders interest first, and principal as

due second.

Issuing notes from an owner trust structure is intended to take advantage of

accounting regulations changes and allow issuers to structure first loss C pieces as

notes. These notes are then treated as debt (rather than equity) for tax purposes.

Classification as debt eliminates both the transfer restriction, which requires, under

the tax code, that holders of equity pieces receive permission from the issuer before

selling their C piece, and the sale restriction under the Employment Retirement

Security Act (ERISA).

Legal Issues Related To Rating CIAsIn transactions where Standard & Poor’s is requested to rate collateral interests

issued by a master trust in a variety of structures, certain tax issues arise that must

be addressed in addition to the bankruptcy issues. These new owner trust structures

are generally intended to enable the sponsor to enhance the liquidity of the collateral

interests (including permitting sales to non-U.S. investors) without triggering entity-level

taxation for the master trust.

In transactions in which the collateral interests are not rated, Standard & Poor’s

typically receives an opinion from counsel for each transaction that:� The class A and class B certificates of a particular series will be treated as debt for

federal income tax purposes, and� The master trust will not be subject to entity-level taxation as an association taxable

as a corporation or as a “publicly traded partnership” treated as a corporation.



However, in transactions where a rating is requested for the collateral interests,

there is an increased risk that the master trust could become a publicly traded part-

nership taxable as a corporation through the transfer of the collateral interest to a

large number of holders, thereby subjecting such holders to double taxation.

The risk to investors in the collateral interests is that, although it is generally

believed that such interests constitute debt for federal tax purposes (as is the case

with class A and class B certificates), it is possible that such interests could be treated

as equity because they have fewer debt-like characteristics than the other, more senior

classes, including a lower level of credit support. In some cases, counsel is sufficiently

sure of the debt characterization of the collateral interest that it is willing to deliver

an opinion stating that the collateral interests are debt for federal income tax purposes.

If such an opinion is delivered from counsel familiar with the issues, Standard &

Poor’s would be reasonable in assuming in its analysis that:� The master trust has only a single class of equity interest (the seller’s interest) and

thus, is a mere security device and not a separate entity for tax purposes, and� Investors in the collateral interests are (as are investors in the other certificate

classes) treated as holders of debt issued by the sponsor.

However, in the event that counsel is unable or unwilling to provide such an opinion,

it would be necessary for Standard & Poor’s to assume that such collateral interests

are not debt for federal income tax purposes. In such a case, the risk that the master

trust may be viewed not as a mere security device but, rather, as a distinct entity

potentially subject to entity-level tax as an association taxable as a publicly traded

partnership treated as a corporation must be taken into account.

Therefore, additional assurances either in the form of:� An opinion of counsel that the collateral interests are debt for federal income tax

purposes, or� An undertaking from the sponsor that it will use its best efforts to prevent the

master trust (or any applicable trust) from becoming a publicly traded partnership

taxable as a corporation are required. Such an undertaking will, in general, include

a covenant from the sponsor that it will limit to 100 the number of holders of

such collateral interests and any other interests issued by the relevant trust that

may not be treated as debt for federal tax purposes as defined by federal tax

regulations.

For owner trust structures, opinions stating that the secured notes are characterized

as debt and that the owner trust is not taxable as a corporation are also reviewed.


Trust Analysis AndPooling And ServicingAgreement For CreditCard Receivables

This section discusses the various structural and operational issues related to

a master trust. These issues include the addition and removal of accounts, the

purpose and sizing of the seller’s interest, and the importance and impact of

payout events. The section concludes with descriptions of two master trust structures,

socialized and nonsocialized, and a discussion of how principal and finance charge

cash flows are allocated to investors.

Structural AnalysisThe structure of each master trust transaction is governed by the terms of a pooling

and servicing agreement and, for each series, its series supplement. The following is

a discussion of some of the more important features found in the documents of a

typical transaction.

The Trust

Account Conveyance And Additions And Removals

When a trust is created, the seller conveys receivables to the trust for the benefit of

certificateholders. The receivables conveyed are under the control of the seller and

are from accounts designated by the seller. The receivables conveyed include those

receivables generated from these designated accounts and from future receivables

created following the transaction’s cutoff date. The trust accounts and receivables

must conform to eligibility criteria and specific representations and warranties of

the seller to ensure that additional credit risks are properly contained.

36

Eligible Accounts, Eligible Receivables, And Representations And Warranties

Standard & Poor’s evaluates asset performance based on historical data provided

by the seller and by comparing the seller with peer issuers. In addition, it relies on

representations and warranties made by the seller of the assets. One of the most

important seller’s representations concerns the quality and eligibility of the assets

in the trust. Each account and receivable must be eligible under the transaction

documents; otherwise, the account or receivable is removed from the trust.

Appendix A lists the common eligibility requirements for credit card transactions

and should be used as a guideline for sellers and issuers, although Standard & Poor’s

will review deals that don’t conform to the standard representations and warranties

listed. Representations made regarding the assets should apply to both the initial

pool of accounts and related receivables and those subsequently added to the trust.

As delineated in the governing documents, any breached representation or warranty

must be cured within a specified grace period. Receivables that are deemed ineligible

are usually reduced to a zero balance for trust-related calculations and for payment

allocation purposes. Any reduction to the receivables balance due to ineligibility

reduces the seller’s interest.

Although accounts are typically selected randomly, designated accounts may be

selected. However, in this case, the transaction documents will include a representation

and warranty stating that the nonrandom selection procedures will not materially

and adversely affect the interests of the certificateholders. The seller is also responsible

for protecting the trust’s interest in the receivables by filing Uniform Commercial

Code (UCC) financing statements and by perfecting the trust’s interest in the receivables

that are transferred or assigned to it.

The trust agreement permits the seller to remove receivables and related designated

accounts from the trust or to add new receivables by designating additional accounts

from another receivable pool. Because receivables may be added to and removed from

the trust, credit risk could arise as a result of changes to the composition of the trust

after closing.

There are risks associated with adding recently originated accounts because new

accounts have not had sufficient time to season and reach their peak default phase.

The addition of new accounts, therefore, potentially skews performance for the overall

trust by making the performance of the receivables from the existing accounts appear

more favorable. Standard & Poor’s estimates that new accounts are not likely to reach

their peak charge-off until between month 18 and month 24. Therefore, receivables

from new accounts may dilute the trust’s charge-off statistics until the new accounts

are seasoned. Adding a large percentage of new accounts could delay a base rate pay-

out event, since losses are temporarily masked. Moreover, the new accounts that are

added may have been originated under more relaxed underwriting standards compared

Trust Analysis And Pooling And Servicing Agreement For Credit Card Receivables



with those of existing accounts. This may result in higher-than-anticipated charge-off

rates for the trust in subsequent months, when these riskier accounts mature and enter

their peak charge-off period. Even given these risks, since most credit card issuers

originate receivables daily as part of their normal course of business, Standard & Poor’s

allows limited additions to the trust subsequent to the transaction’s closing.

Account Additions

Account additions subject to certain limitations are allowed without Standard & Poor’s

confirmation that the ratings will not be lowered or withdrawn as a result of account

additions. Such additions are classified as automatic account additions. Still, these

additions must meet account and receivable eligibility criteria and are subject to

representations and warranties as required. Automatic account additions are permitted

as long as the number of cumulative accounts added in any three-month period does

not exceed 15% of the trust portfolio at the beginning of the quarter, and if the number

of accounts added during any 12-month period does not exceed 20% of the trust

portfolio at the beginning of the 12-month period. In the case of all other account

addition proposals, Standard & Poor’s evaluates the characteristics of the added

accounts and monitors the effects of these lump-sum additions on the credit quality

of the trust.

In addition to voluntary automatic additions and lump-sum additions, the seller

is required to add accounts whenever the interest falls below the minimum seller’s

interest, or when the principal receivables in the trust fall below the minimum aggregate

principal receivables requirement. Such account additions are classified as required

account additions. In most transactions, if the minimum seller’s interest or the minimum

aggregate principal receivables requirement is breached, to correct the imbalance

and to ensure the deal is sufficiently supported, principal collections are deposited

in an excess or special funding account. These deposits are made from the point of

infraction until the seller is able to convey the necessary additional receivables from

newly designated accounts, or until sufficient receivables are generated in the accounts

already designated to the trust.

Because of the revolving nature of credit card accounts and the monthly sale of

newly charged receivables to the trust, legal opinions regarding the receivables conveyed

after the cutoff date are delivered periodically by the issuer’s counsel. The opinions

address the nature of the sale of the newly conveyed receivables and the trustee’s

perfected interest in these receivables. The frequency with which these opinions need

to be reviewed is based on the seller’s rating as follows:� For sellers rated ‘AA’ or higher: seminannully;� For sellers rated ‘A+’ to ‘A’: quarterly; and� For sellers rated ‘BBB+’ or lower: monthly.

Trust Analysis And Pooling And Servicing Agreement For Credit Card ReceivablesTrust Analysis And Pooling And Servicing Agreement For Credit Card Receivables

38

Risks are also associated with account removals, because the seller may elect to

remove the better-performing accounts, causing the overall quality of the trust portfolio

to deteriorate. Additionally, removal may cause the seller’s interest to fall below the

required minimum seller’s interest, or cause the principal receivables in the trust to

fail the minimum aggregate principal receivables requirement. Failure of either require-

ment would reduce the size of the trust portfolio to such a level that the collateral

would be insufficient to support the outstanding certificates at their required enhance-

ment levels.

To protect the securities from these risks, before most removals, the trustee is required

to receive notification from Standard & Poor’s that the proposed removal will not

adversely affect any outstanding ratings. Automatic removal of accounts without

Standard & Poor’s written affirmation is allowed, provided certain criteria are met.

One requirement is that the account selection process must be random to prevent

biased removals from the trust. Another requirement may be that removals are allowed,

but subject to monthly, quarterly, and annual limits. Additionally, removals may only

occur if the minimum seller’s interest and the minimum aggregate principal receivable

requirements are not breached. The seller also agrees to deliver an officer’s certificate

stating that the proposed removal will not adversely affect certificateholders.

Seller’s Interest

Each series of securities issued from a master trust has an undivided interest in the

assets and an allocable interest in the collections on the receivables in the master trust

based on the aggregate invested amount of the series. Trust assets that have not been

allocated to any series of securities are known as the seller’s or transferor’s interest.

Seller’s interest represents the remaining ownership interest in the trust assets; that

is, trust assets that not allocated to certificateholders’ interest. The size of the seller’s

interest is equal to the difference between the aggregate principal receivable balance

of the trust portfolio and the principal balance of all outstanding securities in the

trust. Seller’s interest fluctuates as the amount of securities issued by the trust changes

or as the balance of principal receivables in the trust assets increases or decrease. In

the absence of dilutions, which reduce the receivables balance, when account purchases

exceed account payments during the revolving period, the seller’s interest increases.

Conversely, when account payments exceed account purchases, the seller’s interest

declines. The seller’s interest also declines as a result of any noncash reductions in

the receivable portfolio. These noncash reductions are receivable dilution (see chart 1).

The Purpose Of A Seller’s Interest. The seller’s interest serves two key purposes.

First, it provides a collateralization buffer in instances when account payments

exceed account purchases; and second, it absorbs reductions in the receivable balance

attributable to receivable dilution or as a result of reassignment of noncomplying

receivables. Noncomplying receivables are receivables that breach any representations




made by the seller when sold to the trust and are, therefore, removed from the trust

and bought back by the seller.

Dilution. Receivables are generated in accounts when merchandise is bought, services

rendered, cash advanced, or balances transferred. Dilution is any reduction to the

receivables balance due to any reasons other than losses or an obligor’s cash payments.

Examples of dilution include credit given to the cardholder by the merchant for

merchandise returns; reductions in receivable balances offered by the issuing entity

for items such as rebates, refunds, and adjustments for servicer errors; reductions

due to fraudulent or counterfeit activities; and removals of noncomplying receivables.

Returned or refused merchandise is the primary reason for dilution in a portfolio.

Most services rendered (such as meals at a restaurant), balance transfers, and cash

from cash advances are generally not returnable and, therefore, are not subject to

dilution risk.

Balance transfer has become a popular strategy to generate growth for almost all

bank issuers. Many issuers have grown their portfolios by offering low introductory

APRs and enticing consumers to transfer existing credit card balances. Since balance

transfers are similar to cash advances and are not returnable, portfolios with a high

percent of balance transfers typically have lower dilution rates compared with port-

folios with a lower percentage of balance transfer accounts.

Rebate Programs. Some credit card issuers offer rebate programs designed to

attract new business as well as retain creditworthy and profitable accountholders.


Total Trust Principal Required Seller's Interest

Seller's Interest Invested Amount

80

0

90

100

110107

120

130

140($)

1 3 5 7 9 1113151719

21

23252729313335373941434547 515355 59616365676971

Seller's Interest < RequiredSeller's Interest

Amortization Period Begins49

57

Purc

hase

s >

Prin

cipa

lPa

ymen

ts +

Cha

rge-

offs

Purc

hase

s >

Prin

cipa

l Pay

men

ts+

Char

ge-o

ffs

Chart 1The Components And Mechanics Of Trust Principal

40

Specifically, some rebate programs allow a cardholder to earn points every time the

card is used for purchases or to earn points for keeping the account balance current.

