Banks Rescue Credit Card Trusts, Yet Keep Them Off Balance Sheet

America as banana republic is alive and well. Tonight’s version is that anything that helps banks is permitted, official rules to the contrary.

Banks enjoyed lots of fun and profit from setting up various off balance sheet vehicles that are now coming a cropper. We saw the preview of this movie with structured investment vehicles, off balance sheet entities typically sponsored banks that borrowed heavily, usually 14 to one, and invested in medium term asset backed paper. When subprime worries got acute and the market for asset backed commercial paper dried up, the short-term funding for the SIVs could not be rolled, and the vehicles had to resort to credit lines to keep from liqidating the holdings. The issue in plain sight was that the investors in the SIVs made it clear that the banks were not going to walk from these entities without consequences.

I do not understand how these entities can be considered to be off balance sheet once the sponsor stepped in. Yes, the test is whether the sponsor is “obligated” to provide support. While from a contractual standpoint, they may not have been, but no one wanted that tested in court (if various winks and nods were found to have been commitments, that might have forced consolidation).

We have the same issue in the fore with credit card trusts. This would seem to be a more clear-cut case than SIVs, since rating agencies ‘fess up that their grades presume that banks will intervene in the event of a shortfall. As Joseph Mason and Eric Higgins wrote:

On Monday, May 11, 2009, Advanta Corp. announced that their credit-card securitization trust would go into early amortization and that they will shut down all of the accounts in the trust. What the casual observer (and most regulators) missed is that this announcement is also endemic of the problems at the heart of securitization: the “true-sale” classification from which securitizations obtain their off-balance sheet treatment.

A company like Advanta issues credit-cards through its banking subsidiary (Advanta Bank). These credit card receivables are then sold into a trust (Advanta Business Card Master Trust). The trust then sells the cash flows from those receivables to investors. This trust is created as a truly-sold bankruptcy remote entity from Advanta Bank and Advanta Corp., allowing Advanta to treat the sale of credit-card receivables as off-balance sheet for regulatory and accounting purposes. Technically, Advanta Corp. has no liability for the assets that are sold into the trust and must not provide any recourse to the assets….

The problem with the arrangement is that it has always been a complete fiction…

How can Advanta Corp. prevent early amortization without violating “true-sale” accounting? The truth is that they can’t. Providing recourse has historically been taken as implying that the receivables are assets of Advanta Corp. and should appear on their balance sheet…

Of course, the problem with implicit guarantees is that they are not legally binding. To see this consider Advanta’s May 11, 2009 announcement of the early amortization of their credit-card trust, where Advanta specifically says, “The securitization trust’s notes are obligations of the trust and not of any Advana entity.” What a difference a few days make. On April 30, 2009, management was going to save the securitization trust. On May 11, 2009, management is running away from the trust as fast as they can. Hence, when it is expeditious, firms can ignore true sale provisions and as soon as things get rough true sale provisions protect them.

This problem is not new. A study by Higgins and Mason (Journal of Banking and Finance 2004) looked at recourse provided by credit-card issuers in the mid-1990s. Higgins and Mason found evidence of 17 instances of recourse provided over the 1991-2001 time period that were specifically announced by the parent company. These recourse events helped support 89 separate credit-card securitizations that had a combined value of $35.4 billion.

During the study period, every one of those recourse events violated regulatory rules, but were carried out with a blessing from the regulators despite having recognized the problems of implicit recourse…

Since regulators have chosen to ignore implicit recourse, it has become institutionalized industry-wide. In their announcement regarding the downgrading of Advanta’s debt Fitch noted, “…early amortization would occur in the absence of intervention from Advanta within the next month. Intervention could come in the form of charge-off sales, a yield supplement account, or receivable discounting, as seen recently at other large card issuers.” Among those options, receivables discounting is specifically mentioned in the 2002 joint guidance as a prohibited recourse event that would force a parent company to take the securitized assets back on their balance sheets.

Moreover, such a statement means that Fitch – who rates asset-backed securities for a living – admits that they are, in part, basing their ratings on the expectation of implicit recourse being provided even though implicit recourse is : 1) a violation of true sale and 2) not contractually guaranteed.

