T. A. Pai Management Institute

Lehman Brothers and the

Securitization of AMEX

Charge-Card Receivables;

AMEX TRS Charge-Card

Receivables Submitted in partial fulfillment of the course on

FNMT by,

Arnab Mukherjee

Avirup Chatterjee

Rutwij Rajendra Chaukhande

1. How do Amex charge card receivables differ from the credit card receivables?

(Reference exhibits : 9, 10 and 13)

1.1 Credit Cards

With these instruments, the card holder can make the purchases on credit with a

pre-defined cap. An interest is charged on the credit extended by the issuing

company in order to finance the purchases of the card holder.

Thus, in this case, the receivables are composed of the following two

components:

o Finance Charges

o Principal Charges

Finance charges comprise of the below mentioned factors:

o Interest on balances

o Annual Fees

o Discount Fees

Principal Charges consist of face values of the purchases made with the credit

card.

The finance charges are consumed for the purposes like addressing the cardholder

defaults, servicing and collection charges and other relevant expenses. The table

below gives a snapshot of these attributes for Citicorp’s credit card portfolio:

The residuals after computing the portfolio yield after expenses will generate the

margin for accounting the card holder defaults.

1.2 AmEx Charge Cards

The AmEx charge cards allow the card holder to make any value of uncapped

purchases which are payable at the end of the specified period. These instruments

are designed to serve as an easier method of payment rather than financing the

purchases. They enable the clearance of every purchase by the cardholder in real

time.

Year 1989 1990 1991

Average revenue yield 20.30% 20.10% 19.90%

Loss due to the creditholder's default 4.70% 5.10% 6.50%

Servicing and collection charges 2% 2% 2%

Protfolio yield after expenses 13.60% 13.00% 11.40%

Citicorp's Credit-Card Receivables

The receivables, during the allowable time period, therefore, did not observe any

additional interest charges. The annual fee for the card holders was the dominant

source of cash inflows (as in 1991 it amounted to $2.8 billion)

Credco purchased the receivables from TRS at a discount rate from face value as

no interest was charged on these receivables. These were billed, serviced and

collected by TRS.

1.3 The Comparison

Average receivables outstanding are relatively less in case of American Express

charge cards and major chunk of receivables comes from the charge volume and

fees.

Due to cap on the period for the card holder to return the payables to the

company, the net loss as a percentage of total receivables is relatively less for

American Express Charge Card business vis-à-vis its credit card companies.

However, the delinquency for the AmEx charge card business is in the range of

9% to 9.6% for the period between 1989 to 1991 vis-à-vis the range of 7.6% to

8.6% for credit-card portfolio of Citibank.

2. What purpose does a dedicated finance subsidiary like Credco serve?

2.1 The Company History

Credco was incorporated in 1962 and was based out of Delaware. It was acquired by

American Express in 1965. It became a wholly owned subsidiary of TRS in 1983.

2.2 Purpose served by Credco:

The main purpose of Credco was to finance the charge card receivables of TRS. Credco

worked in similar fashion as GMAC did for automobile loans. Assets side of Credco

consisted of the receivables. The liability side consisted of the debt assumed.

2.3 Functions of Credco:

They used to purchase the charge-card receivables from TRS at a discount from the face

value

However they purchased interest bearing receivables at face value.

All the receivables were billed, collected and received by card issuers for Credco.

Credco also financed Optima and extended-payment-plan partly. The remaining part of

it was financed through Centurion Bank.

2.4 Involvement of TRS:

The receivables could not be re-coursed by Credco to TRS once the purchase had been

made.

However exceptions were made if the card was lost or had been stolen. Credco had to

bear the losses due to default.

3. What are the key features of Lehman’s proposed structure for the securitization of

TRS’s charge card receivables?

3.1 The Proposed Mechanism

Create a master trust.

TRS should sell the receivables from charge-cards to this master trust at a discount from

the face value.

Identify the receivables in two components :

o Interest component/ yield component (initially set at 3%)

o Principal component (Initially set at 97%)

Use the yield component for the interest payment on debts and service expenses as well

as losses

Re-invest the principle component of it into the new receivables until required to take

principal repayments on the trust’s debt

3.2 The Approach

Sell about $1 billion “class A” debt securities through this Trust

Issue the minimum volume of “class B”subordinated debt security in order to ensure

AAA credit rating for class A debt (3.5% of class B as expected by Lehman)

The acceptability of this approach in context with the desired rating is attributed to

the charge cards’ high and consistent yield and payment rate, and real-time clearing

of every card member purchase.