Accumulated rebate points can be redeemed for items ranging from cash to free phone

service or airline travel to a discount on merchandise such as a car purchase.

However, there are credit concerns associated with rebate programs. If the issuing

bank becomes insolvent and subsequently defaults on its obligation to provide

cardholders with rebates already earned, the cardholders may deduct, or “set off,”

the dollar amount of the promised rebate from their current credit card balances.

This deduction will reduce the amount collectible on the account. For example,

assume a bank offers each cardholder a $100 cash rebate for maintaining an average

outstanding balance exceeding $5,000 for 12 consecutive months. Ms. Smith, who

has a $6,000 balance, qualifies for the $100 rebate. Before making payment to Ms.

Smith, the bank goes insolvent. Even though the bank has not credited Ms. Smith’s

account for the rebate she earned, Ms. Smith may decide to set off the $100 from

her current outstanding balance and, in turn, mail a $5,900 payment in full to the

bank to reduce her balance to zero.

The $100 set-off in the example above is a receivable dilution. Because rebate

programs are subject to set-off risk, Standard & Poor’s will review and examine

each rebate program to determine the likelihood of set-off risks and to quantify

any potential set-off amounts.

Quantifying Exposure To Dilution. Standard & Poor’s generally requires issuers

to provide three to five years of monthly return and fraud data for dilution analysis.

In determining the level of protection needed for certificateholders against dilutions

during the life of the transaction and the required seller/transferor interest, analysts

focus on both the level and the timing of current and historical dilution patterns.

Since the majority of dilutions typically occur within one to three months from the

date of sale, analysts focus on returns that occur during 30-, 60-, and 90-day cycles.

In analyzing historical return data, analysts must first determine a steady-state dilution

Table 1

Dilution Analysis

Month Receivables ($) Returns ($) % 100% ($) 20% ($) 10% ($) Total ($) %

January 5,593,504,000 22,174,327 0.40 22,174,327 — — — —

February 5,489,499,000 18,267,896 0.33 18,267,896 4,434,865 — — —

March 5,406,525,000 13,255,427 0.25 13,255,427 3,653,579 2,217,433 19,126,439 0.35

April 5,365,474,000 19,777,845 0.37 19,777,845 2,651,085 1,826,790 24,255,720 0.45

May 5,444,411,000 21,689,546 0.40 21,689,546 3,955,569 1,325,543 26,970,658 0.50

June 5,516,669,000 14,005,223 0.25 14,005,223 4,337,909 1,977,785 20,320,917 0.37

Average — — — — — — — 0.42




rate (see table 1). The March data from table 1 shows that $13 million of merchandise

was returned. Out of the $13 million, it is assumed that a majority of returns are

from March sales, but a portion of returns are also from previous months’ sales. In

this example, analysts assume that 20% of March returns are from February sales

and 10% of March returns are from January sales. This artificial staggering of returns

over 30, 60, and 90 days from the date of purchase allows analysts to arrive at a

steady-state return rate that is more conservative than historical experience in the

portfolio. The return rates for each month are then generally averaged to arrive at a

steady-state dilution number (0.42% in table 1). For an ‘AAA’ rating, this steady state

is typically stressed by a 3x to 5x multiple. If an issuer provides historical timing data

that shows that a majority of returns occurs very soon after the date of sale, Standard

& Poor’s will consider relaxing the 20% and 10% lag assumptions and may choose

instead to use primarily the current month’s dilution numbers. The magnitude and

timing of dilution vary among issuers. These variations depend on the specific obligor

profile and on a specific merchant’s policy regarding merchandise returns and rebates,

as well as the merchant’s liability for stolen cards, fraud, and warranties. If historical

data shows that a majority of returns occurs in later months, Standard & Poor’s may

chose to increase the lag assumptions.

Bank credit card transactions are typically structured requiring the seller or issuer

to reimburse the trust for dilution adjustments. If the seller is unable to do so, the

seller’s interest will be reduced to absorb any dilution adjustments.

If the seller is unable to reimburse the trust for dilution, or if the seller’s interest is

zero and cannot further absorb dilutions, a dilution adjustment to the trust receivable

balance is made, causing the trust portfolio to shrink. As the trust portfolio shrinks,

principal finance charge collections generated by the remaining collateral will also

decline, reducing potential collections needed to pay down outstanding certificates.

Because of this risk and because credit support is typically sized only to cover losses,

credit card securitizations also must include mechanics to cover dilution risks. One

way to cover dilution risk is to structure a deal that ensures that a minimum seller’s

interest is always available to absorb any dilution adjustments should the seller

default on its obligation to reimburse the trust for noncash or noncharge-off

receivables reductions.

Minimum Seller’s Interest. Most bank-sponsored credit card-backed issues require

a minimum seller’s interest of 7%. Standard & Poor’s analyzes an issuer’s rebate

programs, portfolio composition, and timing of returns and determines if the 7%

dilution requirement is sufficient. Following analysis of an issuer’s data, some bank

master trusts have been allowed to reduce their dilution coverage below the standard

7% level. However, deviation from the 7% minimum seller’s interest requirement

is allowed only after careful and detailed analysis of an issuer’s historical dilution

performance and only if the deal’s structure provides that principal collections are

Trust Analysis And Pooling And Servicing Agreement For Credit Card ReceivablesTrust Analysis And Pooling And Servicing Agreement For Credit Card ReceivablesTrust Analysis And Pooling And Servicing Agreement For Credit Card Receivables

42

immediately retained in the trust for the benefit of investors any time the seller’s

interest drops below its required minimum amount.

Timing Of Seller’s Interest Test. In most structures, the seller’s minimum interest

test is performed monthly (see chart 2). For example, on Jan. 12, the determination

date, the servicer will look back to the end of December to determine whether the

seller’s interest was below the required level. If the seller’s interest was below the

requirement as of Dec. 30, the seller must add accounts by Jan. 22, the required des-

ignation date (10 days after the determination date), in order to satisfy the required

minimum seller’s interest test. If the deal is not in compliance on the required desig-

nation date, the deal will enter rapid amortization and all principal payments col-

lected will be passed through to investors beginning Feb. 15, the amortization date,

to pay down outstanding certificates.

Some master trusts require daily testing of the seller’s interest. Before the seller is

allocated or paid any amounts from daily collections, the seller’s interest must be at

or higher than its required minimum amount. If the seller’s interest falls below the

required seller’s interest on any day, principal collections that would have otherwise

gone to the seller are instead deposited in a trust excess funding account (EFA) until

the seller’s interest, together with cash on deposit in the EFA, brings the trust back

into compliance with the minimum requirements.

Tax Considerations. Credit card-backed deals are typically structured and charac-

terized for federal tax purposes as either debt of the transferor, where the trust is a

“mere security device,” or as interest in the partnership formed by the trust.

monthly period

determinationdate

distributiondate

requireddesignation date

amortizationdate

12/1 12/31 1/1 1/31 2/11/12 1/15 1/22 2/15

Dec Jan Feb

Chart 2Timeline




Generally, the intent of the seller is to treat the certificates as debt for tax purposes.

It is, therefore, common for the issuer’s counsel to provide a tax opinion stating that

the certificates would be treated as debt.

A credit card trust may choose to be classified as either a corporation or a part-

nership by filing a form with the IRS. Failure to pick an option results in the default

classification as a partnership.

Payout Events

The inclusion of payout events in credit card transactions protects investors against

adverse situations and provides a way for investors to receive accelerated return of

principal when unfavorable scenarios unfold. A trustwide payout event triggers the

start of the rapid amortization period for all the series issued by the trust, while a

series payout event triggers rapid amortization for the specific series. During early

amortization, all principal collected (and not just the certificate’s floating share of

principal) is passed through to the investors in order of seniority as quickly as possible.

Payout events include asset performance tests, seller insolvency events, and occurrence

of servicer defaults. All payout events indicate potential problems in the deal that

could threaten the likelihood of ultimate payment to investors.

By accelerating payments and paying all principal collections received to certificate

holders, investors are less exposed to losses in a deteriorating environment. Standard

& Poor’s views asset performance payout events, such as the base rate trigger, the

required minimum seller’s interest test, and the required minimum principal receivables

trigger, as important and necessary payout events that provide protection to investors.

The value of the inclusion of these events in structures compared to deals that exclude

them is evident and quantified upon reviewing the results of various cash flow runs.

The Base Rate Trigger. A violation of a base rate trigger as defined in the series

supplement causes the series to enter a rapid amortization period. The base rate trigger

is an automatic payout event and does not require investors’ approval. The base rate

trigger usually consists of two components:� The net portfolio yield, defined as finance charge collections minus losses,

expressed as a percentage of the investor interest; and� The base rate, defined as the amount of monthly interest owed to certificates and

portfolio servicing fees, expressed as a percentage of the investor interest.

If the base rate exceeds the net portfolio yield for a three-month rolling average,

the base rate trigger is violated and principal will be returned to investors as quickly

as possible, beginning on the next distribution date. The violation of a base rate trigger

indicates that the trust assets are not yielding enough to pay trust and certificate

expenses. When a base rate trigger occurs, the deal is no longer solvent and it enters

early amortization, ensuring that investors’ interests are paid down as soon as possible

before performance worsens.


44

When analyzing the impact of a base rate trigger on credit enhancement levels,

analysts examine structural features that can affect the strength of the base rate

trigger. First, if the net portfolio yield definition includes excess finance charge

collections from other series issued from the trust, a payout event may be delayed

even though the trust portfolio is deteriorating. The inclusion of excess finance

charge collections from other trust series may artificially boost portfolio yield

performance. For example, if charge-offs are rising and excess finance charges are

included, a payout event would not occur until after charge-offs increased above the

level of finance charges allocated to the series plus excess finance charge collections

from all other series issued from the trust. To account for the inclusion of excess

finance charge collections in the base rate definition, Standard & Poor’s may assume

higher initial steady-state loss rates in all cash flow modeling.

A second consideration concerning the base rate is servicing fees. Servicing fees

should be based on a fee sufficient to attract a successor servicer. The standard servicing

fee for the credit card industry is 2%. An exception to the standard fee arises when

credit is given to servicer interchange. In deals that include interchange credit, the

original servicer accepts a smaller servicing fee from finance charge collections, but

receives an additional fee generated from interchange revenue. To gain credit for servicer

interchange, the servicer and trustee that is obligated to act as successor servicer must

have the requisite rating, among other qualifications. In addition, the trustee must

be able to service the trust portfolio as a successor servicer. Only in these circumstances

will Standard & Poor’s allow the base rate to include a servicing fee that is less than

the allocable servicing fee of 2%.

Some deals are structured such that a base rate trigger can cause a payout event to

occur before excess spread declines to zero. For example, in certain deals, a payout

event will occur if the net portfolio yield declines below the base rate plus 1%. This

type of trigger allows a deal some cushion before losses and expenses exhaust excess

spread completely. A base rate plus 1% trigger will cause a transaction to go into

rapid amortization sooner than it would if a normal base rate trigger were employed.

Standard & Poor’s recognizes the structural advantage of a tighter base rate trigger

and, as a result, may require less credit enhancement when a stricter base rate trigger

is incorporated.

In nonsocialized master trusts, the base rate trigger is specific to individual series

within the master trust. While the net portfolio yield definition is the same for all

series in nonsocialized master trusts, the base rate definition will vary for each individual

series in the master trust depending on the interest coupons carried by the certificates

in each series. Assuming the same net portfolio yield and servicing fee exist for all

outstanding series, a series with higher coupons will trigger a payout event before a

series with lower coupons.




Socialized trust structures pay the trust’s expenses, including monthly interest,

based on the needs of individual series. The expense need of each individual series

varies depending on the coupon rate of outstanding certificates. Since collections

received are allocated based on series’ needs, portfolio yield is reallocated to series

with higher expenses from series with lower expenses. Consequently, if net portfolio

yield is insufficient for one series in a socialized trust to cover expenses, it is insufficient

to cover expenses for all other series in a socialized trust. Violation of a base rate

trigger in a socialized structure will, therefore, cause all series in a group to enter

into rapid amortization and pay out at once.

Required Minimum Seller Interest And Required Minimum Aggregate Principal

Receivables. If the seller’s interest is less than the required minimum seller’s interest

or the aggregate principal receivables are less than the required minimum aggregate

principal receivables, an early amortization event will occur unless requisite additional

receivables are added to the trust typically within 10 business days. The required

seller’s interest is generally measured as a fixed percentage of current principal receiv-

ables or current investor interest. Therefore, as a series begins to amortize, the invested

amount and required minimum seller’s interest will decline on an absolute basis.

However, the minimum aggregate principal receivables test is calculated in most

deals based on the invested amount of the series as of the end of its revolving period.