Advanta was seen as a localized problem last month:

The company’s woes aren’t likely to spread to other asset- backed issuers, said JPMorgan’s [Chritopher] Flanagan. Advanta’s “precarious liquidity and capital position” make the lender more vulnerable to deteriorating credit than its stronger counterparts, Flanagan said in a May 8 report.

Things look pretty different today. From the Financial Times:

Record credit card losses are pushing big US banks to come to the rescue of off-balance sheet vehicles they use to transform hundreds of billions of dollars in consumer loans into securities sold to investors.

The support provided by Citigroup, Bank of America, JPMorgan Chase and American Express underscores how the deteriorating health of the US consumer is opening new fronts in the financial crisis….

Although they are not obligated to support the pools of credit card receivables when losses mount, banks have done so to ensure investors continue to buy such securities.

The doomsday scenario facing banks is that credit card losses will rise to levels that force the vehicles to repay bondholders early.

Banks have been supporting card trusts by issuing – and then buying – bonds that would absorb the first layer of losses in the underlying loans.

This is designed to provide a protective buffer for existing bondholders.

BofA bought $8.5bn of junior debt from one of its trusts in the first quarter and put aside $750m to cover losses on the investment.

Citi bought $265m of so-called junior debt from one of its credit card trusts in October and an additional $2.3bn of junior debt from the same trust in April, according to a regulatory filing.

JPMorgan and Amex also have issued new junior debt for their credit card trusts.

In addition, JPMorgan has supported credit card bonds issued by Washington Mutual – the troubled lender bought by JPMorgan last year – by substituting its own credit card loans for WaMu’s lower quality ones.

The loss rate on the WaMu pool was 14.8 per cent in October. By comparison, a JPMorgan credit-card pool had an 8.1 per cent loss rate in May.

Can someone explain the accounting logic? Ah, silly me. It’s called might makes right.

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  1. Tom Lindmark

    Aren't there several Enron executives serving rather long jail sentences for this sort of behavior? Have you any idea why the rule of law has been suspended in these instances? Perhaps your last sentence provides a clue.

  2. Richard Kline

    Those who own the officials make the rules . . . .

    Lessee: Banks pushed their MBSs off-balance sheet. They pushed their securitized LBO ASBs off-balance sheet. They pushed their credit card pools off-balance sheet. It would be east to assueme that there is *no* shadow banking system per se, simply a double-entry system in which the great mass of speculative lending was made by nominally chartered organizations but not formally recorded against their regulatory capital and reserves. That's a 'shady banking' system, not a shadow one.

    And understand this: no 19 guys in a couple of communter jets did this do us. No evil empire. No dastardly terrorist slumgullions nowhere in view but reputedly hiding under every rock, kicking aside the dry bones of those supposed 'Communists' formerly alledged to be hiding under said rocks. No; this was done by the richest, most powerful, and best placed the Ol' US of A had to offer. Our tycoons of wealth are a criminal conspiracy against the rest of us, that's the takeaway.

  3. VG Chicago

    >> Can someone explain the accounting logic? <<

    It's impossible to explain logically — it's just "criminal thinking." They're psychopaths, worthy of a diagnosis of "Antisocial Personality Disorder."

    Great post, Yves! Keep them coming. I hope sometimes you could discuss student loans. I also teach grad school, and these kids graduate with $250K+ in student loan, but unimpressive income potentials. I fear for their future.

    Vinny G.

  4. Hugh

    I agree with Tom Lindmark. This is Enron writ large. It goes to the fact that any reasonable accounting of the financial industry would show that virtually all the entities in it are bankrupt. It is the Obama-Summers-Geithner plan, however, to keep this circus going in the hopes that said entities can sufficiently stiff their customers and gamble and win in new speculations until they can work their way our of their predicament. Where the rest of us, the stiffees, will be at the end of this process has not apparently been considered or thought that important.

  5. Bruce Krasting

    Yves, You should not fret about these trivial matters.

    The government will solve all of these problems. Mr. Geithner has brought you TALF to do just that.

  6. Diane

    Back in November 2007 Jamie Dimon was widely quoted as saying that SIVs had no business purpose and would go the way of the dinosaur. Guess he found one after all.

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