3.3 The Structure

Master Trust

Seller's Interest Investor's Interest

Class A debt Class B debt

4. What characteristics of the charge card pool make the receivables attractive to

securitize and what factors make it difficult to securitize?

4.1 Factors making the charge card pool attractive to securitize

(Factors of interest for the investors)

Growing investor interests in Asset Backed Securities

In case of default by the card holder the losses are less in case of charged card pool

as compared to the credit card pool

Very low levels of the loss ratio (computed with the receivables as base) as

compared to the credit card pool

4.2 Factors making the charge card pool difficult to securitize

(Causes of concern for the investors)

The portion of the cash flow allocable to issuer’s interest that was not paid out to the

debt-holders could revert back to TRS

In case of a very large card-member defaults, or in case if large number of card-

members stopped or reduced the use of their American Express Cards, the trust may

not have sufficient amount to make interest payment on both the classes of debt

This may result in early amortization event in case of which the class A debt

securities will be repaid for the interest accruals and the principle amount.

The issue third-party letter of credit to ensure the desired credit rating for the trust’s

debt could shrink in terms of its share in the total debt due to credit crunch faced by

the issuing banks.

5. How would TRS benefit from such securitization? Should it do so? What will be its

implication for Credco and its funding of assets?

We can look into the process of receivables securitization from various perspectives:

By entering into the securitized mechanism for charge card pool, TRS is, in turn, passing the

risks associated with the receivables to the investors. Therefore, with the perspective of

shifting the risk to the investors, the move of TRS to securitize the receivables is

recommended.

However, due to such risk aversion strategy, the net profit figures for TRS might shrink.

Since, the company is going for the cash card system and not the usual credit card system, it

can have a better estimate of the entire portfolio in the sense that, since the time period

allowed for repayment is not unlimited, it can easily understand the credit worthiness of its

customers.

The receivables will be removed from the Consolidated Balance Sheet entirely and also

increase the revenues and hence the value of the business will also become higher.

Credco would also have a lower Debt- Equity ratio.

The long term debts will also get refinanced to a lower YTM.

The assets of Credco, as will be transferred to the new master-trust, will shrink. This also

means lesser working capital requirement and other financing requirements for the company.

Looking at all the above factors, securitization is recommended.

6. How should the receivable backed certificates be priced?

While pricing a bond, the most important factor to be considered is the yield to maturity (YTM) and

the yield can be controlled by one of the following factors:

Coupon payments

Price of the bond

The YTM considers the risks like credit risk, event risk, default risk, prepayment risk etc. into

account and hence it is calculated as a spread over the risk-free treasury notes rate.

Assumptions for pricing of bonds:

The bonds will be redeemed in 5 years.

The interest rate on B rated bonds can be found by extrapolating from exhibit 14:

o AAA Credit-card receivables: 6.4% + 0.55%= 6.95%

o Credco(A rated)= 6.4% + 0.6%=7%

o Hence, YTM on B-rated bonds(by extrapolating)= 7.075%

Coupon is the same for both the bonds.

Delinquent costs give a fair view of all the costs so whatever is remaining after servicing the

delinquent costs is the interest payment. This can be understood from note 1 below.

Mean of

delinquent

days %(average of 3 yrs) Product

45 3.00 135

75 1.37 102.5

105 1.10 115.5

135 3.93 531

360

Average Delinquent Amount

as a percentage of Receivables 2.46Amount remaining for interest

payment(%) 0.54

Note 1:

Now, the additional inputs for the valuation are as follows:

Thus the values can be calculated as follows:

Assuming 1 million of AAA bonds are issued and 0.1 million of B rated bonds are issued we can

conclude that the prices will be $711.04 and $256.40 for each bond of each class respectively

(in $Mn)

Total Receivables to be securitized 1000

Redemption value of AAA Bonds 965.00

Redemption value of B Bonds 35.00

Int Payment(1000*0.54%) 5.400

Coupon payment on AAA bonds 5.211

Coupon payment on B bonds 0.189

Price of AAA Bond $ 711.04 Mn

Price of B Bond $ 25.64 Mn