As a result, the minimum aggregate principal receivables test requires that the princi-

pal receivables be maintained at a higher level than that required by the minimum

seller’s interest test when the invested amount of the series is amortizing (see chart 3).

If either minimum requirement test fails, an automatic payout event occurs.


Invested Amount Required Seller's Interest Seller's Interest

0

20

40

60

80

100

120

140($)

MinimumAggregatePrincipalAmount($100)

1 3 5 7 9 11 1315 1719 21 232527 29 31 3335 3739 4143 45 4749 5153 55 5759 6163 6567 69 71Month

Chart 3Minimum Aggregate Principal Vs. Required Seller's Interest

46

Failure Of The Seller To Make Payments Or Deposits. A payout event also occurs

if the seller fails to either make a payment or deposit within five business days of the

required date under the pooling and servicing agreement, or if the seller fails to per-

form in any material respect a covenant that is left unremedied for 60 days. This

payout event is not automatic and, as a result, requires investors representing at least

50% of the invested amount of a series to vote before such an event results in a

series payout event.

Representations And Warranties. A payout event occurs if there is a material

breach of a representation or warranty by the seller that is unremedied for 60 days.

An unremedied material breach is a payout event that requires investors representing

at least 50% of the invested amount of a series to vote before it affects the series.

The Role Of The Servicer In The Transaction. The servicer agrees to service and

administer the receivables in accordance with its customary practices and guidelines,

and it has full power and authority to make payments to and withdrawals from deposit

accounts that are governed by the documents. Fidelity bond coverage is typically

required to cover any potential wrongdoing by its employees and officers.

Servicers are generally paid 2% of the invested amount for their obligation to service

receivables. Because some servicers of bank receivables are highly rated, some are

allowed to commingle funds with the company’s general funds until one business

day before the distribution date. Those without a short-term unsecured rating of

‘A-1’ or higher are not allowed to commingle and must deposit collections in an

eligible deposit account immediately but no later than within two business days

of receipt.

Independent accounting reports stating whether the servicer is in compliance with

the terms outlined in the documents and whether the servicer’s policies and procedures

are adequate are required at least annually. Any exceptions are listed with an expla-

nation within the accounting report.

A servicer is not allowed to resign unless law prohibits it from performing its duties.

Even if a servicer resigns, the resignation is not effective until a successor servicer or

the trustee, as successor, has assumed all the servicer’s responsibilities for the same fee.

Servicer Default. Any servicer default that would have a material adverse effect

on investors is considered a payout event. A servicer default occurs, for example, if

a conservator or receiver is appointed or if the servicer fails to make any required

payments. This payout event also requires investors representing at least 50% of

the invested amount of a series to vote before it takes effect for that series.

Investors Are Not Paid In Full By The Expected Payment Date. If any class of

securities rated by Standard & Poor’s is not paid in full by the expected payment

date of that class, a rapid amortization will automatically begin and, from that point

on, all principal collected will be paid to certificateholders until the class is paid in

full. A delay in principal payment to investors results if scheduled controlled deposits




or payments during a controlled amortization or an accumulation period are insufficient

to retire certificates by the expected maturity date.

Trust Payout Events. Trust payout events will result in rapid amortization for all

series in a master trust. The following trust payout events are automatic payout events

and do not require an investor vote:� An insolvency event of the seller, which occurs when the seller is no longer able to

pay its obligations and must appoint a conservator, receiver, or liquidator, or file

for bankruptcy. Under an insolvency event, the ability of the seller to generate new

receivables is clearly impaired, and a payout event would be necessary. In addition,

after the insolvency of the seller, the trust may not have an ownership or first priority

perfected security interest in new receivables generated, which further jeopardizes

the likelihood of receipt of collections from the collateral seller.� The trust is deemed an “investment company” under the Investment Company Act.� The seller is unable to transfer receivables to the trust.

Types Of TrustsCredit card securitizations are structured as either discrete trusts, nonsocialized master

trusts, or socialized master trusts.

Discrete Trusts

The first credit card transactions were issued from discrete trusts. As the market

evolved, many of the structural features of discrete trusts were transferred to the

master trust structures. For example, eligibility criteria for accounts and receivables,

representations and warranties of the seller, servicing and servicer requirements, cash

flow allocations between the seller and investor interest, trust payout events, and

series termination methods are all used in similar ways in both discrete trusts and

in master trusts. However, the advent of the master trust brought increased

flexibility for issuers.

Master Trusts

The master trust permits the issuer to sell multiple series from the same trust. Master

trusts also allow each series to share the credit risks as well as the cash flow from

one large pool of credit card receivables. Intercreditor agreements exist among the

investors in each of the series that provide the “fire walls” that preclude investors in

one series from taking credit support from another series. Deal documents further

state that, unless specifically designated as a subordinated series at issuance, no series

is subordinated in terms of cash flow allocation to another series within the trust.

There are two types of master trusts: socialized and nonsocialized. The two types

of trusts differ in the way finance charge collections are allocated to the series.


48

Nonsocialized Master Trusts

In nonsocialized master trusts, finance charge receivables are allocated to the total

investor’s interest and seller’s interest pro rata based on the principal amount of

he series. Principal in a nonsocialized trust is allocated to the investor’s and seller’s

interest of each series based on principal requirements. No reallocation or sharing of

excess cash flow occurs until each series is paid its full amount of allocable cash flow

to cover its current expenses. Although rare among the newer trusts, some nonsocialized

trusts do not share excess finance charges at all. Nonsocialized master trusts that do

not share excess finance charges were common at one point, and in these instances,

excess finance charge collections are not used to cover the monthly shortfall of other

series but, rather, are allocated and paid to the seller. The majority of nonsocialized

master trusts do permit the sharing of excess finance charge collections.

Socialized Master Trusts

In socialized master trusts, finance charge receivables initially are allocated to a group

of series based on the amount of that group’s outstanding principal. Finance charges

are then split among the series sellers’ interests and investors’ interests based on size

within the group. The investors’ share of finance charges is then reallocated to the

investor interest of each series within the group based on the pro rata costs of such

series. Ultimate allocation, then, is based on costs, which include certificate interest,

servicing fees, and investor default amounts, rather than on the size of the series

aggregate investor amounts.

Principal is allocated among each group and series based on principal size. This is

similar to the principal allocation method used in nonsocialized master trusts. As is

the case with some nonsocialized master trusts, socialized master trusts may also

provide for shared principal among groups, if necessary.

Grouping In A Master Trust

A typical feature of all master trusts is the grouping of series within a trust. This feature

is used most effectively in socialized master trusts. For example, an issuer may separate

floating-rate series from fixed-rate series and issue floating series out of group one

and fixed from group two. As previously mentioned, Standard & Poor’s assumes

that for floating-rate transactions, the deal’s costs will become greater during the

rapid amortization period. Cash flows are run assuming the certificate rate increases

to an ultimate capped level over time. This stress for floating-rate liabilities can have

a large impact on enhancement levels when compared to enhancement levels needed

on similar fixed-rate transactions. By separating fixed- and floating-rate transactions

into groups within a trust, the enhancement levels for a series within a group will

more accurately reflect the risk of each series. It should be noted, however, that issuers




use socialization, in part, to smooth out interest rate volatility and avoid a potential

base rate trigger by combining high-liability transactions with deals with lower costs.

Therefore, some issuers chose to keep fixed- and floating-rate series together and

issue both types from one group.

When fixed- and floating-rate transactions are grouped together in socialized trusts

under Standard & Poor’s interest rate-stress scenarios, the fixed-rate transactions

tend to subsidize the floating-rate transactions, which have potentially higher costs.

In a socialized structure, cash flow is reallocated from the fixed-rate series to cover

the higher-cost floating-rate series. Therefore, since all cash flow within a group is

shared, all series within a socialized group require the same enhancement level. As a

group, the required enhancement level for the fixed-rate series in a socialized trust

may seem higher than it is in nonsocialized trusts, while the level for floating-rate

transactions may seem lower. However, the individual enhancement levels between

a fixed- and floating-rate deal, if analyzed separately, will be the same for either a

socialized or a nonsocialized trust.

Although grouping will affect the enhancement level of each series within a socialized

group, it should be noted that the total amount of enhancement for all series in a

socialized master trust is not affected by grouping. Enhancement levels depend on

the performance of the collateral and the series certificate rates. Whether a group is

constructed as a socialized or nonsocialized trust has little consequence on the total

risk affecting certificates issued by the trust. All other variables being equal, overall

enhancement levels for socialized and nonsocialized trusts are identical. The greatest

advantage to socializing finance charge collections is the ability to avoid a series specific

base rate amortization by reallocating the group’s resources to the series in need.

However, if the group’s costs are not covered by net yield, the largest risk is that all

series in a socialized group will amortize simultaneously. In contrast, in nonsocialized

trusts, interest costs are separated from each other, helping to isolate amortization

events to series with higher interest rates.

A Typical Transaction From A Master Trust: Nonsocialized Trusts That Share

Excess Finance Charges. Issuers commonly create nonsocialized master trusts that

allow sharing of excess finance charge collections and principal collections among

series in a group. However, excess finance charges among outstanding series arise

only after each series pays its expenses in full. After series expenses are covered in

full, available excess finance charges from such series are then shared among other

series that experience finance charge shortfalls according to need.

Some nonsocialized trusts also share principal collections. In these cases, principal

collections are allocated to series only during accumulation or amortization. During

either period, principal cash flow is collected to either accumulate up to the scheduled

controlled deposit amount (during accumulation), or to pay the controlled amortization

amount (during amortization), or to make a principal bullet payment on the scheduled


50

payment date. Principal sharing occurs when principal collections allocated to other

series in their revolving period are not needed by those series and, consequently,

are reallocated to other amortizing or accumulating series in the trust that do

need principal collections.


Cash Flow AndStructural Analysis ForCredit Card Receivables

Credit card structures utilize both socialized and nonsocialized master trusts.

This section further highlights the differences between the trusts by examining

how each trust allocates finance charge collections, defaults, and principal

to investors and sellers within a trust and how allocation of these three components

differs during revolving and nonrevolving periods. The section concludes with a dis-

cussion of some structural features associated with credit card analysis, including

the subordination of interest, the reallocation of subordinated cash flows, and the

impact of issuing a paired series.

Cash Flow Allocations

Finance Charges And Default In Nonsocialized Trusts

All nonsocialized trusts allocate defaults and finance charges based on size, whether

or not they share excess finance charges. Allocations are made in two steps:� Finance charges are allocated to each group and seller’s interest, pro rata, based

on size.� Each group’s allocations are divided among all series and classes based on series

and class size.

An example of how nonsocialized trusts allocate finance charges and defaults is

best illustrated using the structure depicted in chart 1. In this structure, the sum of

the investor interests in group one totals $900 million, and the seller owns $100 million.

Assuming a static amount of principal receivables, as finance charges are collected

and charge-offs are realized, the series in group one would be allocated 90% of

finance charge collections and charge-offs. The seller in this example would be allocated

10% of those amounts (see chart 2). The amounts allocated to group one would

then be allocated pro rata to each series within group one. Since the invested amount

52

of the third series in chart 2 totals 50% of group one’s trust principal amount, it

will receive 50% of the finance charges, and it will be allocated 50% of defaults.

Similarly, series 1 and series 2 will receive 20% of finance charge collections, and

each series will be allocated 20% of defaults, since each represents 20% of the trust’s

principal balance.

Each series must pay its own expenses, including monthly interest, servicing fees,

and the allocated charge-offs, from finance charges allocated to that series. Only

after each series covers its own costs will it distribute excess finance charge collections,

if any, to other series in the group. Any excess finance charge collections paid to

other series are distributed among those series based on need.

Following allocation of finance charge collections and defaults at the group level,

allocations are made among classes within a series. Specifically, chart 3 diagrams a

multi-step allocation among classes in a standard nonsocialized master trust series.

Class A Available Funds are defined as class A’s percentage of investor finance

charge collections, and will be used to pay:� Class A interest,� Class A servicing fees, and� Class A investor defaults.

The remainder, if any, is characterized as excess spread, which is used later in the

payment waterfall.

Chart 1

A Typical Trust Structure A Nonsocialized Master Trust That SharesExcess Finance Charge Collections

Seller'sInterest

$100 mil.

Series 1$200 mil.

Investor Interest

Series 2$200 mil.

Investor Interest

Series 3$500 mil.

Investor Interest

Class A$180 mil. 'AAA'

(with 20% support)


(with 20% support)


(with 20% support)

Class B$20 mil. 'A'

(with 10% support)

Class B$20 mil. 'A'

(with 10% support)

Class B$50 mil. 'A'

(with 10% support)

Collateral Interest$20 mil.

'N.R.'

Collateral Interest$50 mil.

'N.R.'

Group 1

Cash Collateral Account$20 mil.

'N.R.'

Cash Flow And Structural Analysis For Credit Card Receivables



Class B’s percentage of investor finance charge collections, called Class B Available

Funds, pays:� Class B interest, and� Class B servicing fees.

