From a sobering article in the Financial Times today titled “Banks Rush to Rescue of Credit Card Trusts” (registration required):
The doomsday scenario facing banks is that credit card losses will rise to levels that force the vehicles to repay bondholders early.
It’s also the same scenario that led me to sell our American Express shares a few months back, though the losses appear to be accelerating even without the cramdown legislation I assumed would be the catalyst.
Here is the issue:
AmEx has an off-balance sheet trust that contains the company’s credit card receivables. The trust is the vehicle that actually sells these receivables – consider them cardholder IOUs – to institutional investors attracted to the high yield. AmEx does all this in a trust to keep it truly distinct from its own business. Why? For several reasons, the most important of which is so that the accountants don’t make AmEx record those huge receivables and the related liability on its own balance sheet.
Enter the problem of “implicit recourse.” That’s a phenomenal name for a band, by the way.
Luckily the domain name is available. no longer available.
“Recourse” typically refers to a guarantee that an undersigner like AmEx will pay if the cardholder defaults. In order to keep its receivables in the trust and off its balance sheet, accounting rules say AmEx cannot have recourse and the trust has got to be an independent entity. In other words, if you don’t pay your bill, neither will AmEx, and the institutional investor must take the loss.
That’s not how the real world works, however. More specifically, the big investors buying securitized receivables from these trusts have historically made it clear to companies like AmEx that they have zero tolerance for eating any losses. And these aren’t idle threats. If even one institution gets burned, it’s likely that none would return, and that would render AmEx unable to sell its receivables. Eventually, all growth stops. Then Hannibal Lecter shows up.
So, to avoid having securitized receivables on its books but to entice big investors to buy them, AmEx and other banks/credit card companies have adopted a policy of implicit recourse. In other words, AmEx and the institutions exchange winks while the regulators, accountants and rating agencies look the other way…and no one presumes things will ever get bad enough that some snarky blogger on a tropical island believes it important enough to mention in between fart jokes and pictures of fish.
Reading between the lines of the article above, things are getting a bit preposterous. AmEx is now issuing and buying back its own junior debt, specifically to create a shock absorber that will take the brunt of future credit card losses rather than pass them onto the institutional investors that own its receivables. This seems only a step or two removed from those institutions asking AmEx for the cash directly.
And to say that common shareholders may get thrown under the bus to protect the institutional lenders implies that AmEx has a choice. It may not. Nor is it a problem confined to just AmEx.
Hat tip to Barry Ritholtz and the folks at LSU.
Disclaimer: Cale Smith does not own shares of American Express. This post in no way constitutes investment advice. Commentary on this blog should never be relied on in making an investment decision. Not now, not ever.