The remainder is also characterized as excess spread. Collateral Available Funds,

or the collateral interest’s percentage of investor finance charge collections, are used

to pay:� The collateral interest’s servicing fee.

The remainder is characterized as excess spread.

Although collateral available funds may be used to pay interest to the collateral

interest amount (CIA), some transactions subordinate that interest. The CIA interest

is then paid in the secondary excess spread waterfall following the payment of class

Cash Flow And Structural Analysis For Credit Card ReceivablesCash Flow And Structural Analysis For Credit Card Receivables

Finance Charge Collections

$100

$10

$90

$9$1

$20

$2

$20

$2

$50

$5

Seller's Interest:$100 mil.

Group One$900 mil.

Seller's 1:$200 mil.



Defaults

Seller's Interest:$100 mil.

Series 1:$200 mil.

Series 2:$200 mil.

Series 3:$500 mil.

Chart 2Allocations Of Finance Charges And Defaults

In Nonsocialized Trusts

Group One$900 mil.

54

Class B Monthly Interest

Class A Available Funds Class B Available Funds Collateral Available Funds

Class A Servicing Fee

Class A Investor Defaults

Class B Servicing Fee

Excess Spreadin the following priority

Collateral Servicing Fee

Class A Monthly Interest

Excess FinanceCharge

Collections fromOther Series

Excess FinanceCharge

Collections fromOther Series

Class B Required Amount(in priority)

� Interest� Servicing Fee� Investor Defaults

Pay the collateral interestholder in the following priority:

� Interest� Servicing Fee� Increase invested amount for prior reductions

Increase Class A InvestorInterest for any prior

charge-offs

Increase Class B InvestorInterest for any prior

reductions and charge-offs

Fund CCA up to the requiredamount and pay other fees tothe collateral interest holder

Excess Finance Charge Collections for Other Series

Chart 3Waterfall For Step Two in Nonsocialized Master Trusts

Class A Required Amount(in priority)

� Interest� Servicing Fee� Investor Defaults




A and class B required amounts and following payment to class A and class B for

any unreimbursed costs (see chart 3). When the collateral interest’s interest payments

are subordinated and made available to cover more senior classes’ costs, both class

A and class B benefit. Finance charge income that would have been used to pay the

CIA interest is used instead to cover class A and B interest and defaulted amounts to

the extent not covered by class A and class B available funds, respectively.

If available funds are insufficient to pay the costs of interest, servicing fees, and

investor defaults as outlined above, a shortfall exists. This shortfall is defined as a

class A required amount or a class B required amount, and subsequently will be paid

in the secondary waterfall.

Class A required amounts are paid from the following sources in priority:� Excess spread (and excess finance charges from other series, if such excess is shared);� Withdrawals from a cash collateral account (CCA) or draws on an LOC, if

applicable; and� Reallocated principal from the subordinated classes.

All reallocated principal collections will first result in a reduction of the collateral

interest until its principal balance is zero, before reducing the class B principal balance

to zero.

In addition, if the monthly investor share of principal and interest collections received

is not sufficient to pay the class A required amount, classes will be written down in

an amount equal to the class A investor default amount in the following priority:� Collateral interest amount,� Class B, and� Class A.

Similarly, to the extent any class B required amounts exist, they are paid from:� Excess spread (and excess finance charges from other series, if such excess is

shared) if it is not needed for class A;� Withdrawals from a cash collateral account or draws on an LOC, if any, if it is

not needed for class A; and� Reallocated principal from the collateral interest if it is not needed for class A.

If monthly cash flow amounts are not sufficient to pay the class B required amount,

classes will be written down in an amount equal to the class B investor default

amount in the following priority:� Collateral interest amount, and� Class B.

After payments of the class A and class B required amounts, collateral interest holders

are paid their interest, their share of the servicing fee, and reimbursed for any prior

write-downs. Remaining excess spread is then used to fund the cash collateral account,

if applicable, to its required amount before amounts are paid to collateral interest


56

holders as required. If not paid to CIA holders, remaining amounts are released as

excess finance charges for the benefit of other series.

Finance Charges And Defaults In Socialized Trusts

Finance charge allocations in a socialized master trust differ from the allocations

of a nonsocialized trust. In socialized trusts, defaults are also allocated to each

group and series based on size, but investor finance charges are allocated based

Series 1Finance Charges Allocated

Based on Size


Based on Size


Based on Size

Master Trust Finance Charge Collections Allocated to Group One

Reallocated Group One Investor Finance Charge Collections(Finance Charge Collections are Reallocated and Distributed to Each

Series in the Following Priority Based on Each Series’ Costs)

Step 1

Step 2

Seller’sFinanceCharges(basedon size)

Investor’sFinanceCharges(basedon size)





Chart 4

Finance Charge Allocations In A Socialized Master Trust

Series 1, Series 2, and Series 3Monthly Interest

Series 1, Series 2, and Series 3Investor Default Amount

Series 1, Series 2, and Series 3Monthly Fees

Series 1, Series 2, and Series 3Additional Amounts

Excess Spread Shared Based on Cost




on the series size and then reallocated and distributed to series based on need. Chart 4

demonstrates how allocations typically occur among group one series in a socialized

trust. Finance charge collections are allocated in three steps.

Group Allocation. Finance charges are allocated to each group, pro rata, based on

the size of the group. Within the group, such amounts are divided between the

investor’s interest and seller’s interest of each series.

Series Reallocation. The group’s investor interest finance charges are then reallo-

cated among series within a group based on need; therefore, the term “socialized.”

It is at this stage that socialized trusts differ from nonsocialized trusts. In socialized

structures, if the total finance charge income allocated to a group is insufficient to

cover the costs of all series within that group, all series will experience negative excess

spread. If this occurs for three months on average, all series in the group will enter

rapid amortization at the same time. A socialized trust is an all-or-nothing proposition-

either all series in a group perform as expected or all enter rapid amortization

simultaneously. In contrast, since series cost are separate in a nonsocialized structure,

one series may enter rapid amortization while the others remain in their scheduled

revolving or accumulation periods.

Class Allocation. Once finance charge income has been reallocated among series

within a group, within each series, the series share of finance charge collections will

be divided among all its classes based on class size similar to the way allocations are

made in a nonsocialized structure at the class allocation level.

Need-based allocation deals will distribute funds according to the pro rata costs

of the series, which include interest, servicing fees, and cardholder default amounts.

Because the trust is socialized, if the cash flow allocated to the group is insufficient

to cover the costs associated with all series within the group, the shortfall will be

allocated equally to all series. The cash flow allocated to each series will be applied

in the following order of priority:� Monthly interest,� Investor default amounts,� Investor monthly fees (including servicing fees), and� Investor additional amounts.

If reallocated amounts will result in any excess, all series will receive a pro rata

share of that excess.

Subordination Of Interest Paid ToThe Collateral Interest HolderIn nonsocialized master trusts, the collateral invested amount’s participation in trust

receivables entitles it to receive a pro rata allocation—along with the class A, class B,

and seller’s interest—of finance charges generated by the receivables.


58

Although the collateral invested amount is always allocated its pro rata share of

finance charges, many structures subordinate the payment of CIA monthly interest

until class A and class B receive their full monthly payment. In these structures,

finance charges allocated to CIA are only used to pay the collateral servicing fee in

the primary waterfall. Interest payments to the collateral invested amount are paid

later from excess spread.

If the collateral invested amount receives its monthly interest payment solely from

excess spread, the class A and class B certificates benefit. The basis for this benefit

lies with the priority of payments at the excess spread level; that is, excess spread is

used first to reimburse class A and B certificates for any unreimbursed costs before

paying CIA monthly interest.

In nonsocialized trusts, the benefit derived by subordinating collateral invested

amount monthly interest is a function of the size of the collateral invested amount

and the share of finance charges allocated to it. The larger the share of finance

charge collections that would have been used to pay CIA interest, the more that

can be redirected and used to pay any existing class A or class B required amounts.

Therefore, the larger the collateral invested amount, the bigger the benefit to the

class A and B certificates.

In socialized trusts, the collateral invested amount’s share is determined by its

expenses. The lesser of either the CIA monthly interest due to investors or finance

charges allocated to CIA determines the actual dollars available for redirection as

excess spread and, ultimately, paid to the class A and B certificates.

Excess spread is used to pay the class A, class B, and CIA expenses that remain

unpaid after the application of class A, class B, and CIA available funds. Excess

spread is used first to pay unpaid class A expenses—monthly interest, servicing fees,

and defaults—followed by unpaid class B expenses, and then unpaid CIA expenses,

including subordinated monthly interest. However, if finance charges were sufficient

to meet class A and class B expenses in the first payment waterfall, there would be

no need to use any additional source of funds to help meet those expenses. In simulating

a stress case, Standard & Poor’s models a scenario in which class expenses always

exceed finance charges allocated to that class, so that no excess spread exists. Therefore,

any structural feature that generates additional excess spread will create a measurable

benefit to the senior certificates.

The following example should help illustrate the economic benefit of redirecting

subordinated class finance charges to excess spread and, ultimately, senior certificates.

Assuming that yield on the portfolio would generate $1,000 per month in finance

charges and class A represents $90,000 and the collateral invested amount is $10,000,

the collateral invested amount would be allocated 10/100 or 10% of the $1,000

finance charge collected, or $100. If the certificate rate payable to the collateral

invested amount were 6%, monthly interest allocable to the collateral invested




amount would represent $50 ($10,000 multiplied by 6%/12). In a revolving period

scenario, diverting this $50 of CIA finance charges to excess spread would produce

0.7% of additional benefit annually to the senior certificates ($50/$90,000 multiplied

by 12). These additional amounts are then available to cover any unpaid class A’s

interest, servicing fees, and defaults.

Standard & Poor’s, however, generally evaluates transactions under performance

stresses associated with a rapid amortization period. Under this more conservative

scenario, excess spread has evaporated to zero while losses increase. This causes two

things to happen simultaneously: the senior certificates will amortize and be paid down

by monthly principal payments, and the collateral invested amount will be written

down for unreimbursed series losses. The more quickly the CIA is written down, the

less benefit it can convey to the class A and B certificates. Summing each of the monthly

benefits to the senior certificates based on the current size of the collateral invested

amount will more accurately capture the total economic benefit available to the

senior certificates from subordination of collateral invested amount monthly interest.

Principal

Revolving Period

In the revolving period, principal collections from cardholders are allocated between

the seller and the investor interest, pro rata. The investor portion of principal collections

is then reinvested in new receivables that arise in the accounts already conveyed to

the trust. Principal cannot be used to pay down the investor interest during the revolving

period, including the collateral interest, unless the actual credit enhancement exceeds

the required enhancement. In that case, the collateral interest is allowed to be paid

down to a required level that will never be below an absolute floor amount.

Amortization Period

At the end of the revolving period, the numerator of the ratio used to allocate principal

to the investor interest freezes; that is, it is not allowed to decrease. The numerator

will equal the size of the investor interest at the end of the revolving period. However,

the denominator may float each month to equal the greater of the following:� The principal amount in the trust, and� The sum of the numerators for all series in the trust.

Although the certificates are amortizing, the allocation percentage will remain

fixed. This will amortize the certificates more quickly than a pro rata allocation of

principal, shortening the period of time that the certificates are exposed to losses on

the underlying assets (see Fixed Principal Allocation Upon Seller Insolvency). The

fixed principal allocation feature provides benefit to all certificateholders.


60

Credit card structures are typically sequential pay structures: the class A certificates

are paid in full before the class B certificates are paid, and then payments are made

to class C. One exception to this sequential structure occurs during a controlled

accumulation or a controlled amortization period. During either of these periods,

principal allocated to the collateral interest may be used to amortize it, subject to a

floor of 3% of the initial investor interest. If the transaction includes a cash collateral

account and the transaction is in one of these two periods, the cash collateral account

may be reduced to 1% of the initial investor interest. If both a collateral invested

amount and cash collateral account are used as enhancement, a weighted average of

3% and 1% will be used as a floor.

Fixed Principal Allocation Upon Seller Insolvency. As mentioned above, at the end

of the revolving period, the investors’ share of principal payments will be governed

by a fixed allocation percentage. As principal is repaid to investors, their actual

percentage participation in the trust is likely to decrease and, therefore, become

smaller than the fixed percentage.

The pooling and servicing agreement generally provides that if an insolvent seller

is unable to transfer receivables that were created after the bank’s insolvency, then

collections on all receivables (both pre-insolvency and post-insolvency) will be paid

first to the master trust until all certificates are retired, and then to the seller. If such

allocations are prohibited, the bank will apply collections on each account to that

account’s oldest balances. The oldest balances are the pre-insolvency balances that

have been transferred to the trust. This provision is commonly referred to as the

FIFO allocation.

There is insufficient legal precedent to conclude with certainty that the FDIC, acting

as receiver in the event of a bank/seller’s insolvency, would comply with the FIFO

allocation mechanism instead of simply allocating collections based on a pro rata

split between the certificates and the seller’s interest. If allocations of principal were

made on a pro rata basis between investors and the seller, certificateholders would

be paid more slowly. This would subject them to risk for a longer period of time.

There are many reasons why Standard & Poor’s believes that the FDIC would be

unlikely to challenge the enforceability of the FIFO provision.

First, if the receiver successfully challenged the FIFO allocation, the payout to

investors would be slower and, as a result, the assets would be encumbered by a

lien for a longer period of time. In addition, a successful challenge would not necessarily

increase the creditworthiness of the receiver’s participation in the pool, because

achieving an earlier payout for the receiver will not reduce the credit risk of the

assets. Finally, since credit card receivables are high-yielding assets, the FDIC would

not incrementally benefit under a scenario of accelerated receipt of collections.

It would be a great administrative burden for FDIC to change the FIFO allocation

provisions. FIFO is very easy to apply because it allocates cash flow on an aggregate




basis, and not on an account-by-account basis. If the receiver decided to apply col-

lections based on something other than the FIFO formula, each account balance

would be flagged as of the insolvency date and all principal collections on each

account would be applied to pre-insolvency balances (which are held by the trust)

before being returned to the seller.

Although this method may more accurately reflect the actual percentage participations

in the pool, the costs associated with the accounting would seem unjustified in an

expected scenario when weighed against the marginal benefit gained by the receiver.

Also, the investors would most likely be paid in full by the time necessary accounting

and system changes were completed, since for most trusts, it takes no longer than

eight months for investors to be paid in full once a deal enters its rapid amortization

period and collections are allocated based on a fixed percentage.

Required Enhancement Freezes. If a deal enters amortization as a result of a payout

event, or due to a draw on a cash collateral account, or because of a reduction to

the collateral interest, the credit enhancement will be “frozen” and will not be

allowed to be reduced until the rated certificates are paid in full.

Shared Principal Collections. Most master trusts have the ability to share principal

collections among series. Series that are in their revolving periods do not need principal

collections to amortize their investor amounts. Series that are not in need of principal

collections will share their allocation of principal collections with other series that

are either amortizing or accumulating principal before a bullet maturity. The ability

to divert cash flow from many revolving series to a few nonrevolving ones helps

make principal payments more predictable and readily available for series that need

principal. The sharing is usually accomplished by paying each series with insufficient

principal collections proportionately, based on the size of the shortfall.

Controlled Accumulation Or Amortization. To make principal payments to investors

more predictable, issuers have structured transactions with controlled amortization

or controlled accumulation periods. The latter helps the issuer pay investors a lump-

sum payment, or bullet, on an expected payment date. Ordinarily, the controlled

accumulation or controlled amortization period starts one year before the expected

payment date and equal and fixed principal amounts (“controlled amounts”) are either

deposited into a trust account or paid directly to investors. Any principal payments

in excess of the controlled amount are either shared by other series with principal

payment shortfalls or paid to the seller.

If the issue is structured with a controlled accumulation period, a principal funding

account (PFA) is established. The servicer deposits the controlled amount in the account

each month until the earlier of the bullet maturity date or the occurrence of a pay-

out event. In either case, all cash on deposit in the principal funding account is used

to pay down the class A certificates.


62

Transactions with a PFA feature include reserve accounts to cover negative carrying

costs while the certificates are outstanding. Since the finance charge allocation formula

allocates no finance charge collections on the portion of the invested amount that is

backed by cash in the principal funding account, shortfalls due to negative carry

may occur. Negative carrying costs may arise because cash in the principal funding

account can only be invested in high-quality, short-term investments, which may

yield less than the interest rate on the certificates. The size of the required reserve

fund deposit depends on the difference between the rate needed to pay certificate-

holders and the reinvestment rate assumption of 2.5% used for cash on deposits. To

cover negative carry risk, a typical deal needs a reserve fund sized to 50 basis points

of the initial aggregate invested amount. This sizing of the required reserve account

amount assumes an extremely conservative scenario when the PFA is close to being

fully funded and the negative carry risk is the greatest. Standard & Poor’s may allow

other ways for a deal to cover its negative carry risks. Negative carry shortfalls may

be covered by a letter of credit or by allocating the seller’s share of collections provided

the seller is rated at least ‘A-1’.

Variable Accumulation Periods. Although an accumulation period is typically

scheduled to start one year before a bullet maturity date, the servicer may elect to

delay its commencement if, according to a formula based on payment rate assumptions

as outlined in the pooling and servicing agreement, the principal-sharing trust will

generate enough principal in future months to fully pay certificateholders by the

expected maturity date. The parameters used by the servicer to estimate future principal

collections include more recent payment rate behavior and the number of series that

are expected to share principal receivables with the maturing one. Postponement of

the start of a variable accumulation period can not be delayed beyond one month

prior to the class A’s expected maturity date.

Paired Series. Some transactions allow the issuer to use the principal of an amortizing

series to fund a new series, called a paired series. Issuing a paired series gives issuers

an alternative way to finance what would otherwise be an increasing seller’s interest.

To accomplish the simultaneous winding down of one series paired with the funding

up of a new series, an issuer can elect to adjust the numerator in the principal allocation

percentage and, therefore, alter allocation between outstanding series in the trust.

Adjusting the numerator primarily affects the tail of the transaction, which normally

begins with the end of the revolving period and ends with the series termination date.

Adjusting the numerator changes the fixed percentage allocation and potentially lowers

the percentage of principal that is distributed to the amortizing certificates. Under

this scenario, Standard & Poor’s will measure the series termination date from the

last date that the principal allocation percentage can be adjusted, which is typically

the expected final payment date. Series that allow for the adjustment of the principal




allocation percentage will usually have later series termination dates than series that

do not allow for this adjustment.

Series Termination And The Credit RatingAlthough each deal incorporates an expected payment date, Standard & Poor’s rating

addresses the return of principal not by the expected payment date, but by the series

termination date, which typically is two to five years after the expected payment date.

As Standard & Poor’s rating addresses the return of principal by the series termination

date, analysts must assume the length of the amortization period is extended to the

latest possible date allowed under the documents and assess whether or not the

lengthening of the amortization period jeopardizes payment to investors by the series

termination date, its final legal maturity. The amortization or accumulation period is

assumed to start after the last possible day of the revolving period. In the case of a

variable accumulation period that is scheduled to start 12 months before the expected

payment date, but may be delayed until one month before that date, analysts will

assume that the end of the revolving period will occur at the latest possible date;

that is, one month before the expected payment date.

Standard & Poor’s runs cash flows that stress the length of the amortization period

to determine a legal final payment date on which investors must be paid the full out-

standing principal balance. Unlike stress credit runs, under a stress termination case,

yield is assumed to rise such that the fixed payment rate will represent a much larger

payment of interest, and less payment collected will be applied as a reduction of

principal. At the same time, payment rates are run at slower rates, similar to the

rates used in the enhancement stress scenarios. Charge-offs are assumed to be low,

so that draws on credit enhancement are not used to return principal to investors,

causing the investors’ principal balance to be reduced more quickly. All of these factors

have the effect of lengthening the amortization period. The series termination dates

of most bank card transactions are between 24 and 48 months after the end of the

revolving period.



Legal Considerations ForCredit Card Receivables

Structured finance ratings are based primarily on the creditworthiness of isolated

assets or asset pools, whether sold or pledged to secure debt and without regard

to the creditworthiness of the seller or borrower. This section discusses the

critical legal issues surrounding credit card securitization including insolvency of the

issuer, special-purpose entity requirements, first priority interest or true sale transfers

of receivables into the trust, and perfection of the trustee’s interest in the receivables

once transferred. While this discussion focuses on the major legal concerns found

in most structured financings, it also describes legal criteria unique to credit card

transactions, especially those issues related to securities issued from a master trust.

General OverviewStructured financing seeks to insulate transactions from entities, such as credit card

account originators, unrated or rated lower than the rating they wish to obtain for

their ABS. Standard & Poor’s worst-case scenario assumes the bankruptcy or insolvency

of each transaction participant that is deemed not to be a bankruptcy-remote entity

or that is rated lower than the transaction. Standard & Poor’s resolves most legal

concerns by analyzing the legal documents and, where appropriate, receiving opinions

of counsel that address insolvency and other issues. Understanding the implications

of Standard & Poor’s assumptions and its criteria enables an issuer to anticipate and

resolve most legal concerns early in the rating process.

Credit card receivables are originated by banks or nonbank corporations, such as

bank holding companies or retailers. Some of the legal issues raised by credit card

transactions differ depending on whether the originator/seller of the credit card

receivables is a corporation or a bank (and, therefore, not subject to the U.S.

Bankruptcy Code).

When the originator/seller is a nonbank corporation, as a general matter, a pledge

of collateral by the originator/seller would not ensure that the creditor would have

timely access to the collateral if the pledgor were to be the subject of a proceeding

66

under the U.S. Bankruptcy Code, 11 U.S.C. Although a creditor ultimately should be

able to realize the benefits of pledged collateral as a matter of law, several provisions

of the Bankruptcy Code may cause the creditor to experience delays in payment

and, in some cases, receive less than the full value of its collateral. Under Section

362 (a) of the Bankruptcy Code, the filing of a bankruptcy petition automatically

“stays” all creditors from exercising their rights with respect to pledged collateral.

The stay would affect creditors holding security interests in any collateral pledged

by a borrower that has become a debtor under the Bankruptcy Code. Although a

bankruptcy court could provide relief from the stay under certain circumstances,

it is difficult to estimate the likelihood of such relief from the stay. Moreover, in

most cases, it would be difficult to estimate the duration of the stay.

Similarly, under certain circumstances, a bankruptcy court can permit a debtor to

use pledged collateral to aid in the debtor’s reorganization (Section 363) or to incur

debt that has a lien on assets that is prior to the lien of existing creditors (Section 364).

Under Section 542, a secured creditor in possession of its collateral may be required

to return possession of such collateral to a bankrupt borrower.

As a result, when a seller/originator of credit card receivables or any intermediary

entity that is not bankruptcy remote is subject to the Bankruptcy Code, the existence

of a strong asset pool to secure debt alone cannot determine the rating on such debt.

The transaction structure must provide the means by which assets would be available

to pay debt service in a timely manner notwithstanding the insolvency, receivership,

or bankruptcy of the seller/originator or other nonbankruptcy-remote entity

involved at any level of the transaction as transferor of the receivables.

If the seller/originator is a bank, the provisions of the Bankruptcy Code do not apply

to its insolvency proceedings, and under the Federal Deposit Insurance Act—which

does not contain an automatic stay provision similar to that in the Bankruptcy

Code—the FDIC would act as receiver or conservator of the financial institution.

Although the automatic stay is not applicable, the FDIC has extensive powers,

including the power to ask for a judicial stay of all payments and/or to repudiate

any contract. To provide for greater flexibility in securitized transactions, however,

the FDIC has stated that it would not seek to avoid an otherwise legally enforceable

and perfected security interest so long as:� The agreement was undertaken in the ordinary course of business, not in contem-

plation of insolvency, and with no intent to hinder, delay, or defraud the bank or

its creditors;� The secured obligation represents a bona fide and arm’s-length transaction;� The secured party or parties are not insiders or affiliates of the bank;� The grant of the security interest was made for adequate consideration; and

Legal Considerations For Credit Card Receivables



� The security agreement evidencing the security interest is in writing, was duly

approved by the board of directors of the bank or its loan committee, and remains

an official record of the bank.

Based on such advice, if the issuance complies with the above conditions, the security

interest granted by a bank should not be avoidable in the event of the bank’s insolvency.

In addition, the FDIC has advised that a secured creditor of an insolvent bank under

the supervision of the FDIC would not be stayed by the receiver from pursuing its

remedies, and, upon a bank default, a creditor could foreclose on its collateral using

commercially reasonable “self-help” methods, if certain conditions are met.

In rating ABS higher than the rating of the issuer, seller, or borrower, Standard &

Poor’s seeks to insulate the transaction from the consequences of the bankruptcy or

insolvency of the issuer, seller, or borrower. This determination is made either:� On the basis that if the pool of assets supporting payments on the securities is

owned by an entity, that entity is bankruptcy remote (thus, unlikely to be the subject

of a bankruptcy or insolvency proceeding); or� In the case of banks, on the basis that a secured creditor that has a first priority

security interest in the credit card receivables would not be prevented by the FDIC

acting as receiver from using self-help remedies to realize on its collateral in a

timely manner.

In addition, for each entity involved in the transaction, all transfers of property

and funds of the entity are evaluated to ensure that these transfers would not be

deemed preferential transfers under the Bankruptcy Code and, in some instances,

that they would not be deemed fraudulent conveyances under applicable state and

federal laws.

Bankruptcy-Remote EntitiesIn transactions involving assets originated by nonbank corporations, Standard & Poor’s

analysis relies on the fact that the entity to which the originator sells the receivables

is deemed bankruptcy remote. Standard & Poor’s criteria seek to ensure that the

entity is unlikely to become insolvent or be subject to the claims of creditors (who

may file an involuntary petition against the entity). The following criteria would

need to be met to ensure that such entity is a special-purpose entity (SPE) and thus

bankruptcy remote:� The entity should not engage in any other business activities that might cause it to

incur liability, other than those arising from the transaction itself.� The entity should be prohibited from engaging in any dissolution, liquidation,

merger, consolidation, or asset transfer so long as the rated obligations are

outstanding.

Legal Considerations For Credit Card ReceivablesLegal Considerations For Credit Card Receivables

68

� The entity should be restricted in the transaction documents or its organizational

documents from incurring additional debt, other than debt rated by Standard &

Poor’s as high as the rating on the issue in question, or debt that is fully subordinated

to the rated debt and is nonrecourse to the issuer or any assets of the issuer other

than cash flow in excess of amounts necessary to pay holders of the rated debt.� The entity should have at least one independent director on the board of directors.

The consent of the independent director should be required in order to institute

insolvency proceedings.� The parties to the transaction documents should covenant that so long as the

rated securities are outstanding, they will not file any involuntary bankruptcy

proceeding against the entity.

The entity should also agree to abide by certain “separateness covenants” whereby

the entity undertakes, among other things:� To maintain its books and records separate from any other person’s or entity’s;� Not to commingle its assets with those of any other entity;� To conduct its business in its own name;� To maintain separate financial statements;� To pay its own liabilities out of its own funds;� To observe all corporate formalities;� To maintain an arm’s-length relationship with its affiliates;� To pay the salaries of its own employees;� Not to guarantee or become obligated for the debts of any other entity or hold

out its credit as being available to satisfy the obligations of others;� To allocate fairly and reasonably any overhead for shared office space;� To use separate stationery, invoices, and checks;� Not to pledge its assets for the benefit of any other entity; and� To hold itself out as a separate entity.

If the SPE is wholly owned by a parent that is not bankruptcy remote, Standard

& Poor’s will request an opinion of counsel to the effect that, in an insolvency of

the parent, the SPE would not be substantively consolidated with the parent under

applicable insolvency laws (for example, bankruptcy laws for Bankruptcy Code entities,

applicable insurance laws for insurance companies, and applicable banking law for

banks). Standard & Poor’s continues to monitor developments in banking and insurance

law and evaluates the need for nonconsolidation opinions on a case-by-case basis.

Transfers, Ownership, And Security InterestThe second level of Standard & Poor’s bankruptcy analysis involves the evaluation

of the nature of each party’s property rights and whether third parties (which may

be unrated or are not bankruptcy remote) have retained rights that may impair the




timely payment of debt service on the securities. Standard & Poor’s will look at each

asset transfer and analyze whether the transfer is a sale or a pledge of collateral. In

general, Standard & Poor’s criteria require that transfers from entities that are not

bankruptcy remote (other than banks) be “true sales.” Standard & Poor’s will require

opinions of counsel to the effect that, in an insolvency of the seller the transfer would

be viewed as a true sale of the property by the seller, and, therefore, the property would

not be viewed as property of the estate of the seller under Section 541 of the Bankruptcy

Code or be subject to the automatic stay under Section 362 (a).

For transfers of receivables by bankruptcy-remote entities or banks, Standard &

Poor’s examines the documents to ensure that the transferee of the receivables, generally

the trustee, has a first priority perfected security interest (FPPSI) in the pledged property

and the proceeds thereof. Standard & Poor’s requires that proper steps be taken to

perfect the security interest under applicable law. In general, filing Uniform Commercial

Code documents (UCC-1) will be sufficient to perfect the sale or the grant of a security

interest in credit card receivables. Standard & Poor’s will also require an opinion of

counsel to the effect that the trustee has a first priority perfected security interest in

the credit card receivables and other property (but not interchange) pledged to secure

the rated issue.

Credit EnhancementFor any reserve funds or other credit support established under the documents,

Standard & Poor’s will examine the transfers of funds deposited in such accounts.

To the extent that monies other than proceeds of the rated securities are used for

such funds, Standard & Poor’s may require one or more of the opinions listed above.

Standard & Poor’s also may require an opinion that the funds transferred and the

related debt service payments to the securityholders would not be recoverable as a

preference under Section 547 (b) of the Bankruptcy Code or be deemed a fraudulent

conveyance under state and federal laws.

To the extent that a transaction relies on funds invested under an investment agree-

ment with a rated entity or a guarantee, LOC, or insurance from a rated institution,

Standard & Poor’s may require an opinion that the investment agreement, guarantee,

LOC, or insurance policy is the legal, valid, and binding obligation of such institution,

enforceable in accordance with its terms. To the extent the institution is a U.S. branch

or division of a foreign institution, a foreign enforceability opinion also would be

required, addressing the enforceability of the obligation against the foreign institution,

among other matters. Standard & Poor’s also will review the investment agreement,

guarantee, LOC, or insurance policy to ensure that there are no circumstances that

would relieve the institution from its obligation to pay.


70

Selected Specific CriteriaIn credit card receivables-backed transactions, criteria that have legal implications

generally relate to the structure of the transaction (that is, bankruptcy-remote entities,

credit support, and deal-specific structure). Criteria relating to the nature of the

collateral will stem from Standard & Poor’s review, for each credit card issuer, of

the underwriting policy, credit and collection policies, and form of credit card agree-

ment and related documents governing the creation of credit card accounts and the

receivables arising under such accounts. Based on the characteristics of the credit

card receivables, Standard & Poor’s determines whether a transaction’s credit enhance-

ment and seller’s interest is sized to appropriate levels given the portfolio’s risk of

dilutions and losses.

Criteria Related To Transaction Structures

In general, credit card receivables-backed transactions are structured as revolving

asset transactions. The legal analysis set forth below does not address legal issues

related to commercial paper programs or commercial paper conduits that are backed

by credit card receivables. Rather, it focuses on the typical credit card receivable

term transactions.

Standard & Poor’s concerns regarding the originator’s bankruptcy risk have been

addressed in credit card receivables-backed transactions by adopting one of two types

of structures, depending on whether the seller/originator of the receivables is a bank

or a corporation (such as a retailer).

If the seller/originator is a bank, it is not eligible to become a debtor under the

Bankruptcy Code, and a direct pledge of the receivables to the trust issuing the rated

certificates is sufficient to make Standard & Poor’s comfortable with the timely

availability of the receivables to pay the holders of the rated securities, based on the

advice of the FDIC that, in an insolvency of a bank, the receiver would respect a first

priority perfected security interest in assets of the bank pledged to securityholders.

The bank originating the receivables also could choose (for accounting, bank regulatory,

or other reasons) to structure the transaction with the two-tier structure described

below, and interpose an SPE between the bank and the trust, so as to remove the

assets from the bank’s balance sheet. If the bank chooses the one-tier structure,

the bank designates a pool of credit card accounts, the receivables in which will be

transferred to a trust in consideration for the rated certificates and a retained interest

in the trust assets. The bank then offers and sells the certificates. For this type of

structure, Standard & Poor’s requires, at closing and for each addition of accounts,

an opinion that:




� The transfer of the receivables from the bank to the trust either constitutes a true

sale or creates a first priority perfected security interest in the assets and proceeds

thereof in favor of the trustee;� The receivables constitute accounts or general intangibles as defined in the UCC;

and� The security interest of the trustee in the assets would not be subject to avoidance

if the FDIC is appointed as a receiver of the bank.

If the seller/originator of the credit card receivables is not a bank, the two-tier

structure is used to isolate the receivables from the bankruptcy risk of the seller. This

structure provides for an outright sale of the receivables to a bankruptcy-remote SPE

and for the sale of the receivables by the SPE, or the grant of a first priority security

interest in the receivables to the trust issuing the certificates.

Under the two-tier structure, an originator of credit card receivables or its affiliate

typically establishes an SPE subsidiary to which it contributes or sells all receivables

existing in a pool of designated accounts as of a specified cutoff date and all future

receivables created in such accounts (some transactions provide for an ongoing auto-

matic sale of all the receivables in all the accounts existing and to be created by the

originator). The SPE sets up a trust that issues the rated obligations and transfers the

receivables to the trust in consideration for the rated trust certificates, a certificate to

be retained by the SPE (or within its consolidated group) representing the transferor’s

interest, a pari passu interest in the receivables held by the trust, and, in some cases,

subordinated certificates that may or may not be rated. The SPE offers and sells

the rated certificates (and, in certain circumstances, the subordinated certificates) to

investors and uses the proceeds of the sale to pay the originator/seller the purchase

price for the receivables transferred. Standard & Poor’s legal analysis examines the

effects of the insolvency of the originator/seller on the transaction structure.

In transactions in which the originator sells the receivables to an SPE that establishes

a trust, Standard & Poor’s will request the following:� A true sale opinion for the transfer of the receivables from the originator/ seller to

the SPE. The true sale opinion should state that the credit card receivables will not

be property of the originator/seller’s estate under Section 541 of the Bankruptcy

Code or be subject to the automatic stay under Section 362 (a) in the event of

any bankruptcy of the originator/seller.� An opinion that the transfer of the receivables from the SPE to the trust either

constitutes a true sale or creates a first priority perfected security interest in the

assets and proceeds thereof in favor of the trustee. Standard & Poor’s also will

request the opinions described in 1 and 2 to be delivered in connection with any

subsequent transfer to the SPE and the trust of receivables in additional accounts.� If applicable, a “nonconsolidation” opinion stating that the SPE would not be

consolidated with its parent in the event of bankruptcy of the parent.


72

In some transactions, there may be several entities interposed between the trust

and the originator of the receivables. In these transactions, Standard & Poor’s will

examine each transfer of receivables and generally will request the following:� A nonconsolidation opinion concluding that the SPE would not be consolidated

with its parent or the seller of the receivables.� A true sale opinion for each transfer of receivables in which the transferor is a

nonbankruptcy-remote entity.� A true sale or first priority perfected security interest opinion for the transfer

between the SPE and the trust.

In some instances, because the value of the receivables purchased-which, to support

the true sale argument, should be fairly reflected in their purchase price-is in excess

of the amount of rated securities issued, the originator/seller, if it is the parent of the

SPE, will contribute an amount of receivables equal to such excess to the capital of

the SPE and/or the SPE may use a subordinated promissory note to cover that amount.

In the cases where the originator/seller is not the parent of the SPE, the SPE will use

the subordinated promissory note method. The subordinated note permits the deferral

of the payment of a portion of the purchase price until the SPE has funds available

for the payment (generally from distributions on the interest retained by the SPE in

the trust assets). However, to the extent the amount of the subordinated note is

greater than an amount representing expected losses on the assets sold to the SPE,

the subordinated note may undermine the validity of the true sale analysis, as the

originator/seller could arguably be said not to have fully divested itself of all rights in

the receivables (one of the legal tests of ownership), and a court could view the holding

of the subordinated note as a “financing” by the originator (secured by a pledge of,

or lien on, the assets) incompatible with a true sale of the assets. Standard & Poor’s

is concerned that the use of a subordinated note may suggest that the originator/seller

has not transferred all of the risks and benefits of owning the assets because the

originator/seller is entirely dependent on performance of the receivables or the

assets in order to be repaid.

Accordingly, Standard & Poor’s will evaluate the likelihood of repayment of the

subordinated note. Standard & Poor’s requires that the subordinated note be shadow

rated at an investment-grade level (taking into account defaults, but not dilutions, of

the credit card receivables). Its analysis focuses on, among other things, the amount

of equity that is contributed to the SPE and is available for payment of the subordinated

note. This requirement offers Standard & Poor’s additional comfort that the risks

and benefits analysis—because of the likely repayment of the subordinated note—

would result in the transaction being deemed a sale.




Criteria Relating To Collections On Collateral

Most structured finance transactions do not explicitly look at the rating (or implied

rating) of the servicer, so long as the servicer does not commingle funds, maintains

them in eligible accounts, and remits such funds with reasonable promptness (generally

within 48 hours) to the trustee. Standard & Poor’s evaluates, however, whether in

the event of the insolvency of the servicer, there would be sufficient funds to pay the

rated obligations in a timely manner. The filing of a bankruptcy petition against the

servicer would place a stay on all amounts held on the date of the filing in a servicer

account. Since these amounts would no longer be available, the transaction needs to

cover the commingling risk through credit support. (Given the high number of obligors

under credit card accounts that would have to be notified to make their payments to

a lockbox, the option of establishing lockbox accounts is generally not used in credit

card transactions.)

Pass-Through CertificatesFor reasons generally related to the preference of credit card issuers for off-balance-

sheet treatment of credit card transactions, the structure of these transactions involves

in most cases a trust that will acquire the receivables and issue trust certificates. In

addition, issuance of trust certificates permits greater flexibility when several series

are contemplated.

Master TrustsIn some structures, Standard & Poor’s is asked to issue different ratings on several

series of securities issued by a master trust. In a master trust, each certificate of each

series represents an undivided interest in all of the receivables in the trust. If a lower-

rated transaction defaults, it is possible that the SPE or the master trust and all higher-

rated transactions will be forced into default. A court may view all transactions as

assets of the issuer and seek to satisfy the holders of defaulted securities with excess

cash flows allocated to the other transactions. Standard & Poor’s views the allocation

provisions in the master trust as akin to an intercreditor agreement and, therefore,

believes that a court would respect the allocation of cash flows to the separate series

notwithstanding an insolvency of the SPE or the originator.

Standard & Poor’s also will look for nonrecourse language in the pooling and ser-

vicing agreement, as well as the rated securities to the effect that the rated securities

are issued on a nonrecourse basis and payable only from the allocable portion of the

proceeds of the trust estate pledged to the trustee and that the holders will not look

to any other assets of the SPE to satisfy the debt. The rated securities should also


74

state that they “do not constitute a claim” of the holder against the SPE transferor

or the master trust in the event the pledged assets are insufficient to pay the holders.

In addition to the opinions addressing multiple issuance problems, each transaction

will require opinions, if any, that reflect the appropriate credit structure and transfer

of receivables as set forth above.


Special Considerations ForPrivate-Label Accounts ForCredit Card Receivables

In addition to evaluating VISA and MasterCard portfolios, Standard & Poor’s

also analyzes portfolios backed by private-label credit card receivables, assigning

its first ‘AAA’ rating backed by private-label credit card receivables in 1988: Sears

Credit Account Trust series 1988-A, class A certificates. This section provides a

comparative analysis of Standard & Poor’s rating approach to private-label credit

card portfolios and bank card portfolios. In particular, the focus here is on the different

performance-variable stresses used and their impact on the credit analysis. The section

concludes with a discussion of dilution coverage.

Collateral AnalysisAlthough private-label and bank credit card receivables share many similar charac-

teristics, Standard & Poor’s private-label analysis reflects differences in, among other

things, credit card utility, issuer motivation, and dilution experience. Standard & Poor’s

rating approach is, generally speaking, similar for both products. For both types of

collateral, cash flow scenarios are run that simulate the effects of a severe deterioration

in portfolio performance. As in the case of bank cards, in the ‘AAA’ and ‘A’ scenarios,

the model assumes a significant increase in portfolio charge-offs, as well as declines

in portfolio yield and cardholder purchase and payment rates. When sizing credit

enhancement levels, analysts consider the portfolio’s historical performance, the quality

of the servicer, cardholder demographics, and the transaction structure. However,

private-label cards exhibit some unique traits. The following are some important

private-label considerations and their impact on credit analysis.

Credit Card Utility And Purchase Rates

When analyzing purchase rate assumptions for private-label and bank card portfolios,

analysts rely primarily on the long-term senior unsecured debt rating of the entity

76

that has underwritten the credit cards and the utility of those cards should the entity

become insolvent.

An entity with a high long-term unsecured debt rating will usually receive more

purchase rate credit than a lower-rated entity because a highly rated company is

more likely to survive adverse economic conditions and fund purchases in the future.

If a company can fund additional purchases while one of its securitizations is under-

going a base-rate rapid amortization, it will be able to partially offset the constriction

of the trust’s pool of principal receivables and prevent the pool’s outstanding receiv-

ables balance from declining as rapidly in the absence of new purchases. When a

constant monthly payment rate is applied to this relatively stable, but incrementally

larger, receivables pool, a larger principal cash flow stream results. This larger cash

flow stream will pay out certificateholders more quickly, shortening the window of

risk certificateholders are exposed to and reducing the credit enhancement required

for the transaction (see chart 1).

As described in Collateral Analysis And The Rating Process, the monthly purchase

rates used in bank card cash flows range from 2% to 5%. The range is dictated by

both the rating of the financial institution and desired rating on the certificates.

Unlike most bank lenders, most retail lenders have low long-term senior unsecured

debt ratings and, upon an insolvency, their credit cards would have little utility.

Consequently, retail cardholders will not use the card toward new purchases. As

a result, most retailers are given no purchase rate credit.

Chart 1Principal Repayment Under Various Purchase Rate Assumptions

0102030405060708090

100

($)

Month

PR—Purchase Rate

0 10 20 30 40 50 60 70

Special Considerations For Private-Label Accounts For Credit Card Receivables



The Purchase Rate’s Impact On Cash Flows

The purchase rate assumption significantly affects cash flow modeling results, maturity

determination, and ultimately, the required enhancement levels needed to support a

transaction at its desired rating level. The impact of the purchase rate assumption is

best illustrated with the curves shown in chart 1. All three curves in chart 1 assume

a total monthly payment rate of 8%, a fixed certificate rate of 7%, a yield of 11%,

and peak losses at 20%. Monthly purchase rate assumptions, however, differ for

each curve. The cash flow run, which assumes a 3% monthly purchase rate, is retired

by month 21 and results in a credit enhancement requirement of 8.25% (see table 1).

If a slower monthly purchase rate of 1% is assumed, the required credit enhancement

increases to 10.5% and the transaction does not pay out until month 31. Finally, if

no purchase rate credit is given, the required credit enhancement jumps to 13% and

the transaction never pays out due to the asymptotic nature of the curve.

If a cash flow run is asymptotic, Standard & Poor’s has devised a methodology for

quantifying credit enhancement, even though model results show that certificateholders

are never technically fully paid. Once a series termination date has been decided upon,

the outstanding certificate balance as of that date is added to the required credit

enhancement amount. This ensures that the rated certificates will be adequately

enhanced for the life of the securitization and that they will be retired by the series

termination date.

Retailer Motivation And Charge-Offs

All retailers want to increase sales, and a retail credit card is often viewed as a tool

to increase sales volume. In fact, charge account purchases typically represent 40%-

50% of retailers’ total sales. When the economy experiences a downturn, however,

the issuer may be tempted to sacrifice portfolio credit quality in order to achieve

other business objectives, such as sales volume targets. Since many private-label

issuers typically judge charge-off rates as a percentage of sales volume rather than

aggregate receivables, they have less incentive to keep charge-offs as a percentage of

receivables low. Consequently, charge-off rates in retailers’ portfolios are generally

higher than those of bank cards.

Special Considerations For Private-Label Accounts For Credit Card ReceivablesSpecial Considerations For Private-Label Accounts For Credit Card Receivables

Table 1

The Effect Of Purchase Rates On Enhancement Levels

Months Credit % differencePurchase rate outstanding enhancement (%) from 3% MPR

3% MPR 21 8.25 —

1% MPR 31 10.5 27

0% MPR * 13.0 58

MPR—Monthly purchase rate. *Asymptotic.

78

However, if charge-offs do increase, retail card portfolios are usually better equipped

to compensate for losses with higher portfolio yields. Although bank card finance-

charge receivable collections generally include both annual fees and interchange,

bank card APRs are still usually lower, resulting in lower portfolio yield relative

to retail cards.

Consumer Behavior And Payment Rates

Although bank cards often are issued by out-of-state banks to customers with no

existing relationship with the bank, individuals who apply for a particular retailer’s

credit card often have a preexisting relationship with the retailer. Thus, customer

loyalty may have a positive impact on the performance of private-label credit card

receivables. Nonetheless, a customer’s loyalty to a store and his desire to maintain a

good relationship with it can be taken only so far. If a customer encounters tough

economic times and has to decide whether to pay a VISA credit card or a private-label

credit card, loyalty may not be the critical factor. If a customer fails to pay his private-

label credit card bill, he loses the ability to charge at one store or chain of stores.

This may be perceived as less serious than having credit denied at all the locations

that accept MasterCard or VISA.

Even if an obligor has a financially sound credit profile, continued usage of a retail

card is not guaranteed once the retailer becomes insolvent. A store bankruptcy could

cause an obligor to pay down a private-label card more slowly than a bank card,

because a bank card has greater utility due to the millions of merchants that are part

of the VISA and MasterCard associations. Bankruptcy of the retailer would likely

diminish the cardholder’s incentive to repay his loan. For that reason, analysts assume

that payment rates for private-label portfolios will be slightly slower than payment

rates for bank cards.

Dilutions

A receivable dilution is any reduction of the receivables balance for any reasons other

than cash payments or charge-offs. Retail card receivables are typically subject to

higher dilution levels than bank card receivables because all of the retail card charges

result from merchandise purchases that are subject to potential return. On the other

hand, cash advances, payments for many services, and balance transfers, which make

up a sizable portion of bank card portfolios, but not retail card portfolios, are not

subject to return.

Standard & Poor’s considers the magnitude and timing of dilutions when quantifying

the potential dilution exposure a securitization may encounter during its life. Other

factors that are considered are the nature of the merchandise and the store’s return

policy. For example, securitized receivables from private-label cards of retailers that

primarily sell big-ticket items such as jewelry or consumer electronics may experience




greater volatility in returns and, therefore, greater fluctuations in trust principal balance

than receivable portfolios from stores that primarily sell clothes. As stated in the section

Trust Analysis And Pooling And Servicing Agreement, one of the purposes of the

seller’s interest is to serve as an overcollateralization buffer against receivable dilu-

tion. The minimum seller’s interest test is the most common way that credit card-

backed transactions address dilution risk. If the actual seller’s interest were to equal

zero, any subsequent dilutions would cause the certificates to be undercollateralized.

In that instance, the seller would be required to make an adjustment payment to the

trust in the amount of the dilution. If the seller fails to make an adjustment payment

and also fails to add receivables to the trust to fully collateralize the bonds after the

addition, the deal will enter rapid amortization. A few private-label transactions

address dilution risk in a different fashion. In these transactions, although the actual

seller’s interest may be greater than zero, the required seller’s interest equals zero,

and dilution coverage is included in the first loss credit enhancement piece.

Dilution risk is covered adequately in either way by implementing a minimum seller’s

test or by combining required credit enhancement to cover both credit losses and

dilution risk. For example, if analysts examined dilutions and concluded that a

transaction needed 9% dilution coverage to achieve a ‘AAA’ rating, that 9% could

either be in the form of a required seller’s interest or it could be incorporated into

the first loss protection for certificateholders (see table 2).


Table 2

Dilution Coverage—Enhancement Vs. Seller’s Interest

Required seller’sClass Class size Rating percentage

Class sizes when seller’s interestcovers dilution risk

A 90 AAA 8.0

B 10 N.R. —

Class sizes when credit enhancementcovers dilution risk

A 82 AAA 0.0%

B 18 N.R. —

N.R.—No rating. Assumptions: 10% required credit enhancement for ‘AAA’; 8% required dilution coverage for ‘AAA’.


Special Considerations ForUnsecured Consumer Loans

This section focuses on personal loans and installment contracts and how

these loans compare to credit card accounts. Also discussed is the analytical

framework used in rating these types on loans. In addition to describing

unsecured loans and how the behavior of unsecured obligors differs from that of

credit cardholders, this section also examines how an unsecured loan transaction differs

from a standard card deal and how these differences affect Standard & Poor’s credit

and structural analysis.

Market Conditions Encourage Unsecured LendingMost issuers continue to search for ways to maintain or attract the best obligors. As

a result, lenders seeking to increase or maintain portfolio growth appear more willing

to approve loans to a wide spectrum of creditworthy obligors, either by expanding

existing product offerings or by introducing new ones such as the unsecured personal

loan. As is the case in the credit card market, telemarketing and direct mail continue

to be the major channels used to acquire these new accounts. In addition, accounts

are generated when customers apply over the phone.

The unsecured consumer product offers a natural extension of lending for credit

card and finance companies. In some cases, it permits originators to reach obligors

already leveraged. For others, the new product allows a company to diversify from

its core business while leveraging off its vast consumer lending experience. Penetration

of the market with consumer loans further allows the company to increase market

share. Still other consumer lending institutions see the installment loan business as a

means of diversifying and extending product lines, cross selling, and expanding market

share without cannibalizing the existing customer base.

Credit card lenders accustomed to unsecured lending most often use this option to

diversify their revenue streams. Retailers, especially those in the furniture business, offer

the installment contract to help increase sales of big-ticket items. Mortgage brokers

leverage their existing databases by identifying customers who are accustomed to

82

tying their debt to the equity of their homes. For homeowners, in particular, the

unsecured product is more attractive than a home equity line of credit because the

approval process is quicker and no appraisal is required. Instead, if the loan is tied

to the value of the home, the loan-to-value (LTV) is computed using the homeowner’s

assessment of the value of his home and credit is established relatively quickly.

In general, issuers tend to target those obligors who have demonstrated good pay-

ment performance, as well as those who show a propensity to carry debt, but not at

excessive levels. For the customer, the main attractions are a fixed monthly payment

schedule and a higher credit line compared with a credit card limit. An unsecured loan

appeals to customers who need additional funding for a specific large purchase, but

do not want to pay a transaction fee or maximize their credit card lines. Also, unlike

a credit card that accrues finance charges based on an index such as prime, the interest

charged on an unsecured personal loan is typically based on a fixed rate, so that an

obligor will know exactly how much is due each month.

A Hybrid ProductThe unsecured consumer loan product is a hybrid between traditional secured consumer

lending and traditional credit card lending. Unsecured consumer lending includes

closed-end personal loans, installment contracts, and the 125%-135% LTV product

that allows obligors to borrow up to 25%-30% above the value of their home. Unlike

a mortgage or an auto loan, the loan is unsecured as the originator does not have a

claim on the collateral to support the loan extended.

Unsecured loans offer an obligor an opportunity to obtain a line of credit faster than

obtaining a home equity line approval. Once approved, the unsecured amount is

generally higher than an approved credit card limit. Obligors use these loans primarily

for debt/bill consolidation, home improvement, medical expenses, educational expenses,

vacation purposes, refinancing of debt, or one-time large, discrete purchases. Although

the method of disbursement of funds varies, obligors typically receive a lump-sum

check to the approved level that expires 60 days from issuance. Some issuers send

the checks to a third party so that the obligor’s debts are paid off directly. Other

programs offer an open-ended line of credit accessed through checks. In these instances,

obligors must make a monthly minimum payment based on their outstanding balance;

these payments are similar those made on an obligor’s credit card account or balance.

Most of the credit agreements stipulate level monthly payments over the life of the

loan, which will then amortize like a mortgage or auto loan. The product is generally

a closed-end, fixed-rate loan with a fixed maturity and limited revolving behavior.

Some loans may involve full revolving ability similar to the revolving behavior allowed

on credit cards. Other loan programs strictly prohibit additional purchases and are,

therefore, purely amortizing. These types of unsecured consumer loans are most similar

Special Considerations For Unsecured Consumer Loans



to a mortgage or auto loan. Still others offer options of both loan types, and may

involve quasi-revolving periods during which obligors are allowed to reborrow and

subsequently redraw once the original loan partially amortizes. Although there is

typically no open-to-buy line, once the loan is partially paid down, the borrower

may reapply and redraw on the loan to its original approved limit. However, unlike

with a credit card, redraws up to an approved limit are not automatically granted.

Rather, the customer’s creditworthiness is generally reassessed at the time of the

new request, and the application goes through the underwriting process as if a new

application had been submitted.

Three Categories Of Unsecured Consumer LendingAlthough unsecured consumer lending may seem homogeneous among lender programs,

subtle differences do exist among the products. To date, Standard & Poor’s has reviewed

unsecured consumer loans that can be broadly classified into three categories: fully

amortizing loans, revolving loans, and partially amortizing loans.

Fully amortizing loans are one-time loans disbursed to the obligor in a lump-sum

payment. The obligor does not have an open-to-buy line beyond the current outstanding

principal balance of the loan. Rather, obligors agree to make monthly payments until

the outstanding balance is paid off. This type of loan typically has a fixed payment

schedule and a fixed term, although in some cases extensions are permitted. Prepayments

on such amortizing loans are allowed. However, prepayment activity is usually minimal,

and prepayments are similar to mortgage prepayments. In a low interest rate envi-

ronment, prepayment activity may increase, but only if alternative financing at a

lower rate is available.

Revolving loans are most similar to credit card loans. In both cases, obligors are

approved for a defined credit line and may draw on the line anytime the account is

open. Unlike a straight amortizing or a partially amortizing loan, an obligor of a

revolving loan may decide not to utilize 100% of his approved credit line immediately

after the loan is approved. Rather, a revolving customer will draw upon his credit

line based on his current needs. The obligor may also pay down his outstanding

balance and then redraw amounts up to his original credit line anytime and

without reapproval from the lender.

Partially amortizing loans combine characteristics found in both amortizing and

revolving loans. A partially amortizing loan is initially a fully amortizing loan. However,

as the customer develops a positive payment history, the lender may approve redraws

on the same account, but only up to the loan amount originally approved. This type

of loan amortizes, but before amortizing to a zero balance, the customer may request

additional advances similar to the way in which a customer would redraw on a line

of credit in a purely revolving loan. However, because redraws are limited, this loan

Special Considerations For Unsecured Consumer LoansSpecial Considerations For Unsecured Consumer Loans

84

cannot be labeled a pure revolving loan. When a request for a redraw is granted, the

lender is, in essence, refinancing the loan and reevaluating credit risks, but doing so

under the same loan account.

Unsecured Consumer Lending Versus Credit Card LendingEven in instances in which the unsecured consumer loan revolves, there is a difference

between a revolving unsecured consumer loan and a revolving credit card. A credit

card is purely a revolving loan for which an obligor is given a line of credit that can

be drawn upon or paid down at any time. Conversely, unsecured consumer loans are

more likely to amortize in some fashion. Typically, a credit card obligor does not utilize

his card up to his limit immediately after approval; although in cases where the obligor

has used the new card for a balance transfer, this may not always be true. On the

other hand, most obligors of unsecured consumer loans receive cash advances on

loans up to the approved credit line on the first day the loan is approved.

A credit card obligor draws on his credit line when he makes direct purchases

from merchants. In return, merchants will shift customers’ credit risk to the credit

card company and compensate the credit card issuer for absorbing the risk in the

form of an interchange fee. In exchange for the right to keep an outstanding loan

balance monthly, obligors must pay finance charges and annual fees.

Credit card users are also entitled to a grace period of approximately 25 days from

the date of loan origination before the outstanding balance begins accruing finance

charges. An obligor of a revolving unsecured consumer loan, however, typically draws

on his credit line by using checks, which, when cashed, are drawn from lender’s funds.

Therefore, when an obligor makes a purchase from a merchant, the merchant is not

charged an interchange fee. In addition, there is no grace period for purchases made

with disbursements from an unsecured loan. Therefore, revolving unsecured consumer

loans are generally not used for small purchases or subject to convenience usage. As

a result, although both of these loan types revolve, an obligor of a revolving unsecured

consumer loan will exhibit much lower revolving activity than a credit card user.

Characteristics Of Unsecured Consumer Loans

Charge-Offs

The average term of unsecured loans is typically four to seven years, with an average

balance of between $10,000 and $20,000, although the terms can be shorter and

the amounts lower, as they sometimes are, for example, in furniture retail contracts.

Average yields typically are not significantly different from yields found in general-

purpose card trusts, although in cases where the product is used for bill-consolidation




purposes, yield on the unsecured product is lower compared with its credit card

product counterparty. Since the product terms vary, charge-off numbers range widely

among issuers and are affected by factors such as the targeted obligor, the issuing

entity, and the specific characteristics of the loans. Also, the loss curves for unsecured

consumer loans are longer than credit card loss curves, although the exact shape of

the curve will vary depending on the remaining term of the loan. Still, credit card losses

typically peak between month 18 and month 24 following origination. In contrast,

a comparable revolving unsecured consumer loan with no defined maturity will

experience a peak level of losses past month 24.

Payment Rates

Payment rates for the unsecured product are much lower than they are for typical

credit card portfolios for which principal payment rates are generally constant, assuming

card repurchases are equal to principal payments. This may be because utility usage

is limited compared with a credit card. Since there is often no open-to-buy line, there

is little benefit to an obligor for paying down an unsecured consumer loan quickly.

Unless an obligor intends to refinance the loan, there is little incentive for an obligor

to prepay. Additionally, most obligors become accustomed to making their monthly

minimum payment. As a result, prepayments on this product are often negligible.

However, unlike a revolving credit card where the obligor carries an outstanding

balance that fluctuates monthly, since some of the unsecured loans are either truly

amortizing or quasi-amortizing, it is natural that the payment rate increases as the

loan seasons. Early payments represent mostly interest costs. However, as the loan

amortizes, principal payment will represent a larger part of the payment. For a

$10,000 loan with a maturity term of 38 months, assuming no prepayments, the

payment rate is equal to 2.5% at month six, but grows to roughly 46% by month 34.

However, payment-rate increases over time occur only if the original terms of the loan

are not changed. If the loan is extended for any reason or if the obligor is permitted

to reborrow, payment rates cannot be assumed to increase in the same manner as if

the loan amortizes. Nonetheless, in general, payment rates for more seasoned portfolios

will be greater than they are for portfolios dominated by new originations.

Dilution

A receivable dilution is any reduction of the receivable balance for reasons other

than cash payment or charge-off. Dilutions are typically lower for the unsecured

product than they are for either a retail or bank card because most of the proceeds

from the unsecured loans are used as cash advances or for services rendered that are

nonreturnable. Although dilution, in general, is relatively low in unsecured lending,

dilutions due to fraud may be a concern in these transactions and are factored into

the overall credit assessment.


86

Analyzing Unsecured Consumer LoansThe unsecured consumer product is not a true revolving product, although frequently

borrowers are given the option to redraw. Because of that characteristic and because

of the relatively short-term maturity inherent in the product, most issuers have elected

to structure deals backed by the unsecured product utilizing a master trust structure

that includes a revolving period. However, due to the nuances of the unsecured product,

the traditional stresses used in Standard & Poor’s credit card analysis of yield, pay-

ment rate, and purchase rate must be adjusted.

Instead of running the stress yield at the regulatory cap, a less severe stress is often

used. More credit is given to the yield on the portfolio at the time of closing, because

once an installment loan is originated, the interest rate is fixed and will not change

even upon the subsequent passage of a regulatory legislative cap. However, full credit

is not given to cutoff date yield, because new accounts and receivables subject to a

regulatory cap may be added after closing and those additions would depress yield.

Also, in most cases, the yield is not as high as the yield on credit card portfolios

because a portion of credit card customers will use unsecured consumer loans to

realize savings by consolidating higher interest rate credit card debt.

The payment rate assumptions are perhaps the most difficult to analyze for this type

of asset. Vintage analysis of repayment trends in this product validates the positive

correlation between the age of the accounts and the rate of payment. In the absence

of any reborrowing by the obligor, principal repayments are expected to accelerate

over time due to the amortization feature of unsecured installment loans. However,

the ability to modify and extend, as well as the option to reborrow, makes the deter-

mination of the payment rate more difficult. The payment rate, in some cases, may

be negative if reborrowings exceed the payment rate: the higher the reborrowing

percentage, the lower the net payment rate. Any subsequent advances granted are

considered reborrowings. As the reborrowing percentage increases, more receivables

are generated, but the net effect on the static pool will be a lower payment rate. Also,

if an extension or a request for additional borrowings is granted, the customer’s monthly

payments typically remain unchanged, but the final maturity of the loan is extended

and the payment rate is lowered. Each additional advance posted will cause the

maturity date of the aggregate balance to extend.

As discussed in Collateral Analysis And The Rating Process, monthly purchase rates

used in bank card cash flows range from 2% to 5%. The range is dictated by both

the rating of the financial institution and the desired rating on the certificates. Like

most retail lenders, unsecured consumer lenders have no or relatively low long-term

senior unsecured debt ratings, and their loans will have little utility once the issuer

becomes insolvent. In addition, even for revolving unsecured loans, repurchases are

lower compared with credit card repurchases. Furthermore, there are no repurchases




allowed for the straight amortizing unsecured loan. As a result, there is typically no

purchase rate credit given in the unsecured product analysis. In fact, in most scenarios,

a zero prepayment scenario with no new purchases or redraws is assumed.

Structural Adjustments

Because of the unique characteristics of the unsecured product, when securitizing this

product, adjustments are made to the standard credit card structure. One adjustment

is necessitated because of the inclusion of a quasi-amortizing asset in a revolving master

trust structure. In deals with semirevolving features, some programs have included a

semirevolving period that allows for the addition of new receivables during this period.

However, during this time, amortization may still occur, even if the deal is in an interest-

paying period, if the payment rate is lower than new purchases. If this occurs, the

amortization of principal may be shared pro rata among outstanding certificates. If

the issuer elects to isolate investors from receiving any principal payment during the

revolving period, the issuer may issue a variable-funding certificate (VFC) to absorb

any unwanted principal collections.

Another variation on the standard credit card structure is the base rate trigger. The

concept of a base rate trigger protects a deal from adverse conditions. In a typical

credit card deal, if yield is no longer sufficient to cover losses and other trust expenses,

and that insufficiency exists for three consecutive months (excess spread is less than

zero), the base rate test is violated and the deal enters into early amortization.

In most unsecured loan transactions, a variation of the typical base rate test is used.

In place of a typical base rate trigger, an amortization payout event is linked to any

credit draws either through a decline in the required overcollateralization amount or

a write-down of the most subordinated class. For example, if overcollateralization is

below 4% on average for three months, or if, on average over three months, the daily

balance of class D (in a class A/B/C/D structure) is not equal to its required class D

invested amount, the deal will enter rapid amortization. In either case, whether the

base rate is tied to the overcollateralization amount or the sizing of the most subordinate

class, the trust is protected when yield is no longer sufficient to cover losses and

other trust expenses and credit support is no longer adequate to support the rated

certificates. As is the case in a standard credit card master trust, during a rapid

amortization period, all principal collections are used to pay the certificates sequentially.


credit card criteria

Documents

credit card collateral

credit card portfolio

credit card cias

structural credit enhancement

contents collateral

required credit enhancement

trust analysis

senior